Why Might Fundamental Analysis Fail to Work?

Why Might Fundamental Analysis Fail to Work?

Despite its plausibility and scientific appearance, there are three potential flaws in this type of analysis. First, the information and analysis may be incorrect. Second, the security analyst’s estimate of “value” may be faulty. Third, the market may not correct its “mistake” and the stock price might not converge to its value estimate.

The security analyst traveling from company to company and consulting with industry specialists will receive a great deal of fundamental information. Some critics have suggested that, taken as a whole, this information will be worthless. What investors make on the valid news (assuming it is not yet recognized by the market) they lose on the bad information. Moreover, the analyst wastes considerable effort in collecting the information and investors pay heavy brokerage fees in trying to act on it. To make matters even worse, the security analyst may be unable to translate correct facts into accurate estimates of earnings for several years into the future. A faulty analysis of valid information could throw estimates of the rate of growth of earnings and dividens far wide of the mark.

The second problem is that even if the information is correct and its implications for future growth are properly assessed, the analyst might make a faulty value estimate. It is very difficult to translate specific estimates of growth and other valuation factors into a single estimate of intrinsic value. Recall the widely different estimates of the value for IBM in the 1980s. The attempt to obtain a precise measure of intrinsic value may be an unrewarding search for a will-o’-the-wisp. Thus, even if the security analyst’s estimates of growth are correct, this information may already be reflected accurately by the market, and any difference between a security’s price and value may result simply from an incorrect estimate of value.

Being brilliant is no great feat if you respect nothing (Johann Wolfgang von Goethe)

The final problem is that even with correct information and value estimates, the stock you buy might still go down. For example, suppose that Biodegradable Bottling Company is selling at 20 times earnings, and the analyst estimates that it can sustain a long-term growth rate of 25 percent. If, on average, stocks with 25 percent anticipated growth rates are selling at 30 times earnings, the fundamentalists might conclude that Biodegradable was a “cheap stock” and recommend purchase.

But suppose, a few months later, stocks with 25 percent growth rates are selling in the market at only 20 times earnings. Even if the analyst was absolutely correct in his growth-rate estimate, his customers might suffer badly because the market revalued its estimates of what growth stocks in general were worth. The market might correct its “mistake” by revaluing all stocks downward, rather than raising the price for Biodgradable Bottling.

Such changes in valuation are not extraordinary – these are the routing fluctuations in market sentiment that have been experienced in the past. Not only can the average multiple change rapidly for stocks in general but the market can also dramatically change the premium assigned to growth. Both these phenomena were important during the early 1970s. It became apparent that accurately forecasting future earnings and dividend growth companies of the early 1970s turned in miserable price performances from 1972 on because of the devastating fall in earnings multiples, especially for rapidly growing companies. Clearly, then, one should not take the success of fundamental analysis for granted.

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