A Project Report

On

“A Fundamental Analysis of Global Currency Market”

at

“J-Wings”
By

SANDIP GANGULY

PGDM NO. 17034

Submitted in partial fulfillment of the requirement of Summer Internship Programme

Under the Guidance of

Mr. Gopal Krishna

&
Prof. M.Sriram SDMIMD, Mysore

SDM Institute for Management Development

Mysore, Karnataka, India
June 2018

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 Acknowledgement

I sincerely thank J-Wings, Bangaluru, (Karnataka) for providing me the

corporate exposure in finance industry and an opportunity to do this
project with their esteemed organization for 2 months during my
summer internship. It was a challenging yet rich learning experience
for me.

I take this opportunity to express my profound gratitude and deep

regards to Mr. Gopal Krishna Sir and Megesh Sir for their exemplary
guidance, monitoring and constant encouragement throughout the
course of the work.

The 2 months of Internship at one of the prestigious financial

organization gave me some valuable lifelong lessons. It has helped me
in shaping way for my professional career and making me stronger in
my approach. I also thank my fellow interns at J-Wings with whom I
was involved in a learning process and together we successfully
completed our Internship.

I sincerely thank my faculty guide Professor M.Sriram Sir for being

there always to support me and guiding me whenever his help was
required. His continuous support during the period of internship helped
me in enhancing my financial knowledge for successful completion of
my SIP.

Sandip Ganguly

10th June, 2018

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Contents
Acknowledgement ..................................................................................................................... 2

INTRODUCTION ..................................................................................................................... 5

Industry Overview.................................................................................................................. 5

PROJECT INTRODUCTION.................................................................................................... 8

SCOPE AND PURPOSE OF INTERNSHIP ......................................................................... 8

LIMITATIONS OF THE PROJECT ..................................................................................... 8

INTRODUCTION TO THE COMPANY ............................................................................... 10

INTRODUCTION TO THE FOREX MARKET ................................................................ 12

PESTLE ANALYSIS ........................................................................................................... 14

2. MARKET ANALYSIS ....................................................................................................... 15

TECHNICAL ANALYSIS .................................................................................................. 15

JAPANESE CANDLE STICKS ...................................................................................... 16

STOCHASTIC OSCILLATOR ....................................................................................... 17

RELATIVE STRENGTH INDEX ................................................................................... 17

MOVING AVERAGES ................................................................................................... 18

PIVOT POINT ................................................................................................................. 19

BOLLINGER BANDS .................................................................................................... 19

FIBONACCI LEVELS .................................................................................................... 20

FUNDAMENTAL ANALYSIS .......................................................................................... 20

FUNDAMENTAL ANALYSIS IN FOREX MARKET ................................................. 21

Fundamentals: Quantitative and Qualitative .................................................................... 23

Fundamental Analysis: Introduction to Financial Statements ......................................... 35

Annual Report of Mutual Funds .......................................................................................... 40

Fundamental Analysis: The Balance Sheet ...................................................................... 40

Fundamental Analysis: Stock Picking Strategies............................................................. 58

Financials ............................................................................................................................. 59

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 The Theory Behind It All ..................................................................................................... 59

The 'Greater Fool' Theory .................................................................................................... 60

The Two Types of Investors ................................................................................................ 60

Conclusion ............................................................................................................................... 60

The Best of Both Worlds ..................................................................................................... 61

The Downside to Blending .................................................................................................. 62

REFERENCES......................................................................................................................... 65

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INTRODUCTION
Industry Overview
Stock Broking industry dates back to the 2nd century BC in Rome when
for the first time any shares were bought or sold. In India, it started in
1875 with the setting up of Bombay Stock Exchange. Since then, the
profession has come a long way and today it has become more than $1
billion industry in the country.

Stock Brokers used to be an elite group of BSE members for a long

period of time. Becoming a broker was extremely difficult for many,
mainly due to the high capital layout involved. The phase changed
dramatically in the last couple of decades since NSE was setup in the
1990s and a lot of trading started moving to the online platforms.
Transparency increased and trading costs reduced which helped the

trading public in general. Introduction of Derivatives trading helped in

devising hedging and other trading strategies.

During this period, the number of brokers increased exponentially due

to relaxation of entry barriers and the increasing market size. However,
over the past 5 years this industry has gone through a major
consolidation phase.

There is a decline in the number of stock brokers in India. This decline

can be attributed to a number of reasons. Tightening of regulations can
be seen as a major factor, with introduction of a number of KYC and
other compliance norms. SEBI and the government are making every
effort to ensure investor safety. Regulations are important to ensure the
stock markets are used in the right way as a savings and investment
avenue, as against a platform for speculation or gambling.

Another reason is the advent of new discount broking players which

have taken the traditional broking houses by surprise and have put a
major pricing pressure on the old school broking players. Increasing
technology costs have also affected all the broking houses as the
customers have started to demand better and swift technology and the

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whole industry is inching towards automation of processes; which is
important for the growth of financial markets in India.

Every industry, at some point in time, goes through a changing phase.

Stock broking is no different. The efficient players are still going strong
and are taking full advantage of the situation by acquiring new
customers aggressively. A lot of big players have diversified
themselves into other businesses like NBFC, Real Estate or Asset
Management. This has given an opportunity to the mid-sized and
emerging brokers to capture the growing and untapped markets.

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 Of the 130 crore people in India, only around 18 crore people invest or trade
in the stock, commodity or currency markets which is around 1.5% of total
population In China or the US, this sub-set is more than 10 percent. SEBI,
stock exchanges, brokers and other market intermediaries are educating
investors and it has started to yield results. New investors are entering the
markets either by way of direct investments or through the mutual funds
route. Other assets like real estate or gold have not yielded as much returns as
the equity markets in the past 5 years and a lot of people are beginning to
understand this. Additionally, the liquidity offered by the stock markets is not
available with most of the other investment avenues. The tightening of the
compliance norms by SEBI has resulted in transparency in the markets and
increased public’s faith in the integrity of the whole industry.

Indian stock broking industry is undergoing a change. A lot of existing

customers are quickly moving to the newer discount broking players which
offer very cheap pricing with basic broking services with excellent trading
technologies. Regular traders and investors are finding these services
extremely cheap and attractive. On the other hand, the traditional brick and
mortar broking houses are focussing more on developing newer markets.
They are now building better & transparent customer support systems. They
have also realised that to survive and compete in this industry, they need to
gradually become more efficient by reducing their overheads.

The times are very opportunative for all the discount brokers as well as full
service brokers in different ways. The stock brokers who become efficient by
focussing on technology, reducing unwanted costs and improving customer
support in their domain will emerge to be the new leading players in future.

7
 PROJECT INTRODUCTION
SCOPE AND PURPOSE OF INTERNSHIP
 The primary objective is to understand the trend of the price movements of
the currencies and commodities in the Forex Market and predict future price
movements of the same.

 This internship helps in developing the ability to understand the Forex

market and trade accordingly with real accounts opened by the potential
clients and gain practical experience in Forex trading.

 This internship also helps me use and understand various analytical tools
like candle sticks, stochastic oscillators, etc. to predict price movements.

 To develop techniques to analyse the market more efficiently and enter into
trade thus, increasing profits for the traders.

LIMITATIONS OF THE PROJECT

 The study is based only on the past historic data. As such it is subject to the
limitations of the secondary data.

 The time period taken for the study was only 3 months and the results
depicted would vary if the research is taken for a longer period of time or
year.

 Data analysis for a short time may not give accurate results.

 Not all the analysis done, like sentimental and fundamental analysis, can be
quantified.

 Due to fast and high volatility in the forex market predicting or

interpretation may not be

8
 100% accurate.

 There are various currencies and commodities in the market but the study is
limited to only one currency pair.

9
 INTRODUCTION TO THE COMPANY

“J Wings Manifest Wealth Company”

In the era of constant changing and volatile financial Market, Investors need,
qualified, trained and an unbiased professional to assist them in achieving
their short term and long term investment goal. At Investor centric, the
company’s single utmost aim is to assist clients with dedication and integrity
so that the company exceed their expectations and build enduring
relationships.

J Wings Wealth Manifest has more than a year of experience in Financial

Service Sectors. It offers technology based services for clients to effectively
monitor their portfolio and help them in reaching their financial goals. They
focus at being the most reliable prompt and efficient provider of financial
services. It endeavours to be one stop solutions for financial boutique and to
be immense help to the investors, learners and provide help regarding, stock
market, advisory services, training, investment planning, wealth creation and
insurance.

For Forex Trading, J Wings has a tie up with Grand Bloom Company Forex
Ltd (GBCFX), with headquarters in Malaysia and Dubai. The company
mainly focuses on Forex trading. It generally trades by keeping US Dollar
(USD) as the base currency as it is the most readily used currency for forex
exchange and is considered to have the most stable economic value.

The major currencies in which the company trades are:

US Dollars (USD)

Switzerland Franc (CHF)

Australian Dollar (AUD)

Euro (EUR)

Great Britain Pound (GBP)

Japanese Yen (JPY)

10
 Along with the above mentioned eight currencies, the Company also trades
in two commodities:

Gold (XAU)

Silver (XAG)

The company also manages a wide variety of portfolios which includes,

Equity Trading.

Commodities Trading.

Currency Trading.

Health Insurance.

Mutual Funds.

Credit Cards.

Loans.

Stock Sip Management.  Wealth Management.

11
INTRODUCTION TO THE FOREX MARKET

Foreign Exchange is the process of conversion of one currency into another

currency. For a country, its currency becomes money and legal tender. For a
foreign country, it becomes the value as a commodity. Since the commodity
has a value its relation with the other currency determines the exchange
value of one currency with the other. For example, the US dollar in USA is
the currency in USA but for India it is just like a commodity, which has a
value which varies according to demand and supply.

Foreign exchange is that section of economic activity, which deals with the
means, and methods by which rights to wealth expressed in terms of the
currency of one country are converted into rights to wealth in terms of the
current of another country. It involves the investigation of the method,
which exchanges the currency of one country for that of another. Foreign
exchange can also be defined as the means of payment in which currencies
are converted into each other and by which international transfers are made;
also, the activity of transacting business in further means.

