Friday, September 11, 2009

Why Fundemental Analysis?

"An object [business] at rest tends to stay at rest and an object [business] in motion tends to stay in motion with the same speed and in the same direction unless acted upon by an unbalanced force."Newton's First Law
Investing is done successfully by understanding direction, and velocity, but not by looking at velocity alone.

The Problem With a Velocity Only Focus

Velocity is the speed at which a company is rising. Direction is which way the company is pointing, up or down.

I see so much time spent in the general media trying to predict the future, trying the estimate the velocity of success a company will achieve over the next ten years . This will likely come as little surprise but analysts have absolutely no idea what will happen next year with the company let alone the next ten. This is what I mean by velocity. If a stock analyst spends 100% of their time trying to anticipate the speed at which a company will rise in the future without the aid of a crystal ball of some sort they are most certainly wasting your time.

Why Direction is More important than Velocity
I am not saying the activity of velocity analysis is without merit, velocity is the spice you add on the top of the meal, but not the main course itself. What you really need to understand is what the past can tell you about how the company is run and how healthy it is. Consider this quote from Martin Fridson's from Financial Statement Analysis: A Practitioner's Guide:
"What financial analysts are actually seeking, but are unable to find in the financial statements, is equity as economists define it. In scholarly studies, the term equity generally refers not to accounting book value, but to the present value of future cash flows accruing to the firm’s owners."
The chief purpose of fundamental analysis is then to achieve an understanding of the true equity of a company. What is that business really worth, how does it work, how does it make money. By becoming engrossed in these details a full understanding of the direction of a business can be determined.

Combine the Two

Determine the direction of a company first, spend the majority of your time here. Once you are sure you aren't dealing with the poseidon then start looking at the velocity. Worst case if you are wrong about the velocity at least your ship will still be pointed in the right direction.
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  1. This is quite a nonsensical post...
    Newton's law was developed by observing physical objects and actions in the real world. To substitute "business" for "object" would be appropriate only if all the other physical laws of nature also apply to business...which they don't. Furthermore, "velocity" is NOT "speed". Quite the contrary ... "Speed" is the magnitude of the velocity. Velocity is a vector quantity that encompasses both speed and direction.

    I am not suggesting fundamental analysis is not worthwhile... just that it has nothing to do with nonsensical comparisons to physical rules that don't apply.

  2. Great post I get it. I am tired of listening to chart people yack about heads and shoulders.

  3. Hi Anon,
    Ah a physics argument in a financial post- sounds like fun, I am in! Sorry that the quote didn't work for you. The point I was trying to accomplish with the quote is this. A business's future tend to strongly correlate with its pasts. If you take the time to understand the plane that the business operates on you are far more likely to understand where it is heading. That is not to say that some other object will not interrupt, but your ability to anticipate a future event of this sort is somewhat inhibited now and approaches impossible as the time frame extends.

    From an epistemological perspective Newton would probably agree with me on this adaptation- assuming he had any interest in financial matters. Newton rejected knowledge not based a posteriori, his laws don't make room for maters such as the sheer speculation of future events.
    As to your argument that for this adaptation to be valid it would have to be valid for all physical laws, I would argue that Newton's own laws don't even work for all physical laws, quantum laws fly completely in the face of several of Newton's laws but I still believe in gravity. So I stick by my quote :)


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