The decision to invest has only one objective: to obtain a profit that exceeds, in the case of shares, an opportunity cost equivalent to the risk-free asset plus a risk premium. Therefore, any instrument that helps us to make decisions is valid for us.
Starting from the previous premise, we are going to develop a whole article based on the Fundamental Analysis, understanding it as one more tool in the complex world of investment decision making. As with all analyses, we must say that it is not infallible, although from our point of view, it is a useful and reliable tool in the conclusion of the data that is derived from it. The argument that the fundamental analysis provides to the conclusions obtained is an added value in the decision making process.
The stock market cycles
It has been demonstrated that stock markets behave similarly to economic cycles, although this does not mean that the oscillations are of equal magnitude or that they coincide in time.
A first characteristic of stock cycles is that when considering time horizons comprising one or several complete economic cycles, data shows that the higher risk of stock investment carries a return premium over investment in risk-free assets.
The second characteristic of stock market cycles is that boom periods are usually longer than recession periods, and that the average fall in the latter is usually lower than the average increase in the corresponding boom periods, which ultimately explains the positive returns in the long term.
Finally, economic cycles do not usually coincide in time with the stock market. Normally, financial markets react with some anticipation to changes that actually materialize in the real economy, so it is not surprising that we find bullish stock markets in periods of clear economic recession.
Perfect and imperfect markets
Market imperfections cannot be considered as exceptions to a general rule. The perfect market does not exist; it simply constitutes a useful abstraction to partially analyze the existing relationships in the variables studied.
We define rational behavior as a reference to two variables: risk and expected monetary value. If a constant risk is assumed, the concept of rational behavior leads to preferring more monetary value to less. Conversely, for a given monetary value, less risk will always be preferred.
Certainty and Uncertainty
The problem of risk can be avoided, methodologically, by assuming a world of certainty. The elimination of uncertainty in the analysis implies that current or potential investors have exact knowledge of the future or that, at least, everyone agrees in relation to the expected evolution of all the variables contemplated: future income, cash flow, dividends and quotations.
Obviously, the hypothesis of a perfect market cannot be confused with that of a certain world.
Basically, two different methods of analysis have been proposed to address the problem of investment selection. The most widespread method, usually known as “fundamental analysis”, follows criteria based on economic theory to arrive at an estimate of the value of a security that, when compared with its actual market price, allows us to decide whether to buy or sell it.
Against this approach appears “technical analysis”, also known as “graphical analysis”, which is limited to studying market activity, understood as the series of historical data on prices and trading volumes.
The fundamental analysis of securities is based on an economic theory of valuation originally set forth in 1938 by John Burr Williams in his book The Theory of Investment Value, which has been extensively studied and applied since then. The central idea of this work is that the value of a security is determined by the current value of the income it will bring to its shareholders in the future. The discount rate to be used should include not only the risk-free interest rate, but also a premium that reflects the uncertainty or risk of this future income.
The fundamental analysis assumes that there is an intrinsic value for each security that depends essentially on the company’s profit potential. This intrinsic value is determined through careful analysis and forecasting of the economy, the industry and the company. The result of this analysis is a recommendation to buy or sell the analyzed value, which is based on the fact that the market price will eventually approach the intrinsic value thus determined.
The fundamental analyst tends to assume a rational market that is conducted with certain logic valuing the securities based on their growth, dividends, risk, etc.
The analyst thinks that eventually the market price will adjust to the intrinsic value of the security. On the contrary, the graphic analyst believes in a market dominated basically by psychological or emotional reasons.
The fundamental analyst tries to anticipate what will be the economic results of the company under analysis given the supposed influence of these on the price of their securities. To do so, he or she carries out a complete analysis in which a large number of data it is involved, some of which are very difficult to quantify, but which, in short, are synthesized into an estimate of the value of the stock. In open contrast to the above, the technical analyst studies the market activity, without worrying about the nature of the securities that are traded.
The fundamental analyst seems to be oriented towards the decision of which securities to buy or sell and is adjusted to the needs of a medium or long term investor.