Most countries of the world have their own currencies The US has its
Dollar, France its Franc, Brazil its Cruzeiro; and India has its Rupee. Trade
between the countries involves the exchange of different currencies. The
foreign exchange market is the market in which currencies are bought and
sold against each other. It is the largest market in the world. Transactions
conducted in foreign exchange markets determine the rates at which
currencies are exchanged for one another, which in turn determine the cost
of purchasing foreign goods; financial assets.

The Foreign Exchange Market (Forex, FX, or currency market) is a global

decentralized market for the trading of currencies. This includes all aspects
of buying, selling and exchanging currencies at current or determined
prices. In terms of volume of trading, it is by far the largest market in the
world, followed by the Credit market. The main participants in this market
are the large international banks. Financial centers around the world
function as anchors of trading between a wide range of multiple types of
buyers and sellers around the clock, with the exception of weekends. The
foreign exchange market does not determine the relative values of different
currencies, but sets the current market price of the value of one currency as
demanded against another.

12
 SWOT ANALYSIS

Figure 1: SWOT Diagram

STRENGTHS

 Average 3%-5% monthly return and 36% -60% annually which is 6 times
higher as compared to domestic market.
 23-hour market from 3:30 am to 2:30 am whereas domestic market is a 6
hour market i.e. 9:15am 3:30 pm IST.

WEAKNESSES

 Amount of investment to be made by an investor is higher as compared to

domestic market.
 There is a risk of 30% of the total investment; varying as per the company
policies.

OPPORTUNITIES

 With the times of high competition in the financial market reliability of

investors withdrawing capital is natural. In such cases companies have a
great opportunity to work and collaborate with competitor companies.
 Survey shows that only 2% of population in India invest in stocks and
supplementary market. Hence there exists an opportunity to create a market
for the people who don’t invest.

13
 THREATS

 Since any financial market are subjected to market risk, requires due
guidelines with SEBI, RBI & corresponding matters non-compliance of
which welcomes criminal proceedings.
 Since company deals with FOREX currency market for which compliance
with international law becomes mandatory and rebates and taxes duly filed
with appropriate government.

PESTLE ANALYSIS
Political

 Political factors have huge impacts on Markets. The factors are:

• Elections Surveys.
• Election polls.
• Wars and Strikes.

Economic

 The Economic factors which influence

the market are:

• Gross Domestic Product (GDP)

growth rate.
• Monetary and Fiscal policy changes
• Consumer Price Inflations (CPI).

Social F 2: Pestle

 The Social factors which affects market are:

• Unemployment Rate.
• Human Development Index(HDI)

Technological

 The Technological factors affecting markets are:

• New technological advancements affect the currency price of that economy.

E.g. Japan.
14
 • Adopting advanced technology affect prices of companies working with
outdated technology Ex: Introduction of cleaner technologies.

Legal

 Markets affect due to the following Legal factors:

• Compliance with law of the land. Ex: FCRA

• Pending Court cases to launch new product and services.

Environmental

 The Ecological factors affecting Market are:

• Compliance with environmental standards ex: Corporate social

responsibility and adopting paperless world.
• Compliance with National Green Tribunal (NGT) on the grounds of keeping
city green and clean.

2. MARKET ANALYSIS

Forex analysis is used by the retail forex day trader to determine whether to
buy or sell a currency pair at any one time. Forex analysis could be technical
in nature, using charting tools, or fundamental in nature, using economic
indicators and/or news based events. The day trader's currency trading
system use analysis that create buy or sell decisions when they point in the
same direction. Forex trading strategies that use this analysis are available
for free, for a fee or are developed by the trader themselves.

TECHNICAL ANALYSIS
Technical analysis is a trading tool employed to evaluate securities and
attempt to forecast their future movement by analysing statistics gathered
from trading activity, such as price movement and volume. Unlike
fundamental analysts who attempt to evaluate a security’s intrinsic value,
technical analysts focus on charts of price movement and various analytical
tools to evaluate a security’s strength or weakness and forecast future price
changes.

15
 Technical analysis is used to attempt to forecast the price movement of
virtually any tradable instrument that is generally subject to forces of supply
and demand, including stocks, bonds, futures and currency pairs. In fact,
technical analysis can be viewed as simply the study of supply and demand
forces as reflected in the market price movements of a security. It is most
commonly applied to price changes, but some analysts may additionally
take numbers other than just price, such as trading volume or open interest
figures.

Technical analysts apply technical indicators to charts of various

timeframes. Short-term traders may use charts ranging from one-minute
timeframes to hourly or four-hour timeframes, while traders analysing
longer-term price movement scrutinize daily, weekly or monthly charts.

Over the years, numerous technical indicators have been developed by

analysts in attempts to accurately forecast future price movements. Some
indicators are focused primarily on identifying the current market trend,
including support and resistance areas, while others are focused on
determining the strength of a trend and the likelihood of its continuation.
Out of the various indicators and charts, for analysis seven types of charts
are used.

JAPANESE CANDLE STICKS

A candlestick chart (also called Japanese candlestick chart) are thought
to have been developed in the 18th century by Munehisa Homma, a
Japanese rice trader of financial instruments. They were introduced to the
Western world by Steve Nison in his book, “Japanese Candlestick
Charting Techniques”. They are often used today in stock analysis along
with other analytical tools.

It is a style of financial chart used to describe price movements of a security,

derivative, or currency. Each "candlestick" typically shows one day; so, for
example a one-month chart may show the 20 trading days as 20
candlesticks. It can be 1 min, 15 mins, 30 mins, 1 hr, 4 hrs, daily, weekly
& monthly.

It is like a combination of line-chart and a bar-chart: each bar represents all

four important pieces of information for that day: the open, the close, the
high and the low. Being densely packed with information, they tend to
represent trading patterns over short periods of time, often a few days or a
few trading sessions.

16
STOCHASTIC OSCILLATOR
The stochastic oscillator was developed in the late 1950s by George Lane. It
presents the location of the closing price of a stock in relation to the high
and low range of the price of a stock over a period of time. The oscillator
follows the speed or momentum of price. As a rule, the momentum or speed
of the price of a stock changes before the price changes itself. In this way,
the stochastic oscillator can be used to foreshadow reversals when the
indicator reveals bullish or bearish divergences.

The stochastic oscillator can play an important role in identifying

overbought and oversold levels, because it is range bound i.e. from 0 - 100.
This range remains constant, no matter how quickly or slowly a security
advances or declines. Considering the most traditional settings for the
oscillator, 20 are typically considered the oversold threshold and 80 is
considered the overbought threshold. However, the levels are adjustable to
fit security characteristics and analytical needs. Readings above 80 indicate
a security is trading near the top of its high-low range; readings below 20
indicate the security is trading near the bottom of its high-low range.

Using a scale to measure the degree of change between prices from one
closing period to the next, the Stochastic Oscillator attempts to predict the
probability for the continuation of the current direction trend. Traders
look for signals generated by the actions of the stochastic lines as viewed on
the stochastic scale.

RELATIVE STRENGTH INDEX

The relative strength index (RSI) is a momentum indicator developed by
noted technical analyst Welles Wilder that compares the magnitude of
recent gains and losses over a specified time period to measure speed and
17
 change of price movements of a security. It is primarily used to attempt to
identify overbought or oversold conditions in the trading of an asset.

The RSI provides a relative evaluation of the strength of a security's recent

price performance, thus making it a momentum indicator. RSI values range
from 0 to 100. The default time frame for comparing up periods to down
periods is 14, i.e., 14 trading days.

For trading, RSI is analysed by taking 3 levels at 70, 50 and 30. If RSI is
above 70 then, it shows that the currency or commodity is overbought
and the price is expected to go down. Similarly, if it is below 30 it is said
that the currency or commodity is oversold and it is expected that the
price will go up. More extreme high and low levels—80 and 20, or 90
and 10—occur less frequently but indicate stronger momentum.

The relative strength index is calculated using the following formula:

RSI = 100 - 100 / (1 + RS)

Where, RS = Average gain of up periods during the specified time frame /

Average loss of down periods during the specified time frame.

MOVING AVERAGES
A moving average is simply a way to smooth out price action over time.
For this the average closing price of a currency pair for the last ‘X’ number
of periods is taken.

Like every indicator, a moving average indicator is used to help us forecast

future prices. By looking at the slope of the moving average, you can better
determine the potential direction of market prices. There are different types
of moving averages and each of them has their own level of “smoothness”.

Generally, the smoother the moving average, the slower it is to react to the
price movement. The choppier the moving average, the quicker it is to react
to the price movement. To make a moving average smoother, you should
get the average closing prices over a longer time period. There are two
major types of moving averages; Simple and Exponential.

A crossover is the most basic type of signal and is favoured among many
traders because it removes the element of emotion from trading. The most
basic type of crossover occurs when the price of an asset moves from one
side of a moving average and closes on the other. A cross below a moving
average can signal the beginning of a downtrend and would likely be
used by traders as a signal to close out any existing long positions.

18
 Conversely, a close above a moving average from below may suggest the
beginning of a new uptrend.

A second type of crossover occurs when a short-term average generally 15

day’s average, crosses through a long-term average i.e. 50 day’s average.
This signal is used by traders to spot when momentum is shifting in one
direction and that a strong move is likely approaching. A buy signal is
generated when the short-term average crosses above the long-term
average, while a sell signal is triggered by a short-term average crossing
below a long-term average.

Forex traders use moving averages for different reasons. Some use them as
their primary analytical tool, while others simply use them as a confidence
builder to back up their investment decisions.

PIVOT POINT
Trading requires reference points (support and resistance), which are used to
determine when to enter the market, place stops and take profits. However,
many traders focus on technical indicators such as Moving Averages and
Relative Strength Index (RSI) and fail to identify a point that defines risk.

Unknown risk can lead to margin calls, but calculated risk significantly
improves the odds of success over the long haul.

One tool that actually provides potential support and resistance and helps
minimize risk is the pivot point and its derivatives. A combination of pivot
points and traditional technical tools is far more powerful than technical
tools alone and this combination, can be used effectively in the forex
market.

Generally, for trading 3 levels of resistance and 3 levels of support is

found. In order to compute

Pivot point, high, low and close values of a daily or weekly or monthly
candle is taken for daily weekly and monthly pivot points respectively.

