Fundamental Analysis: Everything A Trader Needs to Know
Updated: Jan 21, 2023
Fundamental analysis is sometimes viewed as the 'white-collar', 'advanced' research method investors use to make better-informed decisions. After all, almost every institutional investment firm deploys some form of fundamental analysis in weird and beautiful ways.
But, in reality, fundamental analysis is more than just fancy statistics mixed with economics. It is an essential investigative method that can be applied to all financial markets. Whether you're a beginner trading from home or a professional managing other people's money, it's hard to imagine a world where neither uses some form of fundamentals to succeed.
As the name suggests, the word 'fundamental' describes the most important, necessary, and essential foundations upon which all other analyses are built.
Originally derived from the Latin word 'Fundare' (to found), fundamentals should be viewed as the starting point for any endeavour. And for traders, the first step in a healthy investment strategy.
Fundamental analysis - everything a trader needs to succeed.
This is what I'll cover:
Top-down analysis
Bottom-up analysis
What is a systematic trading style?
What is a discretionary trading style?
Systematic vs discretionary: Which is Better?
Examples of Fundamental Analysis in Action
How to do fundamental analysis on stocks
How to do fundamental analysis in forex
What is Fundamental Analysis?
Fundamental analysis describes the core aspects of what makes an asset valuable, usually considering financial and economic factors in markets. It is one of the most thorough and comprehensive research levels that lend investors confidence in their 'buy' or 'sell' decisions.
A great way to remember fundamental analysis is to relate it to decisions we each make in everyday life.
For example, if you are looking to purchase a car, you may consider multiple factors that describe the car's quality and ability to meet its designed purpose. One may account for the number of seats, the quality of paintwork, mechanical efficiency, engine power and many, many other factors.
Those are the fundamentals of a car, the things that make the car 'good' or 'bad' at its intended job.
Then, it would be sensible to compare those fundamentals to other vehicles, historical iterations of the same vehicle, and finally, its price, to see if it's worth buying or not. That's the art of fundamental analysis.
I would go as far as to say everybody conducts fundamental analysis in their daily routines, from choosing what toothpaste they prefer to deciding what forex pair is the best to trade.
The Importance Of Fundamental Analysis In Trading
The importance of fundamental analysis lies within its ability to uncover the intrinsic value of an asset or item. Simply, it informs investors whether something, like a stock or forex pair, is undervalued or overvalued, pathing the way to an educated investment decision.
Fundamental analysis in forex helps investors find strong and weak currencies; in stocks, it helps investors find high-quality businesses with growth potential.
From every aspect, fundamental analysis is one of the best forecasting tools in a trader's toolbox by a mile.
Types of Fundamental Analysis
Fundamental analysis usually falls into two main categories in the financial markets: top-down or bottom-up. They are both different angles to approach the same system.
Working our way from top to bottom, this fundamental analysis system is split into:
Global 'big-picture' - macroeconomics analysis
Sectors and industries - microeconomic analysis
Individual companies - financial analysis
1. Top-down analysis
A top-down approach is when an investor looks at the 'big-picture' relationship between global economies.
In general, the methodology is built upon macroeconomic factors, like interest rates, debt, employment, inflation, manufacturing surveys and much more. These factors are then analysed through a systematic process to find interesting trends and beneficial opportunities.
Investors will then take advantage of their macroeconomic analysis by profiting from currencies, bonds and indices trades.
Top-down fundamental analysis is the go-to choice of many professional forex traders and investment firms due to its ability to successfully forecast market trends.
2. Bottom-up analysis
Bottom-up analysis, on the other hand, is where investors take a narrower view, looking at a specific company's financial performance and discovering its value in comparison to the market.
Investors will hone in on very specific metrics, including return on capital employed (ROCE) [1], earnings, profits, branding and market share.
"It is preferred to buy a wonderful company at a fair price, rather than a fair company at wonderful price" - Warren Buffett, Chairperson of Berkshire Hathaway
Generally, the bottom-up analysis is suitable for investing in stocks and commercial bonds, where discovering the intrinsic value versus the current traded market price is the goal of the game.
How Does Fundamental Analysis Work?
Although a broad area of study, fundamental analysis generally involves either a systematic or discretionary process across a wide range of markets and asset classes. Investors would evaluate opportunities based on economic forecasts, fiscal and monetary policy, or even company financial statements.
The information used by investors could be macroeconomic for a broader view or microeconomic for a narrower view. Most of the time, fundamental analysis requires a firm understanding of economics and finance.
The goal of fundamental analysis is to find the intrinsic value of an asset only using its constituent parts, like financial statements for stocks or macro indicators for currencies.
What is a systematic trading style?
A systematic trading style is when investors mostly rely on quantitative models and methodical systems to find entry, exit and sizing decisions.
Quantitative modelling is the methodology of organising data and using mathematical formulas to discover exciting trends that can be summarised in numerical form. Examples of these models include stochastic processes, monte Carlo simulations, regression models and correlation analysis.
