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What D’ya Want: Fundamentals Or Technicals?

There is always an argument about whether it’s better to invest using fundamentals or technicals. Fundamentals are about the real deal – the analysis of the company, the valuation, the hidden treasure, the discounted cash flow and the kind of things you build an MBA degree with, the high class suit and suede leather shoes of the stock market. Technicals are the crass, two-bit, torn jeans, long hair part of the market where all that matters is the price and volume and nothing else.

I’ve been torn between the two often but I often find it’s easier to trade the technicals. There are many reasons for this.

Value traps: I have bought stocks that looked juicy when I bought them (for their fundamentals). A low P/E, great earnings, a smooth story. But they just stay that way for a long time. The trap is that you keep thinking there is value, so you never leave; but the real problem is that your capital is blocked for  a long time.

Remember, you can’t just put 10,000 rupees per stock and have a hundred stocks in a 10 lakh rupee portfolio. No, that is ridiculous- there is no way you can keep track of 100 stocks at a time. At best you can track 15 – I find myself having trouble once I cross 10. If you’re going to put 10% of your capital in each stock you invest, it better be the best investment out there, otherwise it has to be replaced.

But how do you tell your mind to ignore what seems like a juicy opportunity? If I find something that looks like a value trap, I put a little bit of money in it, and I leave it be until it shows the right “technical” signs. Currently, the value traps I own are SmartLink and Piramal Healthcare.

Promoters Lie. The data that companies provide you – their profit and loss data, their cash flow statements – can all be legally created so that they provide you a certain picture while the reality is different. In cases of outright fraud, like Satyam, even certified checks by chartered accountants was not trustworthy. In others, it’s the small issue of stuffing losses into different quarters, changing your system of accounting mid-way through a year, merging and demerging until no one knows what your real value is.

There are many ways to trick you. At the face-value level, companies put ads on TV channels you watch, and you buy assuming that if they have enough money for TV ads, they must be doing well. But that’s about all they have money for.

Then there’s the revenue buying. You buy my services, I’ll buy yours, and we’ll show “topline growth”.

And there’s innovative accounting. When the dollar goes down, book hedging profits into your quarterly statements. If the dollar goes up, hide the losses in your balance sheet, revealed once a year, and quote some vague accounting rule that is diabolically wicked but allows you to do this.

The methods are too many, and most are subtle. You can’t expect to know all of them, and current regulations don’t even require the company to reveal them in exquisite detail. But someone does know, and that someone often decides to vote with his money; a signal that might make it easier for you if you trust the price.

The Value May Be Siphoned Off. A company sells a large division for cash. Then it acquires a promoter owned company, valuing the promoter company at a much higher level than one might imagine, and pays cash for it. You sit and watch your value go right out the window, while institutional investors sell the stock at the lower circuit every day.

Less obviously, you will find that the promoter will charge crores for the use of a “group logo”. The promoter will create private entities that do exactly the same work, and later merge them together saying there is “synergy”. An infrastructure firm will win a project to build a road, but give the construction contract to the promoters uncle’s second-cousin, at rates conveniently higher than the market.

You excuse some of this because, let’s face it, it happens; and we only think it won’t be too big. But the risk remains: that you are expecting a person with a crooked bent of mind to leave something on the table for you, just because he has done so in the past.

Where there’s no value, there could be momentum. Chasing momentum is considered a bad thing. Because momentum is fleeting, it’s temporary, and it’s dirty. But momentum is powerful, because it gives wings to those that deserve to fly, and sometimes, to those who don’t. The like of a TTK Prestige that were always doing well got a huge fillip in the P/E expansion from around 10 to about 30, and in the process the stock price went from Rs. 300 to Rs. 3000 in three years. Their profit growth was good, but if you look at other companies with sustained similar growth, you find too many that simply don’t move in price.

Since much of the price move happens before value is visible, you can’t easily differentiate between momentum and value based “rerating”. My theory is to find what are “good” companies – that is, sustained strong profit growth – and wait for a momentum trigger. But increasingly I am trying to eliminate the definition of “good” in my momentum buys, or “bad” in the shorts. For a person with a horizon of less than a year, and a stop loss that is primarily designed to capture price moves, it makes little sense to worry about the antecedents of a promoter.

It is important though to try and see if the price is being manipulated so you shouldn’t get stopped out by the volatility. So don’t worry about the fundamentals, unless the fundamentals say they will use the price to cheat you. Beyond that, it shoudn’t matter.

