Here’s Why a Stock’s Fundamentals Will Always Matter

Few investors will forget the last week of 2018. In a year that brought volatility back to the market, the usually quiet period between Christmas and New Year’s was anything but a party for investors. It seemed that every major stock exchange gyrated hundreds of points. It wasn’t uncommon for the market to have a negative to positive swing of close to 1,000 points. But just by looking at current events many investors will see smaller, but still impactful, moves happen on a regular basis. Every time a company launches an Initial Public Offering (IPO) it moves the stock market. When the Fed announces a change to its benchmark Federal funds rate, it moves the stock market. When a hurricane threatens the United States or the President of the United States sends a tweet, it moves the stock market.

The common thread behind this volatility is speculation, and the problem with speculation is that it’s frequently wrong. In many cases, a hurricane turns out to sea; threatened sanctions are never put in place; a company reports better earnings than expected. In every case, the market can – and usually does – quickly correct itself.

Fear is a good thing to fear

The real problem for investors is how they respond to speculation when it feeds on their fears. It could be the fear of missing an opportunity or the fear of being wrong about a stock that seemed like a sure thing.

Whatever the root cause, fear is an emotion, and trading on emotion is always a risky proposition. Fear is often a byproduct of investor sentiment. Despite everything that investors know logically, the heart wants what it wants. And this means that investors can let their emotions make a bad stock look good and a good stock look bad.

The antidote to fear is information

Successful investors understand that knowing how to interpret the right information about a business, not their ability to time the market, is one of the most important factors in ensuring positive stock returns. Understanding how a company makes money gives investors the ability to know when to buy and when to sell in a way that allows them to sleep at night regardless of what is happening in the market. This means taking a close look at a company’s fundamentals. While this takes some time, the key to fundamental investing is patience and understanding. Fundamental investing believes that good stocks don’t suddenly become bad … and vice versa.

Are you a stock trader or an investor?

I don’t mean to offend, but there’s a difference between stock trading and investing. Stock traders look to capitalize on short-term movement in share prices. Investors look to buy stocks that they can hold on to for long-term gains. Both strategies have the same goal of making a profit, but they go about it in very different ways.

One of the key differences has to do with the answer to the question, “What’s your why?” Stock traders are not concerned about the why behind an asset’s price movement. The only relevant fact in making a buy or sell decision is whether an asset is moving in a way that fits a technical pattern. Supply and demand are at the core of their investment decisions.

By contrast, investors make every investment decision by starting with the question, “Why is the company performing the way it is?” To answer this question, they pay close attention to the company’s fundamentals.

Where to look for a company’s fundamentals?

Fortunately for most investors, they can find the information they need anywhere they have a wireless connection. Information from a company’s annual report, analysts’ reports (which MarketBeat subscribers have access to), and financial websites are all excellent sources of company information that can be accessed 24/7 from the internet. When companies submit their quarterly earnings reports, they are required by the SEC to submit all pertinent financial information including their balance sheet and income statement. In many cases, investors will look at several quarters’ worth of earnings reports as part of their analysis of a company’s stock.

What fundamental data are investors looking for?

Knowing where to look is one thing, knowing what to look for is equally, if not more, important. While companies are required to submit pertinent financial information, they may use different accounting formulas to calculate the information. In general, investors will want to make sure that a company has a pattern of revenue growth and earnings growth over a meaningful period of time. For many blue-chip companies with a large market capitalization, it’s not unreasonable to look for growth over a five-year time frame. These companies will also have a tendency to reinvest their earnings. The amount that a company reinvests in its business is determined by comparing their earnings per share with its dividend payout. For stocks that pay dividends, the dividend yield is also important as it factors into an investor’s total return.

Fundamental analysis uses data on a company’s balance sheet to calculate ratios such as the price-to-earnings (P/E) ratio – the price of a share divided by the company’s earnings per share; return on equity and their debt-equity ratio. Another fundamental measurement they will look for is a company’s beta – which measures price volatility in relation to the broader market. A company with a beta of 1 will move in relation to a corresponding index (such as the S&P 500 index).

Many successful investors combine both investing strategies.

The reality of investing is that, depending on their risk tolerance and desired asset allocation, many investors allow themselves some speculative stocks in their portfolio, and even the most devout day traders usually have a core portfolio of individual stocks that they are holding for the long term. Technical analysis can lead to successful trades, but any decision that relies on information without context has an inherent risk that is difficult to quantify. Every investor has heard the axiom “past performance does not guarantee future results”. The most important thing for investors to remember is that successful, long-term investing means having the patience to study a stock’s fundamentals so that when you make an investment, you can do so with the confidence to stick with your strategy no matter how, or why, the market moves.