What is a discretionary trading style?
A discretionary trading style is when investors mostly rely on qualitative inputs to find entry, exit and sizing decisions.
Qualitative analysis is the process of using one's personal judgement to generate conclusions on events in markets that numbers can't crunch. Examples of these inputs include case study research, one-to-one interviews, observations of events and professional opinions.
Systematic vs discretionary: Which is Better?
It's difficult to say definitively which type of trading is "better," as both systematic and discretionary trading have their own unique advantages and disadvantages. Here are some things to consider when deciding which approach might be right for you:
Advantages of Systematic Trading:
Systematic trading relies on a predetermined set of rules or algorithms to make trades, which can be objective and unbiased.
Because it is based on a set of rules, systematic trading can be backtested to see how it would have performed in the past.
Systematic trading can be less time-consuming, as traders do not need to constantly monitor the market and make decisions on their own.
Disadvantages of Systematic Trading:
Systematic trading can be inflexible and may not be able to adapt to changing market conditions.
It may be more difficult to implement more complex or nuanced trading strategies using a systematic approach.
Advantages of Discretionary Trading:
Discretionary traders have the ability to use their own judgment and expertise to make trades, which can allow for greater flexibility in decision-making.
Discretionary traders may be better able to take advantage of short-term opportunities that arise in the market.
Disadvantages of Discretionary Trading:
Discretionary trading can be more time-consuming, as traders must constantly monitor the market and make their own trading decisions.
Discretionary trading can be influenced by the trader's emotions and biases, which can lead to poor decision-making.
It can be difficult to consistently apply a discretionary trading approach, as there may be no clear set of rules to follow.
Ultimately, the best approach for a particular trader will depend on their individual goals, risk tolerance, and trading style. Some traders may find that a combination of both systematic and discretionary approaches works best for them.
Examples of Fundamental Analysis in action
Fundamental analysis is a method of evaluating the intrinsic value of an asset by examining its underlying economic and financial factors. It is often used to assess the prospects of a company's stock, but it can also be applied to other assets such as commodities, currencies, and real estate.
Here is an example of how fundamental analysis might be used to evaluate a company's stock:
Gather financial data: The first step in performing fundamental analysis is to gather financial data about the company, such as its income statement, balance sheet, and statement of cash flows. This data can be used to calculate financial ratios such as the price-to-earnings (P/E) ratio, which is a measure of a company's profitability.
Analyze the company's industry: It is important to understand the industry in which the company operates, as well as its competitive landscape. This includes analyzing factors such as industry growth rates, the strength of the company's competitors, and the overall demand for the company's products or services.
Assess the company's management and leadership: The management team and leadership of a company can have a significant impact on its performance. It is important to evaluate the experience and track record of the management team, as well as their vision for the company's future growth.
Consider macroeconomic factors: Macroeconomic factors such as inflation, interest rates, and economic growth can also impact a company's performance. It is important to consider how these factors may affect the company's ability to generate revenue and profits.
Make a valuation: Once all of this information has been gathered and analyzed, it is time to make a valuation of the company's stock. This can be done using a variety of methods, such as the discounted cash flow (DCF) method or the comparable company analysis method. The valuation should take into account the company's financial performance, industry conditions, and macroeconomic factors.
Compare the valuation to the current market price: Finally, the valuation should be compared to the current market price of the stock to determine whether it is undervalued, overvalued, or fairly valued. If the valuation indicates that the stock is undervalued, it may be a good opportunity to buy. If the valuation indicates that the stock is overvalued, it may be a good time to sell or avoid buying the stock.
In the case of a currency, fundamental analysis involves analyzing various macroeconomic and political factors that can influence the demand for and supply of the currency.
For example, let's say you are conducting a fundamental analysis of the US dollar (USD). You might start by looking at factors such as:
Economic growth: A strong and growing economy is typically seen as a positive for a currency, as it can lead to increased demand for the currency due to increased trade and investment. Conversely, a weak or slowing economy can lead to a decline in demand for the currency.
Interest rates: Higher interest rates tend to attract foreign investment, as they offer higher returns on investments denominated in the currency. This can increase demand for the currency and lead to appreciation. On the other hand, lower interest rates can lead to a decline in demand for the currency.
Inflation: High levels of inflation can erode the purchasing power of a currency, leading to a decline in demand. Conversely, low levels of inflation can increase demand for the currency as it maintains its purchasing power.
Government debt: A country with high levels of government debt may be seen as a riskier investment, leading to a decline in demand for its currency. On the other hand, a country with low levels of government debt may be seen as a safer investment, leading to an increase in demand for its currency.
Political stability: A stable and predictable political environment can increase confidence in a currency and lead to increased demand. Conversely, political instability or uncertainty can lead to a decline in demand for the currency.
By analysing these and other factors, an investor can get a sense of the fundamental value of the US dollar and make informed investment decisions.
