Fundamental Analysis: Why Does It Go So Wrong?

Step by step fundamental analysis

Try to check headlines in some of investing media (blog or youtube channel). You will find articles like: “Why Nvidia rise 10% today” or “S&P500 down 5% due to job report.”. Or try to read conversations in the community like Reddit, ” Panasonic is battery stock due to its status as Tesla supplier.” We tell you, this is not fundamental analysis.

. . .

Too Long, Didn’t Read

Financial Analysis is not Fundamental Analysis

Okay, a company with increasing earnings delivers a satisfying capital gain. So, we just need to find a company with that characteristic, buy it, then let the time do the magic to compound it. Simple.

But. Practically, it isn’t that easy.

Like any other part of life, sometimes you win, sometimes you lose. Imagine you buy Nokia in 2008 – a year after the subprime mortgage crisis. Nokia fulfills the characteristic. In 2008, The Swedish company generated almost 75 M in earnings -a rose of 175% from its 2005 figure. We know how this ends, – at least today. Nokia and its Symbian were eroded by a wave of Android smartphones.

Revenue in thousand
Revenue in thousand

Increasing earning doesn’t guarantee the result. And it is not only Nokia. We have another example from General Electric during the same period, 2005 to 2008.

Ever heard value trap? Nah, this is what we call a growth trap.

Psychological Standpoint: God of Thunder

“You know nothing, Jon Snow.” | Ygrite to Jon Snow

Humans need a reason – an explanation. From the beginning, homo sapiens are extremely curious about something that is unusual, supernatural, or beyond their comprehension. At the neural level, it is due to the behavior of the nerves that try to connect the dot between thought and information.

When the caveman sees and hears the thunder, they are feared. Then they begin to seek the answer. Even from cavemen’s standard, “Not knowing” make them feel intimidated. Eventually at some point, Human has created Thor as an explanation. No, not Chris Hemsworth Thor.

Thousand years later. Humans exist on a trading floor. No thunder-wonder. But the curiosity stills. Humans, or, in this case, investors, seek explanations for every market movement. Thus we have a headline like “Apple stock rise 10% after beat earnings”.

This is the beginning of the thought that every movement is dictated by finances.

Which it isn’t.

Our recommendation is, that investor, or human, has to learn that sometimes, something just happens. Sometimes, an event happens at random. No, don’t tell about God’s plan here, go to church if you need to hear God’s voice on Roman 8 verse 28.

Sometimes something just happens. So do price movement in a short period of time. Humans try their best to explain, the breakout, support resistance, rejection, volume imbalance, new impulse, well…man, it just happens.

Like thunder, it is not Mjolnir’s, it is nature. Price movement is the market’s own nature.

News Analysis isn’t Fundamental Analysis.

If the financial figure doesn’t do the homework, investors try another way. They turn their head around to the news. The logic behind this is finances are the result, thus there is something that creates that figure, as the old saying “buy the rumor sell the news”.

So, instead of focusing on the figure, why not find something behind that number? Which lead (actually the correct word is “mislead”) investors to the news.

The problem is, as humans, investors tend to generalize and make a pattern. This is our habit, we love patterns and order. Take Amazon as an example. The Seattle-based company gets huge success due to its new business model that disrupts old-school retailers. Investors often mistakenly generalize this concept. They often think that every new business model which against the conventional business will always lead to great success.

If it works for Amazon, Facebook, Apple, or even Google, it doesn’t mean that it works for Lemonade, Uber, or Teladoc. Not every new and revolutionary business model delivers success.

Try to peek this:

Psychological Standpoint: Leonardo Fibonacci

source: wiki

Human works and behaves in order and pattern. They sleep at night and work during the day (sorry, night shift). So it is unsurprisingly that humans like to extrapolate, love patterns and predictions. And it is mandatory from the evolutional standpoint. Knowing your predator hunting pattern as well as your prey behavior helps a lot to survive in the wilderness thousand years ago.

In Millenium, homo sapiens still love the harmonics. Humans speculate who make coronavirus in Wuhan, they speculate about Illuminati, Freemansion, and Rothschild clan. Like we have said before, humans can’t accept that something just happens. Sometimes.

We have seen many explanations for market movement from the Fibonacci pattern, Elliot wave, fractal, alligator, price action, and market cycle. All crap. Even the news.