Fundamentals have a lag. Prices anticipate. Balance sheets respond. The point here is that growth could already be happening in the industry and the profits might take time to reflect. For example, prices of UFlex, Polyplex and JindalPoly went up 2x last year before the profit statements revealed that the companies were making truckloads of business. The issue: prices of a certain type of poly-film (BOPET) had skyrocketed all over the world, a phenomenon last seen in the late 90s when again, polyfilm stocks did well. Sure, if you were following the sector you’d know, but how many sectors can you follow? In comparison, a price-based approach is just track sector relative performance in price and when one sector breaks away, you can go ahead and buy or do more research.

You can get stopped out without doubting yourself. When you do fundamental research, you work the numbers, you build your models and you create that solid pitch. Now, if the stock goes down, you might try to rework the numbers. But hardly anything would have changed.

Let’s say you liked Noida Toll Bridge at Rs. 25 in 2007. Based on your counting of how many cars are being sold in the NCR, how many apartments in Noida, the increase in toll rates every year, and the fact they have already built a bridge and have no more capex, just opex, and your discounted cash flow model says they’ll be laughing from the toll-booth to the bank. And the stock had fallen from Rs. 60 in 2006 to Rs. 25 – surely, a mispricing that you could forever gain with!

The stock kept going up and you stood by it, counting even more cars as the stock went to Rs. 80 in Jan 2008, and you didn’t sell because you’re a “long term investor”, you hate selling stocks or it seemed like it would hit 100 very soon, or whatever. After the financial crisis hit, the stock was back to Rs. 20 in November 2008. So, disgusted at this stupid market, you bought some more, averaging your cost to Rs. 22.5. In fact you bought so much more that your average was near Rs. 21 now.

The stock then recovered to nearly Rs. 50, and you decided you won’t be so stupid and sell if it reaches Rs. 75. It didn’t, and you continue to hold it in March 2012 when the
stock quotes at a miserable Rs. 23. It’s been five years, and you have made just 10%, when you could have put your money in a 6%-a-year fixed deposit and made 33% instead.

The lesson is that when you do fundamental analysis, and the stock drops a lot, you find it difficult to doubt your own analysis. Yes, the number of cars coming from Noida has gone up. The tolls are higher. Nothing has changed! So obviously the market is wrong since the stock price has cratered.

The power of using the price instead is that you don’t have to feel that smart. The price tells you, and the bhaav is boss. Yes, the price can be manipulated to make a fool of you, and you learn to avoid (or reduce quantity of shares bought in) those situations. But most of the time, prices move for reasons that aren’t, and never were in your control. So it’s easy to accept that you’re getting the heck out because a stop loss has been hit, and you don’t know why.

Life is fundamental. You choose your car based on comparisons, you get into a business because of careful analysis, and you choose your career after deep thought. But in the stock market, if the goal is to make money, the only thing that matters at the end of the day is: Are you making money?

It doesn’t matter if you’re the biggest, baddest, awesomest analyst out there. It doesn’t matter if your analysis of 600 different parameters comes to a stock value that is to the order of 50 paise here or there. It doesn’t matter what you think, who you are, what you do. All that matters is your bottom line. That’s why you are in the markets. Profit is a dirty, stark leveller. But if you’re running your own money and you say you’re in the market for any other reason than to profit, I think you’d be lying.

Segue: Apologies to those who make a living doing analysis, building models, selling approaches, providing tips ; there, it matters that you did everything you could have done and used an intelligent approach, even if you lose money. I say this even though I am in your camp, where the writing, analysis and consulting helps me with a living. I think truly that the nature of the game is not the intelligence; it’s finding out what works for each person, and exploiting that to the maximum.

If you don’t make money in the market, but make it for yourself, that could work too. John Merriwether of LTCM fame lost money in three funds and was able to raise a fourth, very easily, because he’s the kind of guy that is smart, and demonstrates he’s tried really hard. Some venture capitalists – okay, many VCs – don’t end up making money for their clients, but get paid more than 50 lakhs a year, even after lost-cause investments. These people are way richer than I am, so by the same “profit” yardstick, they are successful, and I am wrong. But you really have to find out what works for you, and deal with its inconsistencies.

Back from that segue.

I find that although I employ both technicals and fundamentals to trade in my discretionary portfolio – I screen for stocks using price and fundamental patterns, wait for a “momentum” trigger to enter, and use price based stop losses (trailing stops or MACD exits). But I’m missing way too many opportunities in what I believe are “dud” stocks. The question the market always seems to ask is: So how much do you really know, boy?

This is a part of a chapter in a book I’m writing about trading. Warning: unedited material – I expect this piece to get condensed to half its size, but the gist is in. Tell me what you think?

  • Saravanan V says:

    fantastic ! right on the head..
    ** I expect this piece to get condensed to half its size** – make it double I say..

