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Investing and Trading Lesson, Check Your Facts!

“Bank profits amongst the Top 12 banks in Australia are up 15% on the previous year and the recent correction in prices leaves many banks at extremely low historical price to earnings ratios (20-year lows). With this in mind, the Australian banking sector is now offering compelling value.

We view the current environment as an ideal time for investors to increase their weightings in the Australian banking sector”

Source: Unnamed analyst at large broking firm – pre GFC in late 2007!!

The above statement certainly appeared to be factually correct at the time of writing. But did those “facts” prevent Australian banks from being devastated by the 2008 GFC? History shows that the answer is an emphatic “No”. So, when it comes to good trading, are the facts relevant or are they downright dangerous?

A novice trader without a trading plan is all too susceptible to following this sort of advice from so-called “experts”. It is very tempting defer to the better judgement of those who appear to be more learned than us – especially when they are armed with a plausible theory as in the analyst’s recommendation above.

If we have not developed a trading methodology of our own, surely it makes sense to simply follow the experts? At least when things go wrong, we are less to blame. Right?

Wrong – when it comes to trading – the buck stops with us. We have nobody to blame for our mistakes or our losses but ourselves!

Fundamentally Sound or Fundamentally Flawed?

The contemporary research industry is almost exclusively based upon this sort of “fundamental analysis”. Fundamental analysis is the study of a company’s business operations, market prospects, management and systems. Ultimately, this method of analysis boils down to the study of the determinants of the price for the goods and services a company produces.

The analyst must then extrapolate past performance into the future to predict the expected revenues likely to be generated by the company. By subtracting expected expenses he/she may then determine the company’s likely future profits. Analysis of these profits going forwards (and through some convoluted valuation model!) allows the analyst to calculate his/her perceived value of what the company is worth today.

The analyst then divides this perceived value of the company by the number of shares on issue to calculate the value per share. Now the analyst compares the perceived value per share to what the company’s share price is actually trading at on the share market. If the current share price is significantly below the perceived valuation, the analyst will label the company’s shares a “Buy”. If the current share price is significantly above the perceived valuation, the analyst will label the company’s shares a “Sell”.

That sounds fair enough doesn’t it? Well, this analysis is indeed good enough for the vast majority of institutional investors in the stock market and constitutes the basis of their buying and selling of shares under most circumstances. For this reason, in most cases, it is worthwhile keeping an eye on what the brokers are saying. In practical terms we can do this by monitoring “broker consensus” data.

Broker consensus data is simply the compilation of a number of brokers’ recommendations in order to gain an understanding of the average valuation of a company, sector, or market. This average valuation often gives us clues to whether the market overall is being influenced by bullish or bearish broker sentiment. As we imply above however, there are going to be some times where this sort of analysis isn’t as effective as most of the investors who follow it would like. In fact, there are times when it is downright useless.

The above statement about the banking sector by our unnamed analyst is an excellent example. Whilst appearing to be sensible and grounded in observable and valid analysis of the facts, it only considers the determinants of the value of a company’s shares, not the determinants of the price of a company’s shares. Value is not price and price is not value. So is it better to study value or price?

Fundamental analysts believe these concepts are interchangeable. They assume that all things being equal, price will tend to move towards value over a period of time. But how long will it take the market to catch up to the analyst’s perceived value of the share, and what then should the determinants of value change in the mean time?

Value tends to based upon assumptions and beliefs, upon plausible theories. What is an example of a plausible theory? Perhaps: “The internet will revolutionise the way the world does business and “new economy” companies can not be valued in the same way as “old economy” companies”. Many will remember that cracker from 1999-2000 when the mania of the Dot-com boom gripped stock markets around the world. How about: “The miracle of Chinese economic growth, and not to mention that of other developing countries such as India will power global growth for the next 20 years driving a sustained commodity boom…”

Plausible theories are potentially the most dangerous red herrings facing novice traders. Unfortunately when the world changes (and the recent financial crises have reminded us of just how quickly this can happen), plausible theories spontaneously combust into a poof of smoke. That’s the fundamental analyst’s bull market profits going up in flames by the way! Comfortingly, the price of a company’s shares will always be determined by the market – regardless of the prevalence of plausible theories. It is for this reason that traders study and follow the market price. Not perceived value. Value is a concept, price is the reality.