BOLLINGER BANDS
Bollinger Bands are a technical chart indicator popular among traders across
several financial markets. Generally, on a chart, Bollinger Bands are two
“bands” that sandwich the market price but, three bands are used with
a period 20 as it helps is deciding the range more precisely for an
intraday trader as compared with two bands.

19
FIBONACCI LEVELS
The Fibonacci studies are popular trading tools. Understanding how they are
used and to what extent they can be trusted is important to any trader who
wants to benefit from the ancient mathematician’s scientific legacy. While
some traders unquestionably rely on Fibonacci tools to make major trading
decisions, others see the Fibonacci studies as exotic scientific baubles, toyed
with by so many traders that they may even influence the market.

Forex traders use Fibonacci retracements to pinpoint where to place orders

for market entry, for taking profits and for stop-loss orders. Fibonacci levels
are commonly used in forex trading to identify and trade off of support and
resistance levels.

There are five types of trading tools that are based on Fibonacci’s discovery.
They are:

 Arcs
 Fans
 Retracements  Extensions  Time zones.
Fibonacci retracements identify key levels of support and resistance.
Fibonacci levels are commonly calculated after a market has made a large
move either up or down and seem to have flattened out at a certain price
level. Traders plot the key Fibonacci retracement levels of 38.2%, 50% and
61.8% by drawing horizontal lines across a chart at those price levels to
identify areas where the market may retrace to before resuming the overall
trend formed by the initial large price move. The Fibonacci levels are
considered especially important when a market has approached or reached a
major price support or resistance level.
The lines created by these Fibonacci studies are believed to signal
changes in trends as the prices draw near them. 61.8% is considered to
be a golden level.

FUNDAMENTAL ANALYSIS
Fundamental analysis is a method of evaluating a security in an attempt to
measure its intrinsic value, by examining related economic, financial and
other qualitative and quantitative factors. Fundamental analysts study
anything that can affect the security’s value, including macroeconomic
factors such as the overall economy and industry conditions, and
microeconomic factors such as financial conditions and company
management. The end goal of fundamental analysis is to produce a
quantitative value that an investor can compare with a security’s current
price, thus indicating whether the security is undervalued or overvalued.
20
 Fundamental analysis determines the health and performance of an
underlying company by looking at key numbers and economic indicators.
The purpose is to identify fundamentally strong companies or industries and
fundamentally weak companies or industries. Investors go long on the
companies that are strong, and short the companies that are weak. This
method of security analysis is considered to be the opposite of technical
analysis.

Fundamental analysis uses real, public data in the evaluation a security’s

value. Although most analysts use fundamental analysis to value stocks, this
method of valuation can be used for just about any type of security. For
example, an investor can perform fundamental analysis on a bond’s value
by looking at economic factors such as interest rates and the overall state of
the economy. He can also look at the information about the bond issuer,
such as potential changes in credit ratings.

For stocks and equity instruments, this method uses revenues, earnings,
future growth, return on equity, profit margins and other data to determine a
company's underlying value and potential for future growth. In terms of
stocks, fundamental analysis focuses on the financial statements of the
company being evaluated. One of the most famous and successful
fundamental analysts is the socalled "Oracle of Omaha", Warren Buffett,
who is well known for successfully employing fundamental analysis to pick
securities. His abilities have turned him into a billionaire.

FUNDAMENTAL ANALYSIS IN FOREX MARKET

Fundamental analysis is often used to analyze changes in the forex market

by monitoring factors, such as interest rates, unemployment rates, gross
domestic product (GDP) and many other economic releases that come out of
the countries in question. For example, a trader analysing the EUR/USD
currency pair fundamentally, would be interested in the interest rates in the
Eurozone, compared to those in the U.S. They would also want to be on top
of any significant news releases coming out of each country in relation to
the health of their economies. In this, the Economic factors i.e. both Micro
and Macro factors related to the country and their respective currencies are
studied in order to predict the price movement of the currency prices.

21
 What Does Fundamental Analysis Mean?
A method of evaluating a security by attempting to measure its intrinsic
value by examining related economic, financial and other qualitative and
quantitative factors. Fundamental analysts attempt to study everything that
can affect the security's value, including macroeconomic factors (like the
overall economy and industry conditions) and individually specific factors
(like the financial condition and management of companies).

The end goal of performing fundamental analysis is to produce a value that

an investor can compare with the security's current price in hopes of
figuring out what sort of position to take with that security (underpriced =
buy, overpriced = sell or short).

This method of security analysis is considered to be the opposite of

technical analysis.

Fundamental analysis is about using real data to evaluate a security's value.

Although most analysts use fundamental analysis to value stocks, this
method of valuation can be used for just about any type of security.

For example, an investor can perform fundamental analysis on a bond's

value by looking at economic factors, such as interest rates and the overall
state of the economy, and information about the bond issuer, such as
potential changes in credit ratings. For assessing stocks, this method uses
revenues, earnings, future growth, return on equity, profit margins and other

22
 data to determine a company's underlying value and potential for future
growth. In terms of stocks, fundamental analysis focuses on the financial
statements of a the company being evaluated.

One of the most famous and successful users of fundamental analysis is the
Oracle of Omaha, Warren Buffett, who has been well known for
successfully employing fundamental analysis to pick securities. His abilities
have turned him into a billionaire.

When talking about stocks, fundamental analysis is a technique that attempts

to determine a security’s value by focusing on underlying factors that affect
a company's actual business and its future prospects. On a broader scope,
you can perform fundamental analysis on industries or the economy as a
whole. The term simply refers to the analysis of the economic well-being of
a financial entity as opposed to only its price movements.

Fundamental analysis serves to answer questions, such as:

 Is the company’s revenue growing?

 Is it actually making a profit?
 Is it in a strong-enough position to beat out its competitors in the future?
 Is it able to repay its debts?
 Is management trying to "cook the books"?

Of course, these are very involved questions, and there are literally hundreds
of others you might have about a company. It all really boils down to one
question: Is the company’s stock a good investment? Think of fundamental
analysis as a toolbox to help you answer this question.

Fundamentals: Quantitative and Qualitative

You could define fundamental analysis as “researching the fundamentals”,
but that doesn’t tell you a whole lot unless you know what fundamentals
23
 are. As we mentioned in the introduction, the big problem with defining
fundamentals is that it can include anything related to the economic well-
being of a company. Obvious items include things like revenue and profit,
but fundamentals also include everything from a company’s market share to
the quality of its management.

The various fundamental factors can be grouped into two categories:

quantitative and qualitative. The financial meaning of these terms isn’t all
that different from their regular definitions. Here is how the MSN Encarta
dictionary defines the terms:

 Quantitative – capable of being measured or expressed in numerical terms.

 Qualitative – related to or based on the quality or character of something,
often as opposed to its size or quantity.

In our context, quantitative fundamentals are numeric, measurable

characteristics about a business. It’s easy to see how the biggest source of
quantitative data is the financial statements. You can measure revenue,
profit, assets and more with great precision.

Turning to qualitative fundamentals, these are the less tangible factors

surrounding a business - things such as the quality of a company’s board
members and key executives, its brand-name recognition, patents or
proprietary technology.

Quantitative Meets Qualitative

Neither qualitative nor quantitative analysis is inherently better than the
other. Instead, many analysts consider qualitative factors in conjunction
with the hard, quantitative factors. Take the Coca-Cola Company, for
example. When examining its stock, an analyst might look at the stock’s
annual dividend payout, earnings per share, P/E ratio and many other
quantitative factors. However, no analysis of Coca-Cola would be complete
without taking into account its brand recognition. Anybody can start a
company that sells sugar and water, but few companies on earth are
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 recognized by billions of people. It’s tough to put your finger on exactly
what the Coke brand is worth, but you can be sure that it’s an essential
ingredient contributing to the company’s ongoing success.

The Concept of Intrinsic Value

Before we get any further, we have to address the subject of intrinsic value.
One of the primary assumptions of fundamental analysis is that the price on
the stock market does not fully reflect a stock’s “real” value. After all, why
would you be doing price analysis if the stock market were always correct?
In financial jargon, this true value is known as the intrinsic value.

For example, let’s say that a company’s stock was trading at $20. After
doing extensive homework on the company, you determine that it really is
worth $25. In other words, you determine the intrinsic value of the firm to
be $25. This is clearly relevant because an investor wants to buy stocks that
are trading at prices significantly below their estimated intrinsic value.

This leads us to one of the second major assumptions of fundamental

analysis: in the long run, the stock market will reflect the fundamentals.
There is no point in buying a stock based on intrinsic value if the price never
reflected that value. Nobody knows how long “the long run” really is. It
could be days or years.

This is what fundamental analysis is all about. By focusing on a particular

business, an investor can estimate the intrinsic value of a firm and thus find
opportunities where he or she can buy at a discount. If all goes well, the
investment will pay off over time as the market catches up to the
fundamentals.

The big unknowns are:

1)You don’t know if your estimate of intrinsic value is correct; and

2)You don’t know how long it will take for the intrinsic value to be
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 reflected in the marketplace.

Criticisms of Fundamental Analysis

The biggest criticisms of fundamental analysis come primarily from two
groups: proponents of technical analysis and believers of the “efficient
market hypothesis”.

Put simply, technical analysts base their investments (or, more precisely,
their trades) solely on the price and volume movements of securities. Using
charts and a number of other tools, they trade on momentum, not caring
about the fundamentals. While it is possible to use both techniques in
combination, one of the basic tenets of technical analysis is that the market
discounts everything. Accordingly, all news about a company already is
priced into a stock, and therefore a stock’s price movements give more
insight than the underlying fundamental factors of the business itself.

Followers of the efficient market hypothesis, however, are usually in

disagreement with both fundamental and technical analysts. The efficient
market hypothesis contends that it is essentially impossible to produce
market-beating returns in the long run, through either fundamental or
technical analysis. The rationale for this argument is that, since the market
efficiently prices all stocks on an ongoing basis, any opportunities for
excess returns derived from fundamental (or technical) analysis would be
almost immediately whittled away by the market’s many participants,
making it impossible for anyone to meaningfully outperform the market
over the long term.

