Short Term Trading Weekend lounge 2nd-4th Dec, page-140

Q. “....does anyone just use FA or do you have to combine them?”

Johnny, I’ll have a go at that. Firstly, I consider there are four key knowledge areas relevant to the market:

1) Fundamentals – “FA” – Valuation, Corporate Strategy, Competitive position, Dividend yield etc;
2) Technicals – “TA” – charting tools analysing price, pattern, time;
3) Macro-Economics – Interest Rates, AUD, Commodity prices, Oil, Gold, Gov’t Regulation/Tariffs, etc
4) Stock Promotion – Broker support, Register structure, Media promotion, Corporate PR’s, Hot sector, SP volatility, HC posting activity etc.

In practice people apply these knowledge areas as a mixed bag, with varying degrees of skill and with a different emphasis on each to come up with their preferred approach, often specialling in a niche area of the market where they have found certain combinations of methodologies/tools works, (e.g. plenty on this STT thread trade penny stocks or “Hot Copper specials” but would never trade a BHP or TLS, as this best suits their skills, time availability, resources. There’s ultimately no absolute right way to make money, just make it).

However, there is some theory you can put around where to apply some of this, including your FA.

Fundamental Analysis FA:

Google the “Wisdom of Crowds” concept. It basically states that the average of a large crowd guessing the number of lollies in a jar will be surprisingly accurate and normally beat the individual guess of any single person or expert. It has some parallels to the Efficient Markets Theory, but is more applicable to speculative situations and should be accounted for in any speculation methodology.

So in betting markets, and acknowledging the wisdom of the crowd, you need to think about situations where the crowd might get it wrong. In horse racing, the public set the odds, so the professional gambler should bet early before the crowd refines the odds and the biggest mispricings can occur, or just before the race starts as newbies will jump on a favourite and push on its price, creating odds mispricings elsewhere.

Bringing this idea across to equity market speculation, the big stocks have multiple full time fund managers analysing them with better access to broker research, company management etc. It’s very difficult for a retail investor, even with a high level of expertise, to consistently beat this end of the market on an FA basis. The biggest FA mispricings will occur at the spec and small cap end of the market, and you can see reading the threads that plenty of retailers on HC invest and trade without any knowledge of the value or fundamentals of a business. Doesn’t make their approach ineffective, but if your skill is FA then your best competitive advantage is to apply those skills to small cap stocks (where enough public information is available) or perhaps into mid-caps, as that’s where the biggest market mispricings should in theory occur.

Technical Analysis TA:

Applying TA skills is more influenced in markets by “The Law of Large Numbers” if you want to google that. It states that the probability of an outcome approaches its theoretical ratio the more events or transactions that occur. Think of throwing a dice 100 times versus 1 million times, the latter will give a more equal and precise distribution of outcomes for each number.

Applying this to the stock market means that the bigger more liquid stocks will give more precise and reliable TA responses than small stocks due to their larger number of transactions. I have found this hugely relevant in practice and anyone skilled and confident in their TA ability would normally find themselves drifting to the big end of the market. (The wisdom of crowds concept above also applies in that the big fund managers don’t normally use TA but there’s plenty of hedge funds and professional TA’s that do at the big end so there’s less distinction based on this concept).

Some Examples:

I’ll mix the stock market knowledge areas raised above in all my trading/investing, but my emphasis is different in different areas of the market. So:

Macquarie Bank is a highly liquid, technically responsive big stock that I regularly trade exclusively with a TA approach. I’ve successfully shorted this even when they are reporting record earnings (FA) and interest rates/AUD are supportive (Macro-Economics) as I’m confident my form