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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