Business Model
Even before an investor looks at a company's financial statements or does
any research, one of the most important questions that should be asked is:
What exactly does the company do? This is referred to as a company's
business model – it's how a company makes money. You can get a good
26
 overview of a company's business model by checking out its website or
reading the first part of its 10-K filing (Note: We'll get into more detail
about the 10-K in the financial statements chapter. For now, just bear with
us).

Sometimes business models are easy to understand. Take McDonalds, for

instance, which sells hamburgers, fries, soft drinks, salads and whatever
other new special they are promoting at the time. It's a simple model, easy
enough for anybody to understand.

Other times, you'd be surprised how complicated it can get. Boston Chicken
Inc. is a prime example of this. Back in the early '90s its stock was the
darling of Wall Street. At one point the company's CEO bragged that they
were the "first new fast-food restaurant to reach $1 billion in sales since
1969". The problem is, they didn't make money by selling chicken. Rather,
they made their money from royalty fees and high-interest loans to
franchisees. Boston Chicken was really nothing more than a big franchisor.
On top of this, management was aggressive with how it recognized its
revenue. As soon as it was revealed that all the franchisees were losing
money, the house of cards collapsed and the company went bankrupt.

At the very least, you should understand the business model of any company
you invest in. The "Oracle of Omaha", Warren Buffett, rarely invests in tech
stocks because most of the time he doesn't understand them. This is not to
say the technology sector is bad, but it's not Buffett's area of expertise; he
doesn't feel comfortable investing in this area. Similarly, unless you
understand a company's business model, you don't know what the drivers
are for future growth, and you leave yourself vulnerable to being blindsided
like shareholders of Boston Chicken were.

Competitive Advantage
Another business consideration for investors is competitive advantage. A
company's long-term success is driven largely by its ability to maintain a

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 competitive advantage - and keep it. Powerful competitive advantages, such
as Coca Cola's brand name and Microsoft's domination of the personal
computer operating system, create a moat around a business allowing it to
keep competitors at bay and enjoy growth and profits. When a company can
achieve competitive advantage, its shareholders can be well rewarded for
decades.

Management
Just as an army needs a general to lead it to victory, a company relies upon
management to steer it towards financial success. Some believe that
management is the most important aspect for investing in a company. It
makes sense - even the best business model is doomed if the leaders of the
company fail to properly execute the plan.

So how does an average investor go about evaluating the management of a

company?

This is one of the areas in which individuals are truly at a disadvantage

compared to professional investors. You can't set up a meeting with
management if you want to invest a few thousand dollars. On the other
hand, if you are a fund manager interested in investing millions of dollars,
there is a good chance you can schedule a face-to-face meeting with the
upper brass of the firm.

Every public company has a corporate information section on its website.

Usually there will be a quick biography on each executive with their
employment history, educational background and any applicable
achievements. Don't expect to find anything useful here. Let's be honest:
We're looking for dirt, and no company is going to put negative information
on its corporate website.

Instead, here are a few ways to get a feel for management:

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 1. Conference Calls
The Chief Executive Officer (CEO) and Chief Financial Officer (CFO) host
quarterly conference calls. (Sometimes you'll get other executives as well.)
The first portion of the call is management basically reading off the
financial results. What is really interesting is the question-and-answer
portion of the call. This is when the line is open for analysts to call in and
ask management direct questions. Answers here can be revealing about the
company, but more importantly, listen for candor. Do they avoid questions,
like politicians, or do they provide forthright answers?

2. Management Discussion and Analysis (MD&A)

The Management Discussion and Analysis is found at the beginning of the
annual report (discussed in more detail later in this tutorial). In theory, the
MD&A is supposed to be frank commentary on the management's outlook.
Sometimes the content is worthwhile, other times it's boilerplate. One tip is
to compare what management said in past years with what they are saying
now. Is it the same material rehashed? Have strategies actually been
implemented? If possible, sit down and read the last five years of MD&As;
it can be illuminating.

3. Ownership and Insider Sales

Just about any large company will compensate executives with a
combination of cash, restricted stock and options. While there are problems
with stock options, it is a positive sign that members of management are
also shareholders. The ideal situation is when the founder of the company is
still in charge. Examples include Bill Gates (in the '80s and '90s), Michael
Dell and Warren Buffett. When you know that a majority of management's
wealth is in the stock, you can have confidence that they will do the right
thing. As well, it's worth checking out if management has been selling its
stock. This has to be filed with the Securities and Exchange Commission
(SEC), so it's publicly available information. Talk is cheap - think twice if
you see management unloading all of its shares while saying something else
in the media.

29
 4. Past Performance
Another good way to get a feel for management capability is to check and
see how executives have done at other companies in the past. You can
normally find biographies of top executives on company web sites. Identify
the companies they worked at in the past and do a search on those
companies and their performance.

Corporate Governance
Corporate governance describes the policies in place within an organization
denoting the relationships and responsibilities between management,
directors and stakeholders. These policies are defined and determined in the
company charter and its bylaws, along with corporate laws and regulations.
The purpose of corporate governance policies is to ensure that proper checks
and balances are in place, making it more difficult for anyone to conduct
unethical and illegal activities.

Good corporate governance is a situation in which a company complies with

all of its governance policies and applicable government regulations (such
as the Sarbanes-Oxley Act of 2002) in order to look out for the interests of
the company's investors and other stakeholders.

Although, there are companies and organizations (such as Standard &

Poor's) that attempt to quantitatively assess companies on how well their
corporate governance policies serve stakeholders, most of these reports are
quite expensive for the average investor to purchase.

Fortunately, corporate governance policies typically cover a few general

areas: structure of the board of directors, stakeholder rights and financial
and information transparency. With a little research and the right questions
in mind, investors can get a good idea about a company's corporate

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 governance.

Financial and Information Transparency

This aspect of governance relates to the quality and timeliness of a
company's financial disclosures and operational happenings. Sufficient
transparency implies that a company's financial releases are written in a
manner that stakeholders can follow what management is doing and
therefore have a clear understanding of the company's current financial
situation.

Stakeholder Rights
This aspect of corporate governance examines the extent that a company's
policies are benefiting stakeholder interests, notably shareholder interests.
Ultimately, as owners of the company, shareholders should have some
access to the board of directors if they have concerns or want something
addressed. Therefore companies with good governance give shareholders a
certain amount of ownership voting rights to call meetings to discuss
pressing issues with the board.

Another relevant area for good governance, in terms of ownership rights, is

whether or not a company possesses large amounts of takeover defenses
(such as the Macaroni Defense or the Poison Pill) or other measures that
make it difficult for changes in management, directors and ownership to
occur.

Structure of the Board of Directors

The board of directors is composed of representatives from the company
and representatives from outside of the company. The combination of inside
and outside directors attempts to provide an independent assessment of
management's performance, making sure that the interests of shareholders
are represented.

The key word when looking at the board of directors is independence. The
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 board of directors is responsible for protecting shareholder interests and
ensuring that the upper management of the company is doing the same. The
board possesses the right to hire and fire members of the board on behalf of
the shareholders. A board filled with insiders will often not serve as
objective critics of management and will defend their actions as good and
beneficial, regardless of the circumstances.

Information on the board of directors of a publicly traded company (such as

biographies of individual board members and compensation-related info)
can be found in the DEF 14A proxy statement.

We've now gone over the business model, management and corporate
governance. These three areas are all important to consider when analyzing
any company. We will now move on to looking at qualitative factors in the
environment in which the company operates.

Fundamental Analysis: Qualitative Factors - The Industry

Each industry has differences in terms of its customer base, market share
among firms, industry-wide growth, competition, regulation and business
cycles. Learning about how the industry works will give an investor a
deeper understanding of a company's financial health.

Customers
Some companies serve only a handful of customers, while others serve
millions. In general, it's a red flag (a negative) if a business relies on a small
number of customers for a large portion of its sales because the loss of each
customer could dramatically affect revenues. For example, think of a
military supplier who has 100% of its sales with the U.S. government. One
change in government policy could potentially wipe out all of its sales. For
this reason, companies will always disclose in their 10-K if any one
customer accounts for a majority of revenues.

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 Market Share
Understanding a company's present market share can tell volumes about the
company's business. The fact that a company possesses an 85% market
share tells you that it is the largest player in its market by far. Furthermore,
this could also suggest that the company possesses some sort of "economic
moat," in other words, a competitive barrier serving to protect its current
and future earnings, along with its market share. Market share is important
because of economies of scale. When the firm is bigger than the rest of its
rivals, it is in a better position to absorb the high fixed costs of a capital-
intensive industry.

Industry Growth
One way of examining a company's growth potential is to first examine
whether the amount of customers in the overall market will grow. This is
crucial because without new customers, a company has to steal market share
in order to grow.

In some markets, there is zero or negative growth, a factor demanding

careful consideration. For example, a manufacturing company dedicated
solely to creating audio compact cassettes might have been very successful
in the '70s, '80s and early '90s. However, that same company would
probably have a rough time now due to the advent of newer technologies,
such as CDs and MP3s. The current market for audio compact cassettes is
only a fraction of what it was during the peak of its popularity.

Competition
Simply looking at the number of competitors goes a long way in
understanding the competitive landscape for a company. Industries that have
limited barriers to entry and a large number of competing firms create a
difficult operating environment for firms.

One of the biggest risks within a highly competitive industry is pricing

power. This refers to the ability of a supplier to increase prices and pass

33
 those costs on to customers. Companies operating in industries with few
alternatives have the ability to pass on costs to their customers. A great
example of this is Wal-Mart. They are so dominant in the retailing business,
that Wal-Mart practically sets the price for any of the suppliers wanting to
do business with them. If you want to sell to Wal-Mart, you have little, if
any, pricing power.

Regulation
Certain industries are heavily regulated due to the importance or severity of
the industry's products and/or services. As important as some of these
regulations are to the public, they can drastically affect the attractiveness of
a company for investment purposes.

In industries where one or two companies represent the entire industry for a
region (such as utility companies), governments usually specify how much
profit each company can make. In these instances, while there is the
potential for sizable profits, they are limited due to regulation.

