The pros and cons of fundamental analysis

Carrying out detailed fundamental analysis requires an investment of your time and effort. So is it worthwhile? To help you decide, let’s consider some of the strengths and weaknesses of this type of analysis.

The strengths of fundamental analysis

Fundamental analysis can help you do a number of things:

Identify long-term trends

Whereas technical analysis generally only identifies short-term patterns and opportunities, a fundamental approach will highlight companies worthy of longer-term investment. This might suit you better if you’re happy to take a patient view and prefer not to incur repeated dealing charges.

Spot value stocks

Solid fundamental analysis can enable you to identify companies whose share price undervalues (or overvalues) their real worth. Investment in companies like this is known as value investing, and it’s an approach that has been championed by many of the world’s leading investors, such as Warren Buffett.

Warren Buffett

Value investor Warren Buffet

Develop your business acumen

By carrying out comprehensive analyses of a number of companies, you’ll build up a thorough understanding of the way these businesses work, getting to know their industry sector and what drives their revenue and profit. This can be invaluable, helping you to recognise which companies to avoid and when it’s the right time to enter or exit a position.

As you become familiar with studying balance sheets and income flows, you’ll also get a sense of the varying levels of volatility and risk that apply to different companies and sectors. For example, tech stocks are generally viewed as being more volatile, exposing you to higher risk than, say, utilities.

Categorise shares correctly

Business is constantly subject to change, and companies can rise to success or fall from grace as their environment evolves. An understanding of a company’s business gleaned through fundamental analysis can help you to categorise it correctly as:

  • A well-managed, well-resourced entity that’s positioned to flourish in a changing environment, or…
  • A flawed, inflexible organisation that will struggle to adapt to a shifting landscape

This in turn will help you to work out its relative valuation in the face of changes within the industry

The weaknesses of fundamental analysis

Fundamental analysis also has certain drawbacks:

It could take a long time to pay off

While fundamental analysis might help you identify companies that have been overpriced or underpriced, it won’t necessarily reveal the likely timescale before the share price moves in line with your assessment. So unlike technical analysis, where the moment to buy or sell can often be predicted on a chart, there’s no way of knowing how long it might take to secure a profit.

Growing plant

No two sectors are the same

The way you assess a company’s value will depend on the sector it belongs to. This means each time you look at a new company in an unfamiliar sector, you’ll probably need to use a different approach altogether. This may mean, in the interests of time, you’ll need to restrict yourself to just one or two sectors.

Objectivity can be impossible

When calculating the fair value of a company, you often have to make assumptions about variable factors: interest rate expectations, for example, or government taxation policy. But these assumptions are, by nature, entirely subjective. The most you can do is to consider multiple scenarios and outcomes, to allow for the fact that your view may be overly optimistic or cynical.

Companies spin their own news

Most of the information fundamental analysts use to assess a company comes from the company itself. By hiring investor relations managers, these businesses ensure any releases reflect as positively on their performance as possible. It’s worth bearing this in mind and taking their announcements with a little pinch of salt.