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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?

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