In other industries, regulation can play a less direct role in affecting industry
pricing. For example, the drug industry is one of most regulated industries.
And for good reason - no one wants an ineffective drug that causes deaths to
reach the market. As a result, the U.S. Food and Drug Administration
(FDA) requires that new drugs must pass a series of clinical trials before
they can be sold and distributed to the general public. However, the
consequence of all this testing is that it usually takes several years and
millions of dollars before a drug is approved. Keep in mind that all these
costs are above and beyond the millions that the drug company has spent on
research and development.

All in all, investors should always be on the lookout for regulations that
could potentially have a material impact upon a business' bottom line.
Investors should keep these regulatory costs in mind as they assess the

34
 potential risks and rewards of investing.

Fundamental Analysis: Introduction to Financial Statements

The income statement is basically the first financial statement you will come
across in an annual report or quarterly Securities and Exchange Commission
(SEC) filing.

It also contains the numbers most often discussed when a company

announces its results - numbers such as revenue, earnings and earnings per
share. Basically, the income statement shows how much money the
company generated (revenue), how much it spent (expenses) and the
difference between the two (profit) over a certain time period.

When it comes to analyzing fundamentals, the income statement lets

investors know how well the company’s business is performing - or,
basically, whether or not the company is making money. Generally
speaking, companies ought to be able to bring in more money than they
spend or they don’t stay in business for long. Those companies with low
expenses relative to revenue - or high profits relative to revenue - signal
strong fundamentals to investors.

Revenue as an investor signal

Revenue, also commonly known as sales, is generally the most
straightforward part of the income statement. Often, there is just a single
number that represents all the money a company brought in during a
specific time period, although big companies sometimes break down
revenue by business segment or geography.

The best way for a company to improve profitability is by increasing sales

revenue. For instance, Starbucks Coffee has aggressive long-term sales
growth goals that include a distribution system of 20,000 stores worldwide.
Consistent sales growth has been a strong driver of Starbucks’ profitability.

35
 The best revenue are those that continue year in and year out. Temporary
increases, such as those that might result from a short-term promotion, are
less valuable and should garner a lower price-to-earnings multiple for a
company.

What are the Expenses?

There are many kinds of expenses, but the two most common are the cost of
goods sold (COGS) and selling, general and administrative expenses
(SG&A). Cost of goods sold is the expense most directly involved in
creating revenue. It represents the costs of producing or purchasing the
goods or services sold by the company. For example, if Wal-Mart pays a
supplier $4 for a box of soap, which it sells to customers for $5. When it is
sold, Wal-Mart’s cost of good sold for the box of soap would be $4.

Next, costs involved in operating the business are SG&A. This category
includes marketing, salaries, utility bills, technology expenses and other
general costs associated with running a business. SG&A also includes
depreciation and amortization. Companies must include the cost of
replacing worn out assets. Remember, some corporate expenses, such as
research and development (R&D) at technology companies, are crucial to
future growth and should not be cut, even though doing so may make for a
better-looking earnings report. Finally, there are financial costs, notably
taxes and interest payments, which need to be considered.

Profits = Revenue - Expenses

Profit, most simply put, is equal to total revenue minus total expenses.
However, there are several commonly used profit subcategories that tell
investors how the company is performing. Gross profit is calculated as
revenue minus cost of sales. Returning to Wal-Mart again, the gross profit
from the sale of the soap would have been $1 ($5 sales price less $4 cost
of goods sold = $1 gross profit).

36
 Companies with high gross margins will have a lot of money left over to
spend on other business operations, such as R&D or marketing. So be on the
lookout for downward trends in the gross margin rate over time. This is a
telltale sign of future problems facing the bottom line. When cost of goods
sold rises rapidly, they are likely to lower gross profit margins - unless, of
course, the company can pass these costs onto customers in the form of
higher prices.

Operating profit is equal to revenues minus the cost of sales and SG&A.
This number represents the profit a company made from its actual
operations, and excludes certain expenses and revenues that may not be
related to its central operations. High operating margins can mean the
company has effective control of costs, or that sales are increasing faster
than operating costs. Operating profit also gives investors an opportunity to
do profit-margin comparisons between companies that do not issue a
separate disclosure of their cost of goods sold figures (which are needed to
do gross margin analysis). Operating profit measures how much cash the
business throws off, and some consider it a more reliable measure of
profitability since it is harder to manipulate with accounting tricks than net
earnings.

Net income generally represents the company's profit after all expenses,
including financial expenses, have been paid. This number is often called
the "bottom line" and is generally the figure people refer to when they use
the word "profit" or "earnings".

When a company has a high profit margin, it usually means that it also has
one or more advantages over its competition. Companies with high net
profit margins have a bigger cushion to protect themselves during the hard
times. Companies with low profit margins can get wiped out in a downturn.
And companies with profit margins reflecting a competitive advantage are

37
 able to improve their market share during the hard times - leaving them even
better positioned when things improve again.

Conclusion
You can gain valuable insights about a company by examining its income
statement. Increasing sales offers the first sign of strong fundamentals.
Rising margins indicate increasing efficiency and profitability. It’s also a
good idea to determine whether the company is performing in line with
industry peers and competitors. Look for significant changes in revenues,
costs of goods sold and SG&A to get a sense of the company’s profit
fundamentals.

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Fundamental Analysis: Annual Report
An annual report is a publication that public corporations must provide
annually to shareholders to describe their operations and financial
conditions. The front part of the report often contains an impressive
combination of graphics, photos, and an accompanying narrative, all of
which chronicle the company's activities over the past year. The back part of
the report contains detailed financial and operational information.

Corporate Annual Reports

It was not until legislation was enacted after the stock market crash of 1929
that the annual report became a regular component of corporate financial
reporting. The annual report is a comprehensive report provided by most
public companies to disclose their corporate activities over the past year.
The report is typically issued to shareholders and other stakeholders who
use it to evaluate the firm's financial performance. Typically, an annual
report will contain the following sections:

 General Corporate Information

 Operating and Financial Highlights
 Letter to the Shareholders from the CEO
 Narrative Text, Graphics, and Photos
 Management's Discussion and Analysis (MD&A)
 Financial Statements, including the Balance Sheet, Income Statement, and
Cash Flow Statement
 Notes to the Financial Statements
 Auditor's Report
 Summary of Financial Data
 Accounting Policies
 etc.

In the US, a more detailed version of the annual report is referred to as Form
10-K, and is submitted to the US Securities and Exchange Commissions
(SEC). Companies may submit their annual reports electronically through
the SEC's EDGAR database. Reporting companies must send annual reports
to their shareholders when they hold annual meetings to elect directors.
Under the proxy rules, reporting companies are required to post their proxy
materials, including their annual reports, on their company websites.

Current and prospective investors, employees, creditors, analysts, and any

other interested party analyze a company using its annual report. The annual
report contains information on a company's financial position that can be
used to measure - a company's ability to pay its debts as they come due;
whether a company made a profit or loss in its previous fiscal year; a
company's growth over a number of years; how much earnings is retained
39
 by a company to grow its operations; the proportion of operational expenses
to revenue generated; etc. The annual report also confirms whether the
information confirms to the Generally Accepted Accounting Principles
(GAAP). This confirmation will be highlighted as an "unqualified opinion"
in the Auditor's Report section. Fundamental analysts attempt to understand
a company's future direction by analyzing the details provided in its annual
report.

Annual Report of Mutual Funds

In the case of mutual funds, an annual report is a required document that is

made available to a fund's shareholders on a fiscal year basis. It discloses
certain aspects of a fund's operations and financial condition. In contrast to
corporate annual reports, mutual fund annual reports are best described as
"plain vanilla" in terms of their presentation. A mutual fund annual report,
along with a fund's prospectus and statement of additional information, is a
source of multi-year fund data and performance, which is made available to
fund shareholders as well as to prospective fund investors. Unfortunately,
most of the information is quantitative rather than qualitative, which
addresses the mandatory accounting disclosures required of mutual funds.

All mutual funds that are registered with the SEC are required to send a full
report to all shareholders every year. The report shows how well the fund
fared over the fiscal year. Information that can be found in the annual report
includes:

 Table, chart, or graph of holdings by category (e.g., type of security,

industry sector, geographic region, credit quality, or maturity)
 Audited financial statements, including a complete or summary (top 50) list
of holdings
 Condensed financial statements
 Table showing the fund’s returns for 1-, 5-, and 10-year periods
 Management’s discussion of fund performance
 Management information about directors and officers, such as names, ages,
and length of time at fund
 Remuneration or compensation paid to directors, officers, and others

Fundamental Analysis: The Balance Sheet

The cash flow statement shows how much cash comes in and goes out of the
company over the quarter or the year. At first glance, that sounds a lot like
the income statement in that it records financial performance over a
specified period. But there is a big difference between the two.

40
 What distinguishes the two is accrual accounting, which is found on the
income statement. Accrual accounting requires companies to record
revenues and expenses when transactions occur, not when cash is
exchanged. At the same time, the income statement, on the other hand, often
includes non-cash revenues or expenses, which the statement of cash flows
does not include.

Just because the income statement shows net income of $10 does not means
that cash on the balance sheet will increase by $10. Whereas when the
bottom of the cash flow statement reads $10 net cash inflow, that's exactly
what it means. The company has $10 more in cash than at the end of the last
financial period. You may want to think of net cash from operations as the
company's "true" cash profit.

Because it shows how much actual cash a company has generated, the
statement of cash flows is critical to understanding a company's
fundamentals. It shows how the company is able to pay for its operations
and future growth.

Indeed, one of the most important features you should look for in a potential
investment is the company's ability to produce cash. Just because a company
shows a profit on the income statement doesn't mean it cannot get into
trouble later because of insufficient cash flows. A close examination of the
cash flow statement can give investors a better sense of how the company
will fare.

Three Sections of the Cash Flow Statement

Companies produce and consume cash in different ways, so the cash flow
statement is divided into three sections: cash flows from operations,
financing and investing. Basically, the sections on operations and financing
show how the company gets its cash, while the investing section shows how
the company spends its cash

41
 Cash Flows from Operating Activities
This section shows how much cash comes from sales of the company's
goods and services, less the amount of cash needed to make and sell those
goods and services. Investors tend to prefer companies that produce a net
positive cash flow from operating activities. High growth companies, such
as technology firms, tend to show negative cash flow from operations in
their formative years. At the same time, changes in cash flow from
operations typically offer a preview of changes in net future income.
Normally it's a good sign when it goes up. Watch out for a widening gap
between a company's reported earnings and its cash flow from operating
activities. If net income is much higher than cash flow, the company may be
speeding or slowing its booking of income or costs.

