Should you use fundamental analysis or technical analysis to take exposure and manage your portfolio in the current market? This article argues that it is always optimal to combine both analyses. You should use fundamental analysis for security selection and apply technical analysis to mark the entry price and manage the asset price risk.
Several interesting questions on the market were posed to us in the last couple of weeks. One such question was: Should we follow fundamental analysis or technical analysis in a trending market such as this?
The truth is one analysis cannot exist without the other. We believe that investor-traders should actively combine technical analysis with fundamentals to optimise gains.
Specifically, we recommend applying fundamental analysis for security selection and using technical analysis for taking exposure and managing the price risk.
Fundamentally yours
Fundamental analysis is about dissecting financial statements, discussing with the management and arriving at earnings estimates. These estimates are then input into a valuation model to arrive at an estimated intrinsic value.
Fundamental analysis has its merits. For one, investors will not be stuck with momentum stocks, which go up purely on noise trading.
While this may preclude them from participating in large upside potential in a trending market, it saves them large losses that are likely when such stocks turn direction. For another, it could inculcate discipline if investors buy and hold the stock till it reaches the estimated intrinsic value.
The problem is that we are not disciplined! An investor who buys a stock based on fundamental analysis is more likely to sell before it reaches the price objective, and more often at a loss.
The reason is that we are not wired to thinking long-term. We invest for the long term but often hope to profit in the short term.
How else can we explain the large cash inflows into mutual funds when the market is trending up or the huge outflows when the market tanks?
Taking exposure purely on fundamental analysis will, hence, not be optimal because it does not suit our craving to realise frequent gains.
Of technical analysis and human behaviour
Assets are priced on emotions and on perceptions of fundamentals. Prices are, hence, footprints of human behaviour. An optimal way to catch this behaviour is through technical analysis. Pure-play technical analysts simply read chart patterns and take action, devoid of fundamentals.
Take Bellary Steel, a stock which according to most fundamental analysts is trading way above its estimated intrinsic value. A technical analyst may not hesitate to buy the stock based on the chart pattern.
Technical analysis has an edge over fundamental analysis in the portfolio management process.
A technical analyst is always armed with three variables before taking an exposure — the entry price, the price objective and an initial stop loss. Using fundamental analysis will only provide the price objective. But what if the stock moves down sharply after taking such exposure?
There is, however, a flip side to technical analysis. This class of analysis will under perform in a whippy market where asset prices are volatile. This is because market timing is not always correct and tends to be more wrong when asset prices are wobbly.
Combining classes
We believe that investor-traders would do well to combine both classes of analysis. Here is a simple approach.
Allocate 80 per cent of the portfolio to buying stocks that boast of strong fundamentals. This part of the portfolio will be based on research reports and will not carry momentum stocks.
Use technical analysis to mark the entry price. Apply initial and trailing stops to manage the asset price risk.
Use fundamental analysis to take initial profits. Suppose you buy 1,000 shares of Bartronics at Rs 200 and your fundamental-based price objective is Rs 340 while your technical-based price objective is Rs 525-550.
Sell 500 shares between Rs 325 and Rs 340. Run the profit on the balance holding for the technical-based price objective.
It would be optimal to trade 10 per cent of the fundamental-based portfolio. You may buy and sell these stocks at regular intervals just to enrich your income account.
Allocate 15-20 per cent of the portfolio to trading momentum stocks. These are stocks that wander far away from their estimated intrinsic value.
Take exposure in these stocks to appease your hunger to herd with the market. Use trailing stops to protect profits and capture upside potential.
We do not recommend that you be fully invested in the market at any point in time. It is optimal to have 5-10 per cent in cash or cash equivalents at all times. This will provide leeway to take exposure to must-have stocks, which you will always find just when you are fully invested!
At this point in time, as recommended in this column few weeks ago, holding 40 per cent cash would be optimal.
This will give you ample opportunity to add several stocks to your fundamental-based portfolio at 20-30 per cent discount from the recent peak prices.
B. Venkatesh
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