October 28th, 2011

The Futility of Fundamental Analysis for Us "Home Gamers"

We’ve heard it often recently, especially after the last nasty Republican debate, the gospel known as “Republican Eleventh Commandment” originally set out by gubernatorial candidate Ronald Reagan during a particularly feisty 1966 California primary: “thou shall not speak ill of a fellow Republican”. It may also be true of bloggers, especially those of the stock, investment or financial variety: “thou shall not speak ill of another blogger”.

But I just can’t resist and am aware that I risk rebuttal or criticism from other bloggers in return. The article in question came in my daily update from Greenfaucet, a piece by Chuck Carnevale, a long-time investment manager and creator of something he calls the F.A.S.T. Graphs (Fundamentals Analyzer Software Tool™). Carnevale applies his F.A.S.T. Graphs to 10 of the Dow-30 stocks and derives the following sort of chart with accompanying financial fact data sheet for each:

The F.A.S.T. approach apparently takes earnings and dividend streams and, like good fundamental analysts, comes up with a fair value for the stock to determine whether the stock, at the time of the analysis was under-, over- or fairly-valued.

His conclusions:

“….we are discussing the valuation of the markets based on the intrinsic values of the underlying companies that make up the markets. In short, based on fundamentals, we believe that many quality companies are on sale today…..

As long as valuation is reasonably aligned with fundamental value in the beginning, comparisons are primarily driven by the rate of change of earnings growth achieved, and how consistently they were achieved…..

in an instant, the investor can determine what kind of company they are looking at and whether or not it is capable of meeting their specific investment objectives and risk tolerances. We believe a specific insight on individual companies is more beneficial and productive than a more general view…..

The fact that markets can and will often misprice stocks is undeniable. Furthermore, we have always felt that it is an exercise in futility to attempt to quantify why a market is behaving the way it is when it is behaving irrationally. In other words, irrational behavior is unquantifiable, and therefore, precisely what it is – irrational. Rather than try to explain it, we believe it’s more important to recognize it and behave accordingly.

And this is where my criticism comes in. The chart of MRK above speaks for itself as to why fundamental analysis doesn’t work …. in fact, it’s worthless (the same can be said for each of the 1o stocks for which he offers similar graphs). One might not have bought MRK at 40 in 1996 when the F.A.S.T. Graphs indicated it was over-valued and missed out on a move to 92 in 2000 (when it was way over-priced) or bought MRK at 55 at the end of 2002 and still be waiting for the dividends to compensate you for the stocks erosion to 35 today.

Rather than proving his point, his charts and data only prove to me, at least, how little fundamentals have to do with valuation for the individual investor as contrasted with the proper execution of market timing, industry selection and the timely entry and exit of individual positions.

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