Fundamental Analysis
The Pandemic era has seen a surge of new investors flocking to gain quick gains in the volatile market. While few were able to place a lucky bet, most cannot survive the choppy waters of the equity markets relying alone on luck.
Then how does one not just survive but thrive in the stock market? What can help navigate the stock market smoothly? While no one answer guarantees a smooth sail, there is one common answer that any seasoned investor will recommend – Fundamental Analysis.
It is said that investment in a fundamentally strong company is a calculated bet that is surely safer than just relying on luck and short-term gimmicks.
Before we understand what exactly fundamental analysis is, it is important to note that there are no shortcuts in equity investing based on fundamentals. It requires patience & dedication.
After all, the legend, Warren Buffet, started investing at the age of 11 years and has continued investing for the last 80 years. However, more than 95% of the wealth that he has today was created only after he turned 52, i.e., after almost 40 years of investing. Talk about patience!
The main objective of fundamental analysis is to arrive at the true worth or intrinsic value of a business, which is also called the fundamental value. This requires a detailed study of a company’s business so that a buy/sell decision can be taken.
Fundamental Analysis is identifying the financial health of the company, which can be done by checking the balance sheet of the company, which in turn helps us analyze its profit and loss. The first step to fundamental analysis is to determine the approach to be used.
There are two key approaches to fundamental analysis- The top-down approach and the Bottoms-up approach, let us understand each of them in detail -
The Top-down approach-
The top-down approach involves selecting key sectors that would benefit from the emerging macroeconomic trends such as GDP, currency and inflation levels, demographics, urbanization, etc. Then, a group of top-performing companies within these sectors is shortlisted.
Most of the important ideas that you get are just around us. For example, let us say you hear the climate change movement is leaning towards reduced usage of fossil fuels, making electric mode the next big potential thing. Well, that’s a sector for you - Electric Vehicles.
Let us take an example here, the electric vehicle is a theme that we are bullish on. i.e. we expect it to go higher than the price we bought at. Within this larger theme, there could be multiple sectors that could play out in our favor – think of an electric vehicle and think of different components that will contribute to making a car.
The automobile industry is a leader, followed by tire manufacturers, batteries, glass, aluminum metals (because electric vehicles are supposed to be lightweight as compared to traditional automobiles), etc.
Financial advisors have identified the sectors that are doing well, we need to study the companies within the sector and identify the pioneers. The market leaders generally perform well in the future subject to the vision and mission of the company for their future.
Thus, in the Top-down approach, advisors start at a macro level and move to the micro.
The Bottoms-up approach-
This approach begins with a company and then an analysis of the sector it operates in followed by macro trends that can impact its business.
Say, we know that Berger paints is a good company and has given good results so we will analyze the paints sector and study the economic trends that will have a bearing on its business. Thus, here we begin at a micro level and move on to understand the macro aspects of the same. Once we decide on the approach to start with, let us understand the next step of our analysis –
The next step would be to identify the top companies within the sector,
Having selected a sector that looks promising, we then use financial screener which financial consultants use shortlist the top-performing companies within those sectors.
With finance, the difficult thing is that there are so many parameters to be bench-marked and hence, you would need to have everything in one place to compare, benchmark and evaluate.
A screener is an online tool that applies a predefined set of financial parameters to a database of all listed companies and shortlists companies that satisfy all the parametric thresholds.
Broadly a screener comprises 5-8 financial parameters and must be customized for different sectors. Like employees, performance parameters are important for IT companies, whereas working capital ratios are more important for a capital goods company.
Once you have identified the company, what are the parameters to look for the next step is to understand the company’s business.
Here we conduct a detailed analysis of all stocks selected through a screener within the sector identified. The end objective is to do future projections based on a complete understanding of the company's business. The factors looked at can be broadly divided into two categories – qualitative and quantitative
Qualitative aspects typically include management and leadership, ESG factors, etc. whereas quantitative factors include more calculations around profitability, growth, market share, etc. These questions will help you segregate good businesses from bad ones.
The last step is to identify the right price for the company.
There is a saying in India, “Bhav Bhagwaan hai” - meaning “Price is everything”. A good company at a not-so-good price could be a potential nightmare for the investor.
What we can understand from this conversation is that fundamental analysis helps you know your stock better and can in turn help you in making informed decisions.
Don’t forget - Select the approach, choose the sector, rank the top preferences, understand the company, identify the right price, and voila you are ready with strong fundamentals to support your key investment decisions or hire a wealth management advisory service to do it for you, happy analysis!
Seek help from financial advisors if you think you are not adept at making fruitful money management decisions.