The Fundamental/Technical Combination
For many investors and traders, the choice of a method for selection of stocks and timing is a matter of passionate belief. The true believers in one system are likely to completely ignore the other approach.
A fundamental analyst makes a mistake, however, by ignoring or discounting the valuable intelligence found with technical indicators. Using technical signs to bolster a fundamental program is valuable for several reasons:
- Confirmation is extremely valuable as a means for judging a company and its overall strength. Anyone who picks stocks and tries to build a portfolio of safe, strong, competitive companies is continually seeking confirmation, and on several levels.
- Changes in price volatility have fundamental meaning and significance. Among the technical indicators most important to fundamental investors is the price volatility of stock. Volatility is another word for market risk, and the wider a trading range, the greater that risk. On a long-term basis, you seek strong companies with earnings growth, great working capital, and exceptional management. However, when volatility increases there is always a reason. Technical indicators based on price volatility (such as breakout from previous trading range or expansion of the range's breadth) may serve as an early warning that the company's fundamental position is going through a change as well.
- Combined indicators are basic tests of fundamental strength. Most fundamental investors accept the use of the P/E ratio as a good test of how fair a company's stock price is at the moment; this ratio is even more valuable when studied over the long term and as an annual range between high and low P/E. The trend is interesting because it tracks the market's perception of the company and its future growth prospects.
Key PointVolatility does not change spontaneously or for no reason. It is usually traced back to something changing in the fundamentals.
ROE is an important expansion of fundamental analysis and comparisons between companies. ROE tests and tracks the trend in how effectively the capital invested by shareholders is used to create profits. To some, this relationship is obscure or indirect; however, it does provide a monitoring ratio that reveals how well the company applies its capital to generate profits. The formula requires dividing net return by shareholders' equity:
A second combined ratio is the return on invested capital (ROIC). This is similar to the ROE, but adjusts for dividends paid out during the year. The theory in this ratio is that dividend payments reduce the net return, so using this net is a more accurate indicator than ROE.
The formula for ROIC is:
Key PointTotal capital and total capitalization are vastly diff erent values. Be sure you know which one is being used to calculate return on invested capital.
ROA is calculated by dividing the period's return by the ending value of assets:
Key PointReturn on total assets is flawed; when long-term debt is high and proceeds were used to buy capital assets, the calculation is misleading. Comparing net return to equity is much more reliable.
- The historical value of fundamentals gains context when compared with the current price-based trend. The fundamental record of a company is most valuable when studied as part of a long-term trend. However, it is historical and thus limited, because by today's standard, the entire financial record of a company may be out of date. This is especially true when the mix of segments and markets has changed since the latest reported year. For this reason, fundamentals can be validated to a degree by incorporating changes in technical indicators to identify emerging new trends. If a technical trend (such as increased volatility) is a symptom of changing fundamental status of the company, this merging of both types of indicators makes sense. Using indicators such as trading range breadth and how it changes, breakouts from established trading range, and emerging new price levels (not to mention changing P/E) can all serve as early signals of changing fundamentals as well.
- Exceptional changes in the fundamentals signal emerging changes in price and in price volatility. Traders, like investors, can easily recognize the relationship between fundamental reliability over many years and levels of volatility in the stock price. The more reliable and consistent the fundamentals, the more predictable the price trend within the short term. However, the real value of tracking fundamentals comes when those long-term indicators and trends begin to change. This occurs in both ways. A previously weak set of indicators may gradually develop into a stronger and more consistent record; or a previously consistent set of indicators may begin to fall apart. When either of these fundamental changes is underway, you will eventually see a corresponding change in price volatility as well. And the direction of fundamental trend shift may also anticipate a change in the price trend direction.
- Perception of value and volatility are found in changes in price, but often begin with earnings reports and other fundamental indicators. It is a mistake for technical analysts to ignore the fundamentals. It is easy to dismiss them as outdated or not directly applicable to price trends. Technicians tend to prefer tracking the interaction between buyers and sellers to spot momentum and volatility. However, your current perception of a stock's value is likely to begin with the earnings report, and to follow up with other fundamental indicators. The earnings report is the key to fundamental trends; however, it also leads the technical trend as well.
- Neither technical nor fundamental indicators develop independently; they are connected to one another although separated by time. You may find yourself resisting the idea that technical and fundamental analysis can work together. However, this is unavoidable because they are connected. Thinking that the two schools of thought are separate and distinct is a mistake. They are simply different symptoms of the same trend. The focus on the company and the stock separate the two, but that does not mean they are not related. They confirm one another and, more to the point, changes in the strength of the fundamentals often are the first signal of changes in the technical trend as well.