2020 is a perfect example of how news analysis fails. That year has an unusual combination, the worst pandemics in human history and a rising stock market. To add more irrelevancy: more than 5 million Americans are unemployed.

This is Wall Street – Main Street irrelevancy.

You can’t compose fundamental analysis just by reading the news.

Formula Analysis isn’t Fundamental Analysis

Some investor thinks that performing simple formula like PER, DCF, and PBV, is equal to fundamental analysis. That is formula analysis, not fundamental.

Honestly, formula analysis falls in a deeper pit than the previous two.

If a financial figure doesn’t guarantee the expected result, how about the formula or ratio derived from that figure?

Psychological Standpoint: Less is More

“Everything is simple, but not simpler” | Albert Einstein

Human loves simplicity. Sometimes, they try to comprehend complex phenomena into simple explanations or even formulas. In investing, the day trader is an obvious example. They try to understand the market – which is a representation of human psychology – only with price action. But they aren’t alone. An investor who relies solely on formulas like DCF or PER also has the same psychological bias.

In ancient times, humans just say that Thor strikes with the thunder. In modern days, we know that it is an electron that flows through the sky due to extreme potential differences. The investor who thinks that could understand the market with oversimplification is like our prehistoric caveman.


Redefining Investing: It isn’t Queen Gambit and You Aren’t Beth Harmon

I like playing chess on my smartphone. The rule is extremely fair. Both of us have the same pawn, knight, bishop, king, and queen. We move in turn. The outcome of the game simply depends on the player’s skill – little or almost no luck.

Investing is the opposite of chess.

Investing is just like any part of life. It involves many participants, events, and components. All of those are uncontrollable. Retail investors face more complex situations, they have no insider information, limited in budget and knowledge. It looks like facing a full house with only double pairs.

Fundamental analysis – the proper one, is a bridge of that gap. Along with psychological skills, investors could beat the market in the long – long run.

Put Financial and News Role At The Best Place

Both financial and news analysis isn’t fundamental analysis but it doesn’t mean that they are useless. As we have said, investing is part of a multi-component that relates one to another. Fundamental analysis is the same. Financial analysis and news analysis can be incorporated with another analysis to cover the blindspot.

Composing Fundamental Analysis

This is what you are looking for.

After redefining the fundamental and correcting the misunderstanding, here are our short guide:

  1. Identify and measure the economic moat or competitive advantage of the company. A company with a durable competitive advantage has more predictable earnings. Understanding this will help you avoid investing in a growth trap company like Nokia or GE. Measuring economic moat or competitive advantage could be performed in several ways. Investors could use Porter Five or SWOT analysis. Or use morningstar characteristics like switching cost, economies of scale, intangible asset, or network effect. Recognizing the economic moat makes your financial figure more meaningful.
  2. Analyze what management does. Years of good hard work can be ruined by careless policy. eBay has a network effect before Amazon, but management policy crushes the company. Investors need to ask when analyzing certain companies: does management create more value for shareholders – or destroy it instead? This management action could be tracked through financial reports. Do the dividend was paid too much? Do companies rely heavily on debt? Do companies make a too expensive acquisition? What company strategy for growth? Investors also need to pay attention to the news. The first question is whether the news has a long-term impact on the company. News like CEO change or acquisition has a long-term effect on the company. On some level, it could reinforce the economic moat or erode it.
  3. With the given price, do you willing to pay it and get what you have analyzed in points 1 and 2? Along with pros and cons.

Don’t get me wrong. These 3 points are far from simple. For instance, if you want to identify the competitive advantage of a company like Nvidia, at least you have to know – yet not too detail – about the data center, and about gaming graphic cards. You also need to know about accounting to confirm your judgment from its competitive advantage. The difficulties of Nvidia are surely far different from the retailer business model.

More Bad News: Investing and Life

Unfortunately, the fundamental analysis is only part of investing – the analytical part. Another vital component of investing is psychological skills. That is, buy your company when the market dumped it or buy something that is unpopular. This needs steel nerves instead of excellent analytical skills. Analytical is difficult but to act accordingly in uncomfortable situations based on that analysis is almost impossible to do.

Wait, don’t get misunderstood here. We don’t tell you like other blogs or books that said psychology plays 80% of your investment. Nope. Your analytical should be right before the psychological blindly follow it.

Any decision-making should be based on correct assessment.