Limitations of Fundamental Analysis
Fundamental analysis is a widely used method of evaluating the intrinsic value of an asset, but it is not without limitations. Some of the main limitations of fundamental analysis include:
Subjectivity: Different analysts can interpret the same data differently, leading to diverging opinions on the fundamental value of an asset. This subjectivity can make it difficult to reach a consensus on the true value of an asset.
Data quality: The accuracy and reliability of the data used in fundamental analysis is critical, but it can be difficult to obtain high-quality data in a timely manner. Incomplete or outdated data can lead to inaccurate conclusions about the fundamental value of an asset.
Forecasting errors: Fundamental analysis relies on making projections about future economic and financial conditions, which can be difficult to do with accuracy. If these projections turn out to be incorrect, it can lead to errors in the fundamental analysis.
Market efficiency: The efficient market hypothesis suggests that all publicly available information is already reflected in the price of an asset, meaning that it is difficult to outperform the market through fundamental analysis alone. This can limit the usefulness of fundamental analysis in certain market conditions.
Limited scope: Fundamental analysis focuses on economic and financial factors, but it does not take into account other factors that can affect the value of an asset, such as market sentiment or technical analysis. This can lead to a narrow view of the true value of an asset.
Despite these limitations, fundamental analysis is still a widely used and respected method of evaluating the intrinsic value of an asset. By considering these limitations, investors can use fundamental analysis as one tool among many in their investment decision-making process.
Combining Fundamental and Technical Analysis
Combining fundamental and technical analysis can provide a well-rounded approach to evaluating the potential performance of an asset. Fundamental analysis involves evaluating the intrinsic value of an asset by analyzing various economic and financial factors that can affect its value. Technical analysis, on the other hand, involves studying historical price and volume data to identify patterns and trends that can provide insight into future price movements.
To combine fundamental and technical analysis, investors can start by conducting a fundamental analysis to determine the intrinsic value of the asset. This can provide a baseline for evaluating the asset's potential performance. Next, the investor can use technical analysis to identify patterns and trends in the asset's price and volume data that may indicate a potential buying or selling opportunity.
For example, if a stock has strong fundamental characteristics but is currently overvalued according to technical analysis, the investor may choose to wait for a pullback in the price before buying. On the other hand, if a stock has weak fundamental characteristics but is undervalued according to technical analysis, the investor may choose to sell the stock even if it is currently trading at a discounted price.
By combining fundamental and technical analysis, investors can make informed decisions about when to buy and sell assets based on both the intrinsic value of the asset and the current market conditions.
What is The Best Fundamental Analysis Strategy?
Developing any successful fundamental analysis strategy is not an easy task. Many off-the-shelf options leave investors scratching their heads with promises of perfect predictions but instead are left overexposed and no way out.
Then there is the problem of inaccurate data sources and affordable options for retail investors. Few traders are willing to spend thousands each month on Bloomberg terminal, and the other lower-cost options generally lack all the information required to succeed. It may be seen as a pay-to-win system, or so it seems.
The struggles of going with the attractive 'full' systematic process of having a computer tell you when to buy or sell fall victim to over-optimisation, eliminating its predictive value. Developers end up 'perfectly' training algorithms on historical data, nullifying its use on future market data.
Then on the other side of the field, the discretionary traders try to apply rules derived from how they 'feel', solely reliant on their experience, having a clear mind and being disciplined 24/7. An unrealistic ask for most ordinary people.
So what is the solution? What is the best fundamental analysis strategy?
The answer is a potent mix of systematic and discretionary methods combined in a sensible and repeatable fashion. The good news is this system is already used by top investors globally. The bad news is it's pretty tricky to pull off.
The strategy I'm referring to here is the global macro approach. A fundamental investment style that seeks market returns regardless of trending up or down. A strategy used by the likes of Morgan Stanley and Ray Dalio that has netted them exceptional returns versus their counterparts.
Although significant, the global macro strategy is challenging to master but is worth it for those that succeed.
For a beginner, we recommend taking a free fundamental trading class to see if it's for you before you commit to this life-long art form.
Fundamental Analysis FAQs
What is meant by fundamental analysis?
Fundamental analysis is a way investors discover the 'true value' of a stock, currency or bond. Sometimes referred to as the intrinsic value, investors will compare this value to current market prices to see if a trade has the opportunity to make a positive return.
What is fundamental analysis and its types?
What is fundamental analysis and its objective?
How do you do fundamental analysis?
Why is fundamental analysis important?
What are the 3 layers of fundamental analysis?
Who uses fundamental analysis?
Sources
Sources
[1] E.B.BishopF.C.W.A.,F.C.I.S.. "R.O.C.E. as a tool for planning and control", 1969. Accessed Sept. 26, 2022.
Jeffrey S. Abarbanell and Brian J. Bushee. "Fundamental Analysis, Future Earnings, and Stock Prices", Vol. 35, No.1 (Spring 1997). Accessed Sept 26, 2022.