Cash Flows from Investing Activities

This section largely reflects the amount of cash the company has spent on
capital expenditures, such as new equipment or anything else that needed to
keep the business going. It also includes acquisitions of other businesses and
monetary investments such as money market funds.

You want to see a company re-invest capital in its business by at least the
rate of depreciation expenses each year. If it doesn't re-invest, it might show
artificially high cash inflows in the current year which may not be
sustainable.

Cash Flow From Financing Activities

This section describes the goings-on of cash associated with outside
financing activities. Typical sources of cash inflow would be cash raised by
selling stock and bonds or by bank borrowings. Likewise, paying back a
bank loan would show up as a use of cash flow, as would dividend
payments and common stock repurchases.

Cash Flow Statement Considerations:

Savvy investors are attracted to companies that produce plenty of free cash

42
 flow (FCF). Free cash flow signals a company's ability to pay debt, pay
dividends, buy back stock and facilitate the growth of business. Free cash
flow, which is essentially the excess cash produced by the company, can be
returned to shareholders or invested in new growth opportunities without
hurting the existing operations. The most common method of calculating
free cash flow is:

Ideally, investors would like to see that the company can pay for the
investing figure out of operations without having to rely on outside
financing to do so. A company's ability to pay for its own operations and
growth signals to investors that it has very strong fundamentals.

Fundamental Analysis: A Brief Introduction To Valuation

While the concept behind discounted cash flow analysis is simple, its
practical application can be a different matter. The premise of the
discounted cash flow method is that the current value of a company is
simply the present value of its future cash flows that are attributable to
shareholders. Its calculation is as follows:

For simplicity's sake, if we know that a company will generate $1 per share
in cash flow for shareholders every year into the future; we can calculate
what this type of cash flow is worth today. This value is then compared to
43
 the current value of the company to determine whether the company is a
good investment, based on it being undervalued or overvalued.

There are several different techniques within the discounted cash flow realm
of valuation, essentially differing on what type of cash flow is used in the
analysis. The dividend discount model focuses on the dividends the
company pays to shareholders, while the cash flow model looks at the cash
that can be paid to shareholders after all expenses, reinvestments and debt
repayments have been made. But conceptually they are the same, as it is the
present value of these streams that are taken into consideration.

As we mentioned before, the difficulty lies in the implementation of the

model as there are a considerable amount of estimates and assumptions that
go into the model. As you can imagine, forecasting the revenue and
expenses for a firm five or 10 years into the future can be considerably
difficult. Nevertheless, DCF is a valuable tool used by both analysts and
everyday investors to estimate a company's value.

Ratio Valuation
Financial ratios are mathematical calculations using figures mainly from the
financial statements, and they are used to gain an idea of a company's
valuation and financial performance. Some of the most well-known
valuation ratios are price-to-earnings and price-to-book. Each valuation ratio
uses different measures in its calculations. For example, price-to-book
compares the price per share to the company's book value.

The calculations produced by the valuation ratios are used to gain some
understanding of the company's value. The ratios are compared on an
absolute basis, in which there are threshold values. For example, in price-to-
book, companies trading below '1' are considered undervalued. Valuation
ratios are also compared to the historical values of the ratio for the

44
 company, along with comparisons to competitors and the overall market
itself.

Fundamental Analysis: Advanced Financial Statement Analysis

In the United States, a company that offers its common stock to the public
typically needs to file periodic financial reports with the Securities and
Exchange Commission (SEC).

The SEC governs the content of these filings and monitors the accounting
profession. In turn, the SEC empowers the Financial Accounting Standards
Board (FASB) - an independent, nongovernmental organization - with the
authority to update U.S. accounting rules. When considering important rule
changes, FASB is impressively careful to solicit input from a wide range of
constituents and accounting professionals. But once FASB issues a final
standard, this standard becomes a mandatory part of the total set of accounting
standards known as Generally Accepted Accounting Principles (GAAP).

Generally Accepted Accounting Principles (GAAP)

GAAP starts with a conceptual framework that anchors financial reports to a
set of principles such as materiality (the degree to which the transaction is big
enough to matter) and verifiability (the degree to which different people agree
on how to measure the transaction). The basic goal is to provide users - equity
investors, creditors, regulators and the public - with "relevant, reliable and
useful" information for making good decisions.

Because the framework is general, it requires interpretation, and often re-

interpretation, in light of new business transactions. Consequently, sitting on
top of the simple framework is a growing pile of literally hundreds of
accounting standards. But complexity in the rules is unavoidable for at least
two reasons.

45
 First, there is a natural tension between the two principles of relevance and
reliability. A transaction is relevant if a reasonable investor would care about
it; a reported transaction is reliable if the reported number is unbiased and
accurate. We want both, but we often cannot get both. For example, real estate
is carried on the balance sheet at historical cost because this historical cost is
reliable. That is, we can know with objective certainty how much was paid to
acquire property. However, even though historical cost is reliable, reporting
the current market value of the property would be more relevant - but also
less reliable.

Consider also derivative instruments, an area where relevance trumps

reliability. Derivatives can be complicated and difficult to value, but some
derivatives (speculative not hedge derivatives) increase risk. Rules therefore
require companies to carry derivatives on the balance sheet at "fair value",
which requires an estimate, even if the estimate is not perfectly reliable.
Again, the imprecise fair value estimate is more relevant than historical cost.
You can see how some of the complexity in accounting is due to a gradual
shift away from "reliable" historical costs to "relevant" marketvalues.

The second reason for the complexity in accounting rules is the unavoidable
restriction on the reporting period: financial statements try to capture
operating performance over the fixed period of a year. Accrual accounting is
the practice of matching expenses incurred during the year with revenue
earned, irrespective of cash flows. For example, say a company invests a huge
sum of cash to purchase a factory, which is then used over the following 20
years. Depreciation is just a way of allocating the purchase price over each
year of the factory's useful life so that profits can be estimated each year. Cash
flows are spent and received in a lumpy pattern and, over the long run, total
cash flows do tend to equal total accruals. But in a single year, they are not
equivalent. Even an easy reporting question such as "how much did the
company sell during the year?" requires making estimates that distinguish
cash received from revenue earned. For example, did the company use

46
 rebates, attach financing terms or sell to customers with doubtful credit?

Financial statements paint a picture of the transactions that flow through a

business. Each transaction or exchange - for example, the sale of a product or
the use of a rented a building block - contributes to the whole picture.

Let's approach the financial statements by following a flow of cash-based

transactions. In the illustration below, we have numbered four major steps:

1. Shareholders and lenders supply capital (cash) to the company.

47
 2. The capital suppliers have claims on the company. The balance sheet is an
updated record of the capital invested in the business. On the right-hand side
of the balance sheet, lenders hold liabilities and shareholders hold equity. The
equity claim is "residual", which means shareholders own whatever assets
remain after deducting liabilities.

The capital is used to buy assets, which are itemized on the left-hand side of
the balance sheet. The assets are current, such as inventory, or long-term, such
as a manufacturing plant.
3. The assets are deployed to create cash flow in the current year (cash inflows
are shown in green, outflows shown in red). Selling equity and issuing debt
start the process by raising cash. The company then "puts the cash to use" by
purchasing assets in order to create (build or buy) inventory. The inventory
helps the company make sales (generate revenue), and most of the revenue is
used to pay operating costs, which include salaries.
4. After paying costs (and taxes), the company can do three things with its cash
profits. One, it can (or probably must) pay interest on its debt. Two, it can pay
dividends to shareholders at its discretion. And three, it can retain or re-invest
the remaining profits. The retained profits increase the shareholders' equity
account (retained earnings). In theory, these reinvested funds are held for the
shareholders' benefit and reflected in a higher share price.

This basic flow of cash through the business introduces two financial
statements: the balance sheet and the statement of cash flows. It is often said
that the balance sheet is a static financial snapshot taken at the end of the year.

Statement of Cash Flows

The statement of cash flows may be the most intuitive of all statements. We
have already shown that, in basic terms, a company raises capital in order to
buy assets that generate a profit. The statement of cash flows "follows the
cash" according to these three core activities: (1) cash is raised from the
capital suppliers - cash flow from financing, (CFF), (2) cash is used to buy
assets - cash flow from investing (CFI), and (3) cash is used to create a profit
- cash flow from operations (CFO).

However, for better or worse, the technical classifications of some cash flows
are not intuitive. Below we recast the "natural" order of cash flows into their
technical classifications:

48
 You can see the statement of cash flows breaks into three sections:

1. Cash flow from financing (CFF) includes cash received (inflow) for the
issuance of debt and equity. As expected, CFF is reduced by dividends paid
(outflow).
2. Cash flow from investing (CFI) is usually negative because the biggest
portion is the expenditure (outflow) for the purchase of long-term assets such
as plants or machinery. But it can include cash received from separate (that
is, not consolidated) investments or joint ventures. Finally, it can include the
one-time cash inflows/outflows due to acquisitions and divestitures.
3. Cash flow from operations (CFO) naturally includes cash collected for sales
and cash spent to generate sales. This includes operating expenses such as
salaries, rent and taxes. But notice two additional items that reduce CFO: cash
paid for inventory and interest paid on debt.

The total of the three sections of the cash flow statement equals net cash flow:
CFF + CFI + CFO = net cash flow. We might be tempted to use net cash flow
as a performance measure, but the main problem is that it includes financing
49
 flows. Specifically, it could be abnormally high simply because the company
issued debt to raise cash, or abnormally low because it spent cash in order to
retire debt.

CFO by itself is a good but imperfect performance measure. Consider just one
of the problems with CFO caused by the unnatural re-classification illustrated
above. Notice that interest paid on debt (interest expense) is separated from
dividends paid: interest paid reduces CFO but dividends paid reduce CFF.
Both repay suppliers of capital, but the cash flow statement separates them.
As such, because dividends are not reflected in CFO, a company can boost
CFO simply by issuing new stock in order to retire old debt. If all other things
are equal, this equity-for-debt swap would boost CFO.

In the previous section of this tutorial, we showed that cash flows through a
business in four generic stages. First, cash is raised from investors and/or
borrowed from lenders. Second, cash is used to buy assets and build
inventory. Third, the assets and inventory enable company operations to
generate cash, which pays for expenses and taxes before eventually arriving
at the fourth stage. At this final stage, cash is returned to the lenders and
investors. Accounting rules require companies to classify their natural cash
flows into one of three buckets (as required by SFAS 95); together these
buckets constitute the statement of cash flows. The diagram below shows how
the natural cash flows fit into the classifications of the statement of cash
flows. Inflows are displayed in green and outflows displayed in red:

50
 The sum of CFF, CFI and CFO is net cash flow. Although net cash flow is
almost impervious to manipulation by management, it is an inferior
performance measure because it includes financing cash flows (CFF), which,
depending on a company's financing activities, can affect net cash flow in a
way that is contradictory to actual operating performance. For example, a
profitable company may decide to use its extra cash to retire long-term debt.
In this case, a negative CFF for the cash outlay to retire debt could plunge net
cash flow to zero even though operating performance is strong. Conversely,
a money-losing company can artificially boost net cash flow by issuing a
corporate bond or by selling stock. In this case, a positive CFF could offset a
negative operating cash flow (CFO), even though the company's operations
are not performing

Now that we have a firm grasp of the structure of natural cash flows and how
they are represented/classified, this section will examine which cash flow
measures are best used for a particular analysis. We will also focus on how
you can make adjustments to figures so that your analysis isn't distorted by
reporting manipulations.
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 Which Cash Flow Measure Is Best?
You have at least three valid cash flow measures to choose from. Which one
is suitable for you depends on your purpose and whether you are trying to
value the stock or the whole company.

The easiest choice is to pull cash flow from operations (CFO) directly from
the statement of cash flows. This is a popular measure, but it has weaknesses
when used in isolation: it excludes capital expenditures, which are typically
required to maintain the firm's productive capability. It can also be
manipulated, as we show below.

If we are trying to do a valuation or replace an accrual-based earnings

measure, the basic question is "which group/entity does cash flow to?" If we
want cash flow to shareholders, then we should use free cash flow to equity
(FCFE), which is analogous to net earnings and would be best for a price-to-
cash flow ratio (P/CF).

Free cash flow to equity (FCFE) equals CFO minus cash flows from
investments (CFI). Why subtract CFI from CFO? Because shareholders care
about the cash available to them after all cash outflows, including long-term
investments. CFO can be boosted merely because the company purchased
assets or even another company. FCFE improves on CFO by counting the
cash flows available to shareholders net of all spending, including
investments.

Free cash flow to the firm (FCFF) uses the same formula as FCFE but adds
after-tax interest, which equals interest paid multiplied by [1 – tax rate]. After-
tax interest paid is added because, in the case of FCFF, we are capturing the
total net cash flows available to both shareholders and lenders. Interest paid
(net of the company's tax deduction) is a cash outflow that we add back to
52
 FCFE in order to get a cash flow that is available to all suppliers of capital.

A Note Regarding Taxes

We do not need to subtract taxes separately from any of the three measures
above. CFO already includes (or, more precisely, is reduced by) taxes paid.
We usually do want after-tax cash flows since taxes are a real, ongoing
outflow. Of course, taxes paid in a year could be abnormal. So for valuation
purposes, adjusted CFO or EVA-type calculations adjust actual taxes paid to
produce a more "normal" level of taxes. For example, a firm might sell a
subsidiary for a taxable profit and thereby incur capital gains, increasing taxes
paid for the year. Because this portion of taxes paid is non-recurring, it could
be removed to calculate a normalized tax expense. But this kind of precision
is not always necessary. It is often acceptable to use taxes paid as they appear
in CFO.

Adjusting Cash Flow from Operations (CFO)

Each of the three cash flow measures includes CFO, but we want to capture
sustainable or recurring CFO, that is, the CFO generated by the ongoing
business. For this reason, we often cannot accept CFO as reported in the
statement of cash flows, and generally need to calculate an adjusted CFO by
removing one-time cash flows or other cash flows that are not generated by
regular business operations. Below, we review four kinds of adjustments you
should make to reported CFO in order to capture sustainable cash flows. First,
consider a "clean" CFO statement from Amgen, a company with a reputation
for generating robust cash flows:

53
 Amgen shows CFO in the indirect format. Under the indirect format, CFO is
derived from net income with two sets of 'add backs'. First, non-cash
expenses, such as depreciation, are added back because they reduce net
income but do not consume cash. Second, changes to operating (current)
balance sheet accounts are added or subtracted. In Amgen's case, there are
five such additions/subtractions that fall under the label "cash provided by
(used in) changes in operating assets and liabilities": three of these balance-
sheet changes subtract from CFO and two of them add to CFO.

For example, notice that trade receivables (also known as accounts

receivable) reduces CFO by about $255 million: trade receivables is a 'use of
cash'. This is because, as a current asset account, it increased by $255 million
during the year. This $255 million is included as revenue and therefore net
income, but the company hadn't received the cash as of the year's end, so the
uncollected revenues needed to be excluded from a cash calculation.
Conversely, accounts payable is a 'source of cash' in Amgen's case. This
current-liability account increased by $74 million during the year; Amgen
owes the money and net income reflects the expense, but the company

54
 temporarily held onto the cash, so its CFO for the period is increased by $74
million.

We will refer to Amgen's statement to explain the first adjustment you should
maketoCFO:

1. Tax Benefits Related to Employee Stock Options (See #1 on

Amgen CFO statement)
Amgen\'s CFO was boosted by almost $269 million because a company
gets a tax deduction when employees exercise non-qualified stock
options. As such, almost 8% of Amgen\'s CFO is not due to operations
and is not necessarily recurring, so the amount of the 8% should be
removed from CFO. Although Amgen\'s cash flow statement is
exceptionally legible, some companies bury this tax benefit in a
footnote.
To review the next two adjustments that must be made to reported CFO,
we will consider Verizon\'s statement of cash flows below.
2. Unusual Changes to Working Capital Accounts (receivables,
inventories and payables) (Refer to #2 on Verizon\'s CFO statement.)
Although Verizon\'s statement has many lines, notice that reported CFO
is derived from net income with the same two sets of add backs we
explained above: non-cash expenses are added back to net income and
changes to operating accounts are added to or subtracted from it:

55
 Notice that a change in accounts payable contributed more than $2.6
billion to reported CFO. In other words, Verizon created more than $2.6
billion in additional operating cash in 2003 by holding onto vendor bills
rather than paying them. It is not unusual for payables to increase as
revenue increases, but if payables increase at a faster rate than expenses,
then the company effectively creates cash flow by "stretching out"
payables to vendors. If these cash inflows are abnormally high,
removing them from CFO is recommended because they are probably
temporary. Specifically, the company could pay the vendor bills in
January, immediately after the end of the fiscal year. If it does this, it
artificially boosts the current-period CFO by deferring ordinary cash
outflows to a future period.

Judgment should be applied when evaluating changes to working capital

accounts because there can be good or bad intentions behind cash flow
created by lower levels of working capital. Companies with good

56
 intentions can work to minimize their working capital - they can try to
collect receivables quickly, stretch out payables and minimize their
inventory. These good intentions show up as incremental and therefore
sustainable improvements to working capital.

Companies with bad intentions attempt to temporarily dress-up cash

flow right before the end of the reporting period. Such changes to
working capital accounts are temporary because they will be reversed in
the subsequent fiscal year. These include temporarily withholding
vendor bills (which causes a temporary increase in accounts payable and
CFO), cutting deals to collect receivables before the year's end (causing
a temporary decrease in receivables and increase in CFO), or drawing
down inventory before the year's end (which causes a temporary
decrease in inventory and increase in CFO). In the case of receivables,
some companies sell their receivables to a third party in a factoring
transaction, which has the effect of temporarily boosting CFO.

3. Capitalized Expenditures That Should Be Expensed (outflows in

CFI that should be manually re-classified to CFO) (Refer to #3 on the
Verizon CFO statement.)
Under cash flow from investing (CFI), you can see that Verizon invested
almost $11.9 billion in cash. This cash outflow was classified under CFI
rather than CFO because the money was spent to acquire long-term
assets rather than pay for inventory or current operating expenses.
However, on occasion this is a judgment call. WorldCom notoriously
exploited this discretion by reclassifying current expenses into
investments and, in a single stroke, artificially boosting both CFO and
earnings.

Verizon chose to include 'capitalized software' in capital expenditures.

This refers to roughly $1 billion in cash spent (based on footnotes) to
develop internal software systems. Companies can choose to classify

57
 software developed for internal use as an expense (reducing CFO) or an
investment (reducing CFI). Microsoft, for example, responsibly
classifies all such development costs as expenses rather than capitalizing
them into CFI, which improves the quality of its reported CFO. In
Verizon's case, it's advisable to reclassify the cash outflow into CFO,
reducing it by $1 billion.

The main idea here is that if you are going to rely solely on CFO, you
should check CFI for cash outflows that ought to be reclassified to CFO.

4. One-Time (Nonrecurring) Gains Due to Dividends Received or

Trading Gains
CFO technically includes two cash flow items that analysts often re-
classify into cash flow from financing (CFF): (1) dividends received
from investments and (2) gains/losses from trading securities
(investments that are bought and sold for short-term profits). If you find
that CFO is boosted significantly by one or both of these items, they are
worth examination. Perhaps the inflows are sustainable. On the other
hand, dividends received are often not due to the company's core
operating business and may not be predictable. Gains from trading
securities are even less sustainable: they are notoriously volatile and
should generally be removed from CFO unless, of course, they are core
to operations, as with an investment firm. Further, trading gains can be
manipulated: management can easily sell tradable securities for a gain
prior to the year's end, boosting CFO.

Fundamental Analysis: Stock Picking Strategies

It involves evaluating a security using quantitative and qualitative factors to

answer questions such as:

 Are the company’s revenues growing?

58
  Is the company actually making a profit?
 Can the company beat its competitors in the future?
 Can the company repay its debts?
 And ultimately: Will the company’s stock be a good investment?

Financials

Fundamental analysts pay close attention to a company’s financial

statements. After all, they reveal a lot about the current – and future – health
of the company. The financials are where investors find many of the
quantitative factors used in fundamental analysis. Key financials include a
company’s balance sheet, income statement and cash flow statement – all of
which provide valuable information to the fundamental analyst.

Still, it’s worth taking the time to develop a set of preferred metrics – the
numbers on those financials that mean the most to you. Some key numbers
to look for include net income, profit margin, debt-to-equity ratio and the
price-to-earnings ratio.

The Theory Behind It All

The goal of analyzing a company's fundamentals is to find a stock's intrinsic

value, a term meaning what you believe a stock is really worth – as opposed
to the value at which it is being traded in the marketplace. For example, if
you estimate a stock is worth $50 based on your DCF analysis – and it’s
currently trading at $30 – you know the stock is undervalued and it might be
a good time to buy it.

Although there are many different methods of finding the intrinsic value, the
premise behind all the strategies is the same: A company is worth the sum
of its discounted cash flows. In plain English, this means that a company is
worth all of its future profits added together. These future profits must be
discounted to account for the time value of money, that is, the force by
which the $1 you receive in a year's time is worth less than $1 you receive
today. In simple terms, DCF analysis attempts to value a project, company
or asset today, based on how much money it’s projected to make in the
future, with the idea that the value is inherently contingent on its ability
generate cash flows for investors. The idea behind intrinsic value equaling
future profits makes sense if you think about how a business provides value
for its owner(s). If you have a small business, its worth is the money you
can take from the company year after year (not the growth of the stock).
And you can take something out of the company only if you have something
left over after you pay for supplies and salaries, reinvest in new equipment,
and so on. A business is all about profits, plain old revenue minus expenses
– the basis of intrinsic value.

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 The 'Greater Fool' Theory

One of the assumptions of the discounted cash flow theory is that people are
rational, that nobody would buy a business for more than its future
discounted cash flows. Since a stock represents ownership in a company,
this assumption applies to the stock market. But why, then, do stocks exhibit
such volatile movements? It doesn't make sense for a stock's price to
fluctuate so much when the intrinsic value isn't changing by the minute.

The fact is that many people do not view stocks as a representation of

discounted cash flows, but as trading vehicles. Who cares what the cash
flows are if you can sell the stock to somebody else for more than what you
paid for it? Cynics of this approach have labeled it the greater fool theory,
since the profit on a trade is not determined by a company's value, but about
speculating whether you can sell to some other investor (the fool). On the
other hand, a trader would say that investors relying solely on fundamentals
are leaving themselves at the mercy of the market instead of observing its
trends and tendencies.

The Two Types of Investors

This debate demonstrates the general difference between a technical and

fundamental investor. A follower of technical analysis is guided not by
value, but by the trends in the market often represented in charts. So, which
is better: fundamental or technical? The answer is neither. As we mentioned
in the introduction, every strategy has its own merits. In general,
fundamental is thought of as a long-term strategy, while technical is used
more for short-term strategies. (We'll talk more about technical analysis and
how it works in a later section.)

Most strategies in the following chapters are based on some aspect of

fundamental analysis. Some of these strategies are easier than others to
learn: The Dogs of the Dow strategy, for example, is simple enough that
even the most novice investor could understand and execute with relatively
limited effort. Most strategies, however, require significant time and effort
to master, and becoming a proficient fundamental analyst should be viewed
as a life-long journey.

Conclusion

Whenever you’re thinking of investing in a company it is vital that you

understand what it does, its market and the industry in which it operates. We
should never blindly invest in a company.

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 One of the most important areas for any investor to look at when
researching a company is the financial statements. It is essential to
understand the purpose of each part of these statements and how to interpret
them.

People often ask if technical analysis can be used as an effective substitute

for fundamental analysis. Although there is no definitive answer whether
technical analysis can be used as a whole substitution for fundamental
analysis, there is little doubt that combining the strengths of both strategies
can help investors better understand the markets and gauge the direction in
which their investments might be headed. In this article, we'll look at the
pros and cons of technical analysis and the factors that investors should
consider when incorporating both strategies into one market outlook.

The Best of Both Worlds

Some technical analysis methods combine well with fundamental analysis to

provide additional information to investors. These include:

1) Volume Trends: When an analyst or an investor is researching a stock,

it's good to know what other investors think about it. After all, they might
have some additional insight into the company or they might be creating a
trend.

One of the most popular methods for gauging market sentiment is to take a
look at the recently traded volume. Large spikes suggest that the stock has
garnered much attention from the trading community and that the shares are
under either accumulation or distribution.

Volume indicators are popular tools among traders because they can help
confirm whether other investors agree with your perspective on a security.
Traders generally watch for the volume to increase as an identified trend
gains momentum. A sudden decrease in volume can suggest that traders are
losing interest and that a reversal may be on its way.

Intraday charting is growing in popularity because it enables traders to

watch for spikes in volume, which often correspond with block trades and
can be extremely helpful in deciphering exactly when large institutions are
trading.

2) Tracking Short-Term Movements: While many fundamental investors

tend to focus on the long haul, the odds are that they still want to obtain a
favorable buy-in price and/or a favorable selling price upon liquidating a
position. Technical analysis can be handy in these situations as well.

More specifically, when a stock punches through its 15- or 21-day moving
average (either to the upside or the downside), it usually continues along
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 that trend for a short period of time. In other words, it is largely an indicator
of what to expect in the coming term. Incidentally, 50- and 200-day moving
averages are often used by chartists and some fundamental investors to
determine longer term breakout patterns.

For those looking to time a trade or to solidify a favorable entry or exit price
in a given stock, these types of charts and analyses are invaluable.

3) Tracking Reactions Over Time: Many fundamental analysts will look at

a chart of a specific stock, industry, index or market to determine how that
entity has performed over time when certain types of news (such as positive
earnings or economic data) has been released.

Patterns have a tendency to repeat themselves, and the investors who were
lured (or put off by) the news in question tend to react in a similar manner
over time.

For example, if you take a look at the charts of various housing stocks,
you'll often see that they react negatively when the Federal Reserve chooses
to forgo a cut in interest rates. Or check out how home improvement stores
tend to react when reports of new and existing home sales decline. The
reactive move lower is pretty consistent each time.

In short, by analyzing historical trends, investors can ballpark the possible

reaction to a future event.

The Downside to Blending

Technical analysis may also provide an inaccurate or incomplete perspective

on a stock because:

1) It's History: While it is possible to decipher and anticipate certain

movements based on patterns or when a particular stock crosses a major
moving average, charts cannot usually predict future positive or negative
fundamental data—instead they are heavily focused on the past.

However, if news leaks out that a company is about to release a good

quarter (for example), investors might be able to take advantage of it and
this good news will be apparent in the chart. A simple chart cannot provide
the investor with crucial long-term fundamental information such as the
future direction of cash flow or earnings per share.

2) The Crowd is Sometimes Wrong: As mentioned above, it's nice to buy

into a stock that has upside momentum. However, it is important to note and
understand that the crowd is sometimes wrong. In other words, it is possible
that a stock that's being accumulated en masse this week may be under
heavy distribution the next. Conversely, stocks that are being heavily sold
this week may be under accumulation in the weeks to come.

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 A terrific example of the "crowd is wrong" mentality can be found in the
large amount of money that went into technology shares at the turn of the
millennium. In fact, money kept flowing into shares of companies such as
CMGI or JDS Uniphase, as well as a number of other high-tech issues.
When the bottom dropped out, the money flow into these stocks and the
stock markets on which they traded dried up almost overnight. The charts
did not indicate that such a harsh correction was coming.

3) Charts Don't Typically or Consistently Forecast Macro Trends: Charts

also are generally unable to accurately forecast macroeconomic trends. For
example, it is nearly impossible to look at a major player in the oil and gas
sector and decipher definitively whether OPEC intends to increase the
amount of oil it pumps, or whether a fire that just started at a shipping
facility in Venezuela will affect near-term supplies.

4) There is Subjectivity: When it comes to reading a chart, a certain amount

of subjectivity comes into play. Some may see a chart and feel that a stock
is basing, while another person might see it and conclude that there is still
more downside to be had.

Anyone who has relied on "hot" news or company fundamentals to buy a

stock knows that this practice often leads to disappointing results. The
reason is simple. Fundamental analysis data lags the market. Earnings news
can be as much as over a month old when released. In the majority of cases,
by the time news announcements are made, the stock has usually already
made its move.

Also, what if the fundamentals change? Most fundamental investors

maintain the belief that it is better to hold onto a stock through thick and
thin and hope the company recovers once better times return. But as we saw
through the 2000 – 2002 bear market correction and all bear markets before
it, this approach can lead to complete disaster.

The continued popularity of the traditional buy-and-hold strategy is due in

no small part to the 18-year bull that ended in 2000. During this market, the
buy-and-hold approach to investing worked great, but then so did throwing
darts. It was only when the market turned to a bear that the fundamental
flaw in this method became obvious.

Lastly, fundamental investors generally do not use stop losses to protect

profits. Worse, those adopting a value approach employ the practice of
averaging down, using the rationale that the cheaper a stock gets, the greater
its value. This only serves to compound losses when a market is in plunge
mode.

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 At the opposite end of the spectrum, technical analysis ignores fundamentals
altogether and focuses strictly on technical indicators and chart patterns.
While an excellent method of short-term trading, it can lead to losses in
longer-term trades unless the trader continually readjusts profit targets and
stop-losses. Also, this type of on-going maintenance may not be everyone's
cup of tea and can cause unnecessary stress.

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 REFERENCES

Ø Company details available from http://www.jwings.in (Accessed 4th March, 2018)

Ø Market Analysis available from

https://www.extension.harvard.edu/academics/courses/economics-
financialmarkets/23271 (Accessed 31th March, 2018)

Ø Fundamental Analysis available from:

https://www.forexfactory.com/
https://www.babypips.com

Ø
https://www.babypips.com (Accessed (7th May, 2018) ii)
https://www.forexfactory.com/ (Accessed 9th May,
2018)

http://www.investopedia.com/terms/t/technicalanalysis.asp
https://www.dailyfx.com
https://en.wikipedia.org/wiki/Technical_analysis

Meta Trader 4 Platform available form https://www.gbcfx.com/ (Accessed 9th May,

2018)

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