  • Nilesh says:

    I too belong to the camp which looks at fundamentals (thanks to the MBA days knowledge) and technicals (learned this out of curiosity but started giving results) but if I find technicals compelling, I believe that Fundamentals will follow.

  • Ravi says:

    you write well. you create mystery and adventure in money. double your writings!

  • Mehul says:

    you obviously write well, and you know it! So I am not saying it 😉
    IMHO, (mainly for the book), it would be great if you are able to give lotsa examples of price moments (like here, TTK, et al.) and also attempt at describing pros and cons of fundamental analysis (again, can demonstrate some fantastic fundamental stories played out (and not played out) in the past (Titan?). I have been avid reader of your posts and have learnt a lot (not yet implemented yet), mainly from MV posts about trend based investment strategies. I am hoping your book is on the same subject (or is it more macro?).
    Do lemme know if any “mechanical turk” (and pro-bono for you) work is required (proof read, checking pagination, cross-ref, absolutely no financial knowledge ;-)).
    Book pre-order possible? 🙂

  • shankar says:

    Nice post. Reminds me of the old gujju market limerick, Market su che? Bhav bagwan che, vadhare vadhare levanu, gasare gasare vechvanu.Loosely meaning Price is God, Keep buying as the price goes up and keep selling as it goes down

  • Praveen says:

    Too gud one 🙂

  • Raja says:

    One of the problem i have always had is in understanding how much %tage returns do the traders (both great and normal folks) make over a really long period of time. say 10 years, 20 years etc…
    I mean every T,D & H know how much %tage return Mr. Buffet has made over last so many years or for that matter so many other lesser known value investors (or normal long term investors) have made. But there is hardly much news about the traders. May be you can shed some light on that in the write just build up the case for traders 🙂

    • That is a darn good point. Must check it out. I know that there are recorded instances of 10 yr+ gains of over 30% p.a., and I know traders who have built a fortune with next to nothing (a gazillion percent return 🙂 ). After a certain point it’s tough to be a pure trader in India since there is no liquidity – so if you haev 5000 cr+ then pure trading is difficult, you’ll have to do some longer term bets as well. But hey, that is good enough 🙂

  • Suhail says:

    Seconding saravanan’s motion. Why condense, otoh this topic has solid scope for expansion. And very well written too! Do maintain this tone in the book.
    This article reminds me of yr other article ‘school of hard knocks’ – bottomline for every investor should be ‘have you made money’? And wrt that as a newbie I’ve been trying to settle down in my own rhythm – trying to find what works best for me.
    FA vs TA: One advtg in FA world is that there are lot of wise guys, both of yesteryears (Buffet, Graham et al) and current fund mgrs (GMO, Klarman etc) and in general a pantheon of popular must-read material. Every once in a while we can go back to these and glean some learnings from them. I find similar must-read books/guys lacking in TA pond. Or maybe I haven’t been introduced to that world. Any reccos for the same?
    Also, I’ve observed that somehow TA world tends to attract more punters, operator type people; it just messes up with amateur/newbie’s takeaways.
    Also, my earlier offer regarding your book stands 🙂
    (hopefully comment goes through this time – lets see)

  • Deepak says:

    Smartlink, Piramal, and now numeric power are not value traps – they are greed traps of promoters thinking they own 100% of the company assets when they own < 100% of the equity in the company – you have highlighted it and we have seen enough cases… lack of any corporate governance and democracy and pliant lawyers, tax advisors and auditors stack up the odds against a minority investor… What you see is definitely not what you get in Indian listed mid caps ( and most of large caps!!) – I see you shifting to a trader from a fundamental value investor mindset….interesting to read you trace that journey.

  • Rajesh says:

    Good write up .
    I started investing with FA and later switched to TA later.
    So far I was not able to accurately project the earnings of the company for which i am working even though I am in the middle of action. Then How can I expect to analyze and accurately project earnings of other firms which operates in other sectors and industries.
    You can always read a lot of useless analysis written by some analysts who gets paid for that. Then you can speak to your friends and relatives and pretend to be an expert in the field . That is all.
    Either you should be lucky or you must get inside information to make money with FA.

  • prabeesh says:

    I am buying it!
    Not this article but the Book 🙂

  • prabeesh says:

    One question on this blog entry
    When you say “Momentum Trigger” how long is it. I mean can a person take dip into the Momentum stock in a months time or is it within 2-3 trading sessions.
    If its small window of opportunity ,,how much of it will we be able to capitalize on?

  • Sachin says:

    For newbie TA is even more difficult than FA. So for them its best to buy decent company with good fundamentals (read analysis some where free of cost) than go for wild and risky TA bets. As they even don’t know where and how to put stop loss.

