As an investor, you should be searching for those unloved companies whose shares are seeking a munificent buyer. However, never dwell on the analyses of a company’s share price. Instead your evaluation should delineate a clear view of the future potential of a company’s financial posture going forward.
Yet, experience has proven that it is a never-ending battle to try and convince investors that you cannot judge the efficacy of a company by its share price performance, high or low. Using methodologies such as discounted cash flow and intrinsic value, you separate yourself from daily market activity, while concentrating on determining a company’s mathematical worth.
Your investment objective should always be to create a return that at a minimum exceeds the sum of the risk-free rate of return. (A good proxy is the rate paid on a 10-year Treasury note combined up with what you will lose through taxes and inflation.)
Then add in a couple of points for the Gipper, as was so profoundly said by Knute Rockne in his “Win One for the Gipper” speech to the Notre Dame players at halftime of the 1928 Army game.
To simplify the equation, consider that the guideline I teach students is try to achieve a compounded annual return (CAGR) over a two- to three-year period of something in the neighborhood of 8-10%, including dividends.
However, even with the best of analysis, there will always be a random component. Even a decision with all the attributes of success can fail for reasons that are unexpected and beyond your control. You are working with probabilities, which dictates that total certainty never exists.
Success entails having an edge. Therefore, your knowledge of a given company must be superior to that of others. This is often not the difficult task it would appear to be.
Unfortunately, investors are often stalwart in their belief that the answer lies in the opinion of others. If you found a successful path to rising returns would you publicize it or debate its worth? Probably not.
This is not the case with professional purveyors of financial wisdom, many of whom favor diametrically opposed methodologies. For example, there are those who recommend investments based of an evaluation of a company’s historical performance as illustrated by a variety of ratios, such as the often-used price-to-equity or P/E ratio, or by extension a CAPE ratio.
These fundamentalists drill down on the basic value of a company and the probability of a rising share price by recasting a company’s outlook via the permutations and machinations of its historical financial data usually in ratio form.
A technical analyst is not concerned with a company’s name or what it does, much less its fundamentals. To a technician, that information is factored into the current share price at any moment in time. Technicians are only concerned with share price and trading volume.
To a technical analyst, a steep rise in trading volume could be an important sign that a stock is ready for a significant break-out or advance, thereby leading to recommending acquiring the shares with little or no investigation into a company’s financial health.
Technicians live in a world of charts, graphs and indicators that require frequent computation. Fundamentalists often scoff at the seemingly never-ending stream of calculations employed by technical analysts.
Fundamental analysis has as a precedent the recognition that a company’s performance and share price develop over a timeframe measured in years. Unfortunately, for many the wait soon becomes too excruciating and they move on.
The opposite is true in technical analysis, which often uses a short time horizon, sometimes measured in minutes or hours. Furthermore, technicians have a greater tendency to sell stocks short. This is due to the belief that technical indicators predict not only movement, but also direction.
Which school of thought has a higher probability of success? Investors will be well served to study both theories and try to draw on the best features of each.
Lauren Rudd is president of Rudd International, an asset management firm. You can write to Lauren Rudd at [email protected] or call him at 941-706-3449. For back columns go to RuddInternational.com.
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