6.3 Why Fundamental Analysis?

IMPORTANCE OF FUNDAMENTAL ANALYSIS

What can you expect from fundamental tests and why perform analysis at all? These questions are good starting points because they establish the very reasons to undertake any analysis. Fundamental tests, more than anything else, provide a means for comparison. We can make judgments only by comparing one thing to another. We don’t know what our preferences are until we look at two or more alternatives. This is as true in the stock market as it is everywhere else. Fundamental tests are a consistent application of standards to several companies. We hope that the results of those tests will guide us in our decisions to select one stock over another; and then to buy, hold, or sell.

But why perform analysis at all? Why not simply choose stocks by throwing darts at the stock listings? Some people forward an argument that random selection of stocks is as effective as any other method. The random walk theory, for example, states that stock prices change in a random and unpredictable manner, and that the effect of new information on market prices cannot be predicted with any degree of certainty. Anyone who seriously approaches investing has to question the wisdom of the random walk theory. It, in fact, makes sense that studying the fundamental and intrinsic information about a company leads to an intelligent stock selection, while the failure to perform research may result in bad choice and a loss of money. Most people agree that doing research is better than not doing any research at all.

A second theory concerning the market is the effective marketing theory which states that the current price of a stock reflects all the known information about the company. The theory also states that as new information becomes known, it is factored into the stock’s price immediately. This theory assumes that some group - presumably the market as a whole - keeps track of information and immediately raises or lowers its estimation of market value. In reality, most people know that the stock market has a degree of chaos to it, and that such efficiency is suspect and unlikely.

For example, when the Satyam Computer Services’ scandal broke out and the stock price of the company plunged to Rs 13, many people were left holding Satyam’s shares while many investors bought fresh shares, expecting some positive change in the immediate future. Many in the market were, at that time, given to making predictions about the winding up of the company. After some time, the share price of Satyam was seen to steadily improve. Meanwhile, there was a rumour in the market that the government was going to appoint a nominee to the Board of Directors to encourage the investors’ sentiments. On the basis of this factor, the stock price went up. However, when the nomination was actually announced the stock price did not move substantially as this development had already been factored into the stock price. So, if you are buying the stock on the day after the announcement, the possibility of there being no substantial change in the stock price is quite high.

The two most likely reactions to new information are to completely discount the information, thus not affecting the stock’s market price, or to temporarily over-react, thereby greatly affecting the price. It is easy to theorise about market forces, supply and demand, and the psychological nature of the typical investor without really knowing how the market works. Such is the nature of any theory. If it were possible to know precisely how the market works, it might be easier to know how to pick stocks. Since prices change, often without obvious cause and effect, a degree of excitement surrounds stock market investing. That excitement makes it easy to fall prey to belief systems that have no basis. It is important to remember, though, that the market prices of stocks reflect a perception of value rather than a reaction to any new logical or fundamentally- based information.

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