The Technical-vs-Fundamental Debate

It is often said that stock markets, cricket, politics, and Bollywood are among the favorite topics of discussion for Indians.

Steady gains in the stock markets over the last few years have further stoked this interest. Investors have made money through not just direct investments in the equity market, but also through mutual funds. And this, with relatively lesser efforts as compared to other asset classes.
 

As a result, “Market kya lag raha hai?” or “Kya stocks lena chahiye?” are among the frequently asked questions when one is referring to stock markets. A lot of investing and trading in India, in fact, happens based on tips and recommendations taken from friends and family or media, especially television and digital.

This brings us to a key point of discussion - how does one make the judgment of what shares to invest in - be it for the short, medium, or long term?

How Are Stocks Assessed, and What Are Valuations?

The analysis of stocks - essentially the companies whose equity they represent - can be broadly divided into two categories: fundamental and technical analysis. Both these methods of evaluating stocks follow different ideologies and have their strengths and weaknesses.
So what are the key points that one must know about each of these methods of evaluating shares? Let’s get an overview:
 

Technical Analysis

• This method uses data - price and volume - of shares to identify patterns created on their charts and then uses this reading to identify trading or investment opportunities. Technical analysis can be used to get signals for both buying and selling of shares, but a technical study of shares is generally more conducive for investing in shares from a near to medium-term perspective.
   
• Like most valuation methodologies, technical analysis also works on certain assumptions. One of these key assumptions is that prices tend to move in a particular fashion, and these movements are repetitive in nature. This means that technical analysis uses historical data to understand if the movement, and hence, their pattern on charts are repetitive. This helps analysts predict whether share prices are likely to move higher or lower, and to the extent to which they could see movement.
   
• Another assumption in technical analysis is that the current market price of a stock is factoring in all publicly available information. This means that this methodology assumes that shares are discounting all information and are fairly valued, which may not always be the case.
   
• A basic tool for technical analysis is charts - that is the graphic representation of price movement through bars, lines, and candlesticks. The volume of shares is an important aspect that is taken into consideration, often to confirm the trend that is being indicated by price movement.
   
• Another important aspect of technical analysis is the time frame for which the price movement of the shares is being analyzed. Charts can be studied on an intraday, daily, weekly, and monthly basis, and increasingly, analysts are using this methodology in combination with fundamental analysis.
   
• While technical analysis can be used across asset classes - that is equities, bonds, currencies, commodities, and derivatives - a key requisite is that the market must be liquid. This is so that a relatively small trade does not skew prices.
   

Fundamental Analysis
 

• This method primarily delves into both the qualitative and quantitative aspects of a company with the goal of arriving at the intrinsic value of the asset. This is often also referred to as the fair value of an asset.
   
• This method also takes into account the various macro and micro-economic factors that could impact the stock price.
   
• Once the fair value of the company’s share is arrived at, it is then compared to its market price, which indicates whether shares can be bought or sold. Simply put, if the market price of the shares of a company is lower than its intrinsic value, then the shares are referred to as undervalued. This means that there is headroom for the prices to go up from the current levels, and hence, the shares can be bought at the current levels.
   
• Similarly, if the intrinsic value of a share is lower than its current market price, it means that the shares have already discounted further positives, and are, in fact, overvalued. Because of this, there is a probability that the shares could see a correction in their price, and hence, investors can consider selling these shares.
   
• The fundamental analysis of shares, though, is not just divided into just a ‘buy’ or ‘sell’. Depending on the upside or downside expected in the share price, there are several recommendations that analysts may have. Some of these include ‘buy’, which means that the shares can be bought at the current levels, or ‘add’, meaning that investors can accumulate these shares on correction. A ‘hold’ rating means that no action needs to be taken at the current levels, while ‘sell’ means that investors must look at exiting the shares at current levels.
   
• Some of the most commonly used methods for the fundamental valuation of shares include the price-to-earnings method, the price-to-book-value method, and the discounted cash flow analysis method. The method of valuation chosen for a company can vary from industry to industry, based on what works best for each.
   

Conclusion

While one cannot compare which method of analysis has an edge over the other, a prudent strategy would be to use whichever methodology works best in a given situation, while sometimes combining the two for a more effective outcome.