Saturday, May 16, 2015

Why I don't rely on fundamentals

There are undoubtedly a lot of traders, as well as the investing community, who place great faith in researching, analysing and interpreting the underlying fundamentals of a company. This information is then used to assist them make buying and selling decisions. However, some traders (like myself) place no reliance whatsoever on what the fundamentals are telling me.

Frankly, I don't care how many widgets they are making, whether the directors are buying or selling, or what the price to earnings ratio is. I'm far more interested in what price is doing, because ultimately the company's stock price and its movements is what generates a profit or a loss for a trader.

Fundamental analysis is based on three factors: historical performance, new developments and forward guidance. Basically, the board of directors are telling you what has happened, but quite often the share price will tell you what's going on before any announcement about earnings, or a trading update, is made. Bearing that in mind, here's what two famous traders have to say on these points:

"The concept of paying one-hundred-and-something times earnings  for any company for me is just anathema. Having said that, your job is to buy what goes up and to sell what goes down so really who gives a damn about P/E's?" - Paul Tudor Jones

"Fundamentals that you read about are typically useless as the markets has already discounted the price, and I call them "funny-mentals". However, if you catch on early, before others believe, then you might have valuable "surprise-a-mentals." - Ed Seykota

"I always believe that prices move first and fundamentals come second" - Paul Tudor Jones

"I cannot predict a non-existent future" - Ed Seykota

Try telling investors in companies like Waste Management, Enron, Worldcom, to name a few, that fundamental information can be relied upon at all times.

In the UK, last year we had the situation surrounding Tesco and its £260m accounting 'error'. Yet, if you had looked at the chart, you would have seen it had been in a downtrend for quite a while before that news came out.

With your focus on price, there can be no such errors - the share price quoted is basically the price that there are buyers prepared to pay to acquire stock, and where sellers are prepared to sell stock. It is what it is.

Relying on fundamentals can also mean that you could miss out on some phenomenal price trends. You only have to think back to the bubble in 1999/2000. A lot of those tech companies had no earnings at all, yet there were traders, solely focused on price, who were able to generate huge profits, AND keep them when price finally topped out.

Of course, simply following the price will not always work - I can think of lots of examples where price has been going in a particular direction, only for an announcement to be released and there be a quick about turn in price (often with a price gap to boot).

A trader's job is to try and make money while controlling risk.  And, to achieve that, all I can do is focus on what price is doing now. What has happened in the past is only of use to me in the sense of whether price now is moving upwards or downwards when compared to the recent past, and even then I do not know what price will do going forwards. Hence the reason for good risk control.

However, what we do know is that, once price does start moving in a particular direction, it has a tendency to persist. What we don't know is how far price will move in that particular direction. As Marty Schwartz says:

"Based on the first law of physics, an object in motion will continue in motion until an outside force affects it. A stock that's going down will continue to go down until it stops going down. A stock that's going up will continue to go up until it stops going up."

Therefore, all we can do is follow price, place our bets when price tips its hand, and hop on for the ride.

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