Using Fundamental and Technical Analysis Together

Using Fundamental and Technical Analysis Together

Many analysis use a combination of techniques to judge whether individual stocks are attractive for purchase. One of the most sensible procedures can easily be summarized by the following three rules. The persistent, patient reader will recognize that the rules are based on principles of stock pricing:

Rule 1: Buy only companies that are expected to have above-average earnings growth for five or more years. An extraordinary long-run earnings growth rate is the single most important element contributing to the success of most stock investments. Merck, Dun & Bradstreet, MCI, Service Corporation International, and practically all the other really outstanding common stocks of the past were growth stocks. As difficult as the job may be, picking stocks whose earnings grow is the name of the game. Consistent growth not only increases the earnings and dividends of the company but may also increase the multiple that the market is willing to pay for those earnings. Thus the purchaser of a stock whose earnings begin to grow rapidly has a chance at a potential double benefit – both the earnings and the multiple may increase.

Rule 2: Never pay more for a stock than its firm foundation of value. While I have argued, and I hope persuasively, that you can never judge the exact intrinsic value of a stock, many analysts feel that you can roughly gauge when a stock seems to be reasonably priced. Generally, the earning multiple for the market as a whole is a helpful benchmark. Growth stocks selling at multiples in line with or not very much above this multiple often represent good value. Service Corp. In the study just described is a good example.. Its multiple was actually below the market’s.

There are important advantages to buying growth stocks at very reasonable earnings multiples. If your growth estimate turns out to be correct you may get the double bonus: the price will tend to go up simply because the earnings went up, but also the multiple is likely to expand in recognition of the growth rate that is established. Hence the double bonus. Suppose, for example, you buy a stock earning $1 per share and selling at $7.50. If the earnings grow to $2 per share and if the price-earnings multiple increases from 7,5 to 15 (in recognition that the company now can be considered a growth stock) you don’t just double your money – you quadruple it. That’s because your $7.50 stock will be worth $30 (15, the multiple, times $2, the earnings).

From a small seed a mighty trunk may grow (Aeschylus). Photo by Elena

Now consider the other side of the coin. There are special risks involved in buying “growth stocks” wheere the market has already recognized the growth and has bid up the price-earnings multiple to a hefty premium over the accorded more run-of-the-mill stocks. Stocks like International Flavors and Fragrances, Avon Products, and other recognized growth companies had earnings multiples well above 50 in the 1950s. The warning was made very clear that the risks with very-high-multiple stocks were enormously high.

The problem is that the very high multiples may already fully reflect the growth that is anticipated, and if the growth does not materialize and earnings in fact go down (or even grow more slowly than expected), you will take a very unpleasant bath. The double benefits that are possible if the earnings of low-multiple stocks grow can become double damages if the earnings of high-multiple stocks decline. When earnings fall the multiple is likely to crash as well. But the crash won’t be so loud if the multiple wasn’t that high in the first place. Reread the grim stories of National Student Marketing or Home Shopping Network or the Nifty Fifty growth stocks, if you want more evidence of the enormous risks involved with very-high-multiple stocks.

What is proposed, then, is a strategy of buying unrecognized growth stocks whose earnings multiples are not at any substantial premium over the market. Of course, it is very hard to predict growth. But even if the growth does not materialize and earnings decline, the damage is likely to be only single if the multiple is low to begin with, while the benefits may double if things do turn out as you expected. This is an extra way to put the odds in your favor.

We can summarize the discussion thus far by restating the first two rules: Look for growth situations with low price-earnings multiples. If the growth takes place there’s often a double bonus – both the earnings and the multiple rise, producing large gains. Beware of very-high-multiple stocks where future growth is already discounted. If growth doesn’t materialize, losses are doubly heavy – both the earnings and the multiple drop.

Rule 3: Look for stocks whose stories of anticipated growth are of the kind on which investors can build castles in the air. I have stressed the importance of psychological elements in stock price determination. Individual and institutional investors are not computers that calculate warranted price-earnings multiples and print out buy and sell decisions. They are emotional human beings – driven by greed, gambling instincts, hope, and fear in their stock-market decisions. This is why successful investing demands both intellectual and psychological acuteness.

Stocks that produce “good feelings” in the minds of investors can sell at premium multiples for long periods even if the growth rate is only average. Those not so blessed may sell at low multiples for long periods even if their growth rate is above average. To be sure, if a growth rate appears to be established, the stock is almost certain to attract some type of following. The market is not irrational. But stocks are like people – what stimulates one may leave another cold, and the multiple improvement may be smaller and slower to be realized if the story never catches on.

So Rule 3 says to ask yourself whether the story about your stock is one that is likely to catch the fancy of the crowd. Is it a story from which contagious dreams can be generated? Is it a story on which investors can build castles in the air – but castles in the air that really rest on a firm foundation?

You don’t have to be a technician to follow Rule 3. You might simply use your intuition or speculative sense to judge whether the “story” on your stock is likely to catch the fancy of the crowd – particularly the notice of institutional investors. Technical analysts, however, would look for some tangible evidence before they could be convinced that the investment idea was, in fact, catching on. This tangible evidence is, of course, the beginning of an uptrend or a technical signal that could “reliably” predict that an uptrend would develop.

While the rules outlined here seem sensible, the important question is whether they really work. After all, lots of other people are playing the game, and it is by no means obvious that anyone can win consistently.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc