In this lesson we explain the two popular approaches to stock research: technical and fundamental analysis. They are often viewed as opposites by their most ardent advocates. Here we define both analytical methods and how to use them, with reference to a real-world example.
We also explain why a pragmatic stance that applies the strengths of both approaches is best, but with fundamental analysis being the most important of the two, although that may ultimately depend upon whether you see yourself as primarily a trader or an investor.
What is technical analysis?
The word in itself can be off-putting to novice investors, but at its simplest is focused on the changes in the stock price and the interplay of buying and selling in determining those changes historically. Put another way, it is the study of patterns in price charts for clues as to the future direction of travel of a share price.
This in itself tells us the most important thing about technical analysis, which is that it is mostly used by traders for short-term positions or for longer term investors trying to set entry and exit points for their stock positions.
What is meant by ‘technical’?
Technical analysis is described as such because it attempts to divine from trading patterns seen in price charts an explanation for price movements and to discern indicators that can predict where the price might go next – the analysis is technical in the sense that the conclusions drawn are solely or largely dependent on what can be read and interpreted from stock price charts.
Why historical prices are important
The breakdown and dissection of a stock’s price chart is an important part of stock research because it allows an investor to quickly digest the historical movement of a stock’s price.
For example, you could bring up a realtime price quote for a stock, but that price in isolation is not much use to you unless you have an idea of what preceded it – in other words the context. Is the price trending up or down, would be the first thing you might want to know – all a price chart does is tell you for any given period in time the history of those price movements. This is the starting point for all technical analysis and the types of indicators to be deployed to deliver actionable predictive power.
How technical indicators make sense of investor psychology
Technical indicators can quickly move from the basic to the relatively more complex by not just looking at price level, but also the factors such as trading volumes, moving averages of the price, how a stock price behaves in relation to the overall market, indices or stocks in the same industry.
Ultimately a price chart is a window into the collective psychology of buyers and sellers.
Technical analysis seeks to answer the question, what will market participants, taken as a whole, do next?
And because the collective of buyers and sellers is not really a collective in the sense of consciously coordinating their actions among each other (that would be considered market manipulation, known as working ‘in consort’), the task of the technician can lend itself to every higher levels of complexity in pursuit of more deeply understanding and predicting how the sum of all the individual trading decisions of market participants weighs up to explain where the price is in realtime, as well as were it may be heading.
What is fundamental analysis?
Fundamental analysis, as we mentioned, is often viewed as the diametrical opposite of technical analysis, and as such the methods and tools adopted with this analytical approach are different. Instead of focusing on price dynamics, the fundamental analyst is concerned with determining the actual value of a stock and viewing its price in that context.
Why company performance comes first
Whereas technical analysis starts and finishes with price movements, fundamental analysis is centred on the performance of the company itself. From this perspective, the price of the share is but one input of many.
As the name implies, it is the fundamentals of a company’s business, such as sales, revenue, income, profits, margins, debt, competitors, markets and more, that will be the bread and butter of the analyst investor.
Indeed, it could be reasonably argued that fundamental analysis is the more important of the two approaches for investors, as opposed to short-term traders.
In these lessons we have armed investors first and foremost with the tools to conduct fundamental research and analysis.
Why it helps to invest in what you know
The investment maxim to invest in businesses you know and understand amplifies the importance of having a handle on the fundamentals of a company.
At its simplest, this means asking questions such as, is the company profitable? If not, why not? Are there any mitigating circumstances? Are there prospects for future growth that mean current losses could turn into profits down the road?
Answers to those sorts of questions require an investor to be able assess the strengths and weaknesses of company operations and profitability, return on capital, its sources of net income, levels of capital expenditure and all other relevant information and data about its business and trading history.
However, fundamental analysis is not just about the information that can be gleaned from a balance sheet.
What is a bottom-up style?
Fundamentals extend to the very human attributes of a company – its management team for example, the quality of its employees, the culture of the company and so forth.
This is why fundamental analysis is sometimes referred to as a ‘bottom up’ style.
As such, one reason why some investors prefer to invest through mutual funds is because of the greater access to company management that analysts at fund management firms will have in addition to all their other resources.
What is the importance of ‘kicking the tyres’?
Institutions such as the giant fund managers Fidelity or Aberdeen Standard, have analysts positioned all over the globe with expertise in specific regions, sectors and industries. They will often make visits to the companies in which their firms invests in order to ‘kick the tyres’, where they can see first-hand the business at work and ask pertinent questions of the management team.
Taking this further, professional analysts will have the resources to, for example, delve into the supply chains of the companies they are interested in, for clues as to how the company is actually trading, so they can make their forecasts or select them for portfolios.
But individual investors can also do this sort of fundamental research, to some extent – or access it via their brokerage account or some high-quality financial websites and stock apps.