  • There is no such thing as being half pregnant. You have to follow through fully if you want to do fundamental analysis.
    Fundamental analysis of a balance sheet would not work if you do not read the schedules. Most of the stuff you mention would be caught if you read the schedules and not just the broad numbers.
    I do agree there are value traps. If however you are prudent and have an apropriate check list you can avoid them. You don’t have to buy all stocks that are under valued.
    in the example you used of TTK prestige …. Did you compare the right peer like Hawkins, Gandimathi …? Did you compare the under valuation at 300 or the over valuation at 3000? Is it a broad genralization or a sensational example to bring out a point ignoring the other point of view.
    When you used the Noida toll Bridge example have you measured the underlying value or just the price as in technicals ? If noida toll bridge is a value trap how did it go to Rs. 80 was it a value trap then or was it technicians running in at unsutainable value ? Did you use assumptions or was the growth expectations in the top line numbers ? fundamental analysis is not about expectations which are forward looking. Most importantly Fundamental analysis is about patience and reversion to mean.
    Attributing ones failure to use of any stock picking technique is fooling oneself. Tchnical analysis used wrongly can also cause disaster . The question is when implimenting a wrong technique in tecnicals or funamentals where do you lose more?
    >Disclosure : I don’t own any of the stocks mentioned , nor have I seen teh numbers in depth . Thats why the questions ?

    • Fundamentals have no stop losses, do they? technicals do – and it’s way easier to do right. Plus even with schedules, companies lie big time. Heck, I’ve even shown here how ICICI bank gave different information about how much provisioning they had done in earlier quarters! (And it was not in the schedules, where they give you one big number – it was in the call transcripts where they told you much they did each quarter)
      TTK Prestige and Hawkins etc were all undervalued for a while, and suddenly moved up. That concept applied to the likes of VIP Industries and Bata as well. Momentum really rocks.
      Overall you have to figure out what works for you. I for one think the fundamental zone is much more shaky than the one with technicals. Others needn’t feel the same way.

  • Rudra Chowdhury says:

    The whole school of Peter Lynch and finding “multibaggers” is based on FA. If one is quick to spot opportunities and identify the underlying growth story, it’s only a matter of time when earnings would follow. And price is a slave of earnings in the long run.
    Although TA sounds pretty good and comforting with strict stop losses, you do not get to play the momentum stories. There are plenty of examples in stocks like Titan, Page, TTK, Bharti, Pantaloons etc which have returned many folds over the course of 5-10 years. I doubt anyone playing on TA only hardly plays for more than 1 year horizon. The constant churning may feel soothing, but they miss the eighth wonder of the world – steady compounding.

    • I’d wish the Peter Lynches the very best 🙂 But different things work for different people – Enron for instance was a fraud, but before it was uncovered it was a fantastic company with fantastic earnings. Global Crossing, Worldcom or some of the lesser known evils were also great before they weren’t. Btw, TA does play a huge role in momentum stories – I played TTK with a wide stop – have gotten in and out twice, but managed to make the meat of the move from 400 to 3000 (missed about 400 points, and have been able to deploy elsewhere). I know people who’ve done it with Titan, with Pantaloon (where they have ridden it both up and down), and Bharti – again, up and down. The idea isn’t to discount a strategy, but to say what works for me, and why fundamentals alone is not good enough.
      TA Players do end up playing longer term- I held TTK for nearly 2 years through the move up.

  • Sanjeev B says:

    Hi, you say “it makes little sense to worry about the antecedents of a promoter”. I personally feel it’s the one thing you shouldn’t ignore. If a promoter has a clean reputation, there is less chance of losing value or getting caught in a deck-of-cards build up. For example, after knowing that Raju of Satyam paid Rs.400 crore for IndiaWorld in 1999-2000, would it be prudent to trust that management?

  • Vigi says:

    Hey, nice post Deepak. I look forward to the book.
    This is a battle I’ve been fighting all my life. When each side has finished bashing the other, I say use what works. As Dylan says, “Dont speak too soon, for the wheel’s still in spin…”
    The undeniable question is, ” what to do control?” – Return? Nah, you take what the market gives you. The ONLY thing you control is your risk – what you can afford to lose without looking at financial ruin in the face – even if its only MTM. Risk, and a few other equally important things like 1> number of stocks in the portfolio (the barometer I use is -hold only as many positions whose stops I / my dealer can pull in a gapped long trending day, before the impact cost goes out the window), 2> who your client/boss is (both need to buy-in completely into the way your system works, the ups and particularly the downs) 3> how much to risk on each position etc