The Fundamental Analysis Myth
By Jesse Czelusta (from the May 2006 issue of Index Rx)
Disagreement is the essence of equities trading--buyers believe that the value of their acquired assets is greater than the cost; sellers demur.
Yet beliefs regarding optimal investment choices revolve around answering a single question. Answers to this question drive not just individual investment decisions, but also markets, industries, and economies. This question is the Alpha and Omega of investing:
"What determines the price of an asset?"
For many years, a single notion has held sway over the minds of the investment masses: fundamental analysis. This notion provides a simple, intuitive, and natural explanation for movements in prices. As Bodie, Kane and Marcus (2005) put it, "the purpose of fundamental analysis is to identify stocks that are mispriced relative to some measure of 'true' value that can be derived from observable financial data." (p. 606). In other words, each stock has a correct price, this price can be calculated, and prices in markets do not always equal correct prices. Underpriced stocks should be bought and overpriced stocks sold.
The hegemony of this view can be attributed to common sense. Over time, earnings determine the price of a stock. Earnings should be determined by characteristics of firms and industries. These characteristics should be reflected in valuation measures. Pay closer attention to these measures than others and your investments will produce higher returns than theirs.
Or so the argument goes. But just because a sense is common does not mean it is correct. And just because Wall Street says it doesn't make it so. Although it may be blasphemous to question Investment Truths that flow from so many hallowed tongues, the fact remains: For individual investors, fundamental analysis is worthless.
First, for all of the reasons provided by theories of efficient markets. All available information should be incorporated in the price of a stock long before your order reaches a trading floor. Even if new information becomes available, you will not be able to profit from this information. Unless you are somehow more prescient than the world's best financial minds or somehow able to act sooner than those whose lives revolve around stock markets, fundamental analysis is akin to armchair quarterbacking. While there may be such a thing as the "intrinsic value" of a company, there is no reason to think that one's own knowledge of this value is likely to be better than anyone else's.
Second and more importantly, because there is very little that is "fundamental" about fundamentals. Any valuation measure is meaningless absent expectations. And expectations are as slippery as fish on hooks.
Consider the most ubiquitous of valuation measures, the price-earnings ratio. When juxtaposed with those for similar firms, this ratio allegedly captures the relative growth prospects of a company. Wall Street's rule of thumb is that a stock's price-earnings ratio should approximately equal growth in company earnings and dividends. According to Peter Lynch,
The P/E ratio of any company that's fairly priced will equal its growth rate. I'm talking about growth rate of earnings...If the P/E ratio of Coca Cola is 15, you'd expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain. (p.198)
But unless you are in possession of prophetic powers (or have the ear of Wall Street and the ability to act before you whisper into it), Mr. Lynch's advice is not actionable. The problem with Lynch's example is that we have no way of knowing what growth rates will be. Even if we did, twenty dollar bills do not lay long on sidewalks.
By the same token, the term "bargain stock" is a misnomer. Bargains materialize only in hindsight and are invisible to honest foresight. To borrow Mr. Walton's phrase and place it in a different light, in investing, "expectations are the key to everything." And not simply your own expectations, of course, but those of all investors.
Interpretation rests upon expectations. Valuation measures are determined not by traits of companies, but by expectations regarding those traits. And there is not much that is necessarily "true," or "intrinsic," or "fundamental" about expectations. Expectations can be wrong (remember "the new economy?") Fundamentals are nothing of the sort; instead, they are mirrors of beliefs. Fundamental investing works only if beliefs move in consistent patterns.
Which leads to an inevitable conclusion, one that may someday turn the investment world on its head--valuation measures (or any other measures) matter only as much as the market thinks they do. The reason that Lynch and other notable "value investors" have done well for themselves, often outperforming market indices, is that beliefs do move in predictable patterns. Value investors may be unknowingly tracking these patterns of beliefs, thinking that they are wise assessors of "fair value," when in reality they are benefiting from the consistent ebbs and flows of sentiment. They would do even better if they stopped worrying about valuation measures and started looking for patterns in these measures.
Bodie, Z., A. Kane, and A. Marcus (2005). Investments. McGraw-Hill Irwin: New York.
Lynch, P. (1989). One Up On Wall Street. Running Press Book Publishers: Philadelphia.