For example, perhaps you have an investment in ABF, owner of Primark. You visit the store on a number of random occasions and discover it is always full and there are queues at the till. That could tell you that the store is popular but also that it could perhaps be selling more if it organised its stores better to increase throughput at the tills. This might not seem like stock analysis, but it is.
What do we mean by a top-down style?
Fundamental analysis doesn’t just include the bottom-up perspective but also a bottom-down one too. What does that mean?
Taking this perspective, the investor takes into account macro and market-wide factors that can impact upon company trading conditions and performance.
With this approach, investors will bring into the mix considerations such as how, by way of example, a trade war between the US and China might affect a company’s sales if it has a large proportion of its customers in China or it relies on imports from China in order to manufacture its products and faces higher costs because of tariffs.
Or perhaps you are investing in financials, in which case the direction of travel of interest rates will be a major concern – the higher the interest rates the more leeway there is for banks to make profits on their loans; the lower the rates the harder it is.
Why you must keep an eye on corporate actions
Other developments, this time directly under the control of the company, can play a big part in determining the behaviour of the share price. Such events are referred to as corporate actions and can include things such as the company buying back its own shares, announcing dividend payment increases or cuts, director dealings, mergers and acquisitions and the comings and goings of key personnel.
How technicals and fundamentals overlap
Corporate actions can be placed in the fundamental bucket but overlap with technical analysis in that they can usefully be integrated into a price charts to help explain underlying price movements. Doing so enables the investor to see at a glance how a particular corporate event may have impacted the price in the past.
We could add to this the things that can be predicted with certainty, such as events on a company’s calendar of financial statements (same for economic calendar ‘macro’ events). Often, these events can be market-moving, although it is difficult to discern in what direction prices might move as it would depend on what is actually released in the company financial report.
A company that has been a pandemic winner, for example, such as a cloud computing stock, might have results upcoming, and reports from the marketplace suggest it has been putting on new customers at a steady clip. It might therefore be worth buying some shares before the report to be in position to reap the benefit of any rise in share price on the day of the earnings announcement.
Fundamentals and technicals: how investing timescales influence analytical approaches
Again such decision-making considerations depend on your timescale for investing – whether you are taking a short-termist trading view or are investing – as investors should – with a longer view. If its the latter, certainly you will want to time your entry as favourably as possible, but this is not the major consideration; you have presumably already decided through fundamental analysis that the stock will appreciate in price because of the strength of its business, therefore the exact buying price, while not irrelevant, is not the most important things. For the trader however, timing is all important and technical analysis an essential analytical approach.
What is momentum investing?
We should add that momentum investors – those who buy shares on the basis of their strong price momentum over a preceding period, will also, in addition to availing themselves of an overview of the company fundamentals, will also want to study the price chart technicals because the nature of the investing strategy requires it.
How to apply fundamental and technical analysis: Pets At Home (PETS)
At the time of writing (Monday 23 November 2020) this lesson, Pets At Home share price has opened higher for the second consecutive trading day. Market participants appear to be buying in advance of its interim results that will be released at market open at 8pm on Tuesday 24th.
What the fundamentals analysis shows
Let’s begin with the fundamental analysis of Pets At Home. Our starting point is its most recent statement – fiscal year 2021 first quarter results, which we can find at the dedicated investor section of its website: Investors – Pets at Home Group plc
After reading the interim trading statement looking at the report and the chief executive’s commentary therein, we learn important details about the state of the business, as it grapples with the effects of the Covid pandemic and the lockdown in the first half of the year, which we list below, with what we consider to be the most significant points for prospective shareholders highlighted in bold:
- The company chose not to take part in the government job retention scheme; Covid-related costs “remain elevated” but it has a healthy balance sheet.
- Pet ownership is growing and the firm has positioned itself for that.
- Subscribers are up 18% for the quarter, year on year.
- It is investing £48 million (gross) over five years in a new fulfilment centre for both stores and online.
- The company’s previous shift towards an “omnichannel” approach is paying off, and it is doubling down on that agile approach, with its investment in the new fulfilment centre will rationalise its previous legacy set up.
- Investments in IT infrastructure and e-commerce are already paying off by providing the firm with actionable insights into customer behaviour allowing it to segment its audience.
- The CEO says “momentum returning across all area of the business ahead of our previous expectations, and the company provides a table breaking down revenues before and after lockdown to show this.
- But that positive news come with a large caveat: “…it could be misleading, at this stage, to extrapolate our recent exceptional momentum across the rest of the year”.
- Total group revenue was down 1% in the 16 weeks from the 27 March to 16 July, with Vet services the main reason for this. Vet group revenue and like for like sales (i.e. sales this period compared to the same period in the previous fiscal year) was -10.9 and -9.3, respectively.
- However, omnichannel (in-store and online) revenue was up 71%. The company was designated an ‘essential’ service during lockdown, so although revenues stalled initially, they quickly recovered to capture some of that extra spending by consumers on their pets, as well as the lockdown trend for consumers to increase pet ownership, with puppies now in short supply.
- The company has maintained its dividend.
What conclusions can we draw from the fundamentals?
Our conclusion is that Pets At Home is a strong business in a strong position to grow. It as proven in the first quarter of fiscal year 2021 that has the nimbleness and agility to seize the opportunities presented by “lockdown loneliness” that has driven sales higher in the Petcare segment.
Both the July statement we analyse here and the investor presentation in mid September were followed by sharp rallies in the stock. Will that happen again? Probably.
If you have a longer view, Pets At Home looks like a buy although its stock has become more expensive on a price-to-earnings ratio basis (a multiple of 27).
The size of its investment in warehousing and fulfilment (£48 million) is a risk to its otherwise healthy free cash flow per share, currently 34.5p. We also note that net debt has been growing steadily, jumping from £119 million in 2019 to £534 million this year. However, the risk of earnings not meeting expectations could send the shares into a knee-jerk tailspin, making it a risky time to make the purchase.
What the technical analysis shows
Why candles are better than line charts
The chart above uses price candles as opposed to lines. Candles provide the viewer of the chart with much more information than a simple line chart, namely the opening and closing price (the thick body of the candle) and the price range traded during the session (the wick). See more on this in the more detailed lesson on technical indicators.
Where do we draw the price support trendline?
We begin by drawing a trendline (the dashed red line), which acts as support for the price. This means that when the price moves closer to the trendline, the chances of the price rebounding rises as the price level approaches support. Price support forms where buyers previously entered the market and selling activity waned. The price is currently trading substantially above support which is an encouragement for bulls. If you were looking to place a stop-loss on your trade, the support trendline provides a good starting point.
Note, we could also have drawn a trendline joining up the price highs to show areas of resistance faced by bulls. This would create what technical analysts call a channel.
Why the price spikes before 24 November
The ‘E’ symbol on the right of the x axis denotes the earnings release on 24 November and as predicted, the price is rising in anticipation of results meeting or exceeding expectations.
We also add to the chart two notes to indicate the impact of previous trading statements on the price, which is significant, on 15 July and 31 September.
What is the significance of volume in the Pets at Home chart
The chartist – as those who read price charts are sometimes referred to – will be quick to observe (highlighted with the two green circles) that the price spikes are backed by extremely strong trading volume. That’s a good thing as it means there was plenty of broad conviction in the market driving the price higher.
How to use the Relative Strength Index
The relative strength index underneath the volume section shows the strength of price movements based on past closing prices. TradingView (the charting software we are using in this example) helpfully shows the lower and upper bounds of ‘healthy’ price points. If the price falls below 30 it indicates an oversold price, while if the price rises above 70 it is indicates it is overbought.
Again, we have circled in green the pertinent information, which is that the price of Pets At Home stock is approaching overbought territory.
What the moving averages show – the golden cross
We have overlaid the chart with a 100-day moving average (MA – blue line) and the 200-day MA (red line). The moving average is useful as it is the sum of closing prices over a given period divided by the number of units (eg, days, weeks months) of that period. The moving average is the foundation for many other indicator, notably Bollinger Bands.
When the shorter-term MA (in this case the 100 MA) crosses above the longer-term (200 MA), it is considered a bullish signal for the price and is sometimes referred to as a golden cross. On the PETS price chart, the second crossing of the MA lines is an example of a golden cross.
What are the technical conclusions?
The technical analysis with the indicators we have used, shows that the price is in a bullish phase but is approaching overbought territory. We have also identified a pattern of trading in which its positive earnings statements have led to price rallies, but past performance alone is not a guide to future performance. Given the fundamental analysis above, the technical analysis on this occasion might support a buy call.
What are the risks in buying PETS before the earnings report?
The main risk is one that presents itself for the short-term trader, because they face a binary position (either the results are good or bad), which is probably not a good place to be. In other words, there is a risk that the earnings fail to meet expectations and the price falls as a result.
There is a danger, therefore, of a ‘buy the rumour, sell the news’ situation.
Overall though, on the balance of the fundamental and technical analysis, Pets At Home is a buy, but a better way to play the stock may have been to buy in the run up to the earnings statement on 24 November.
What happened to the PETS price after the earnings release?
We looked at the chart after the earnings results, and the price has fallen as much as 8% in early trading. Despite a rise in revenue of 14%, the company says Xmas trading could hit margins because of social distancing rules and that the outlook remains uncertain due to Covid. Although the company maintained its dividend, early market reaction was negative, as the chart below shows.
For those that waited for the release before deciding on taking a position, the intra-day decline could be a buying opportunity, in expectation of support holding and if the investor concludes that they market has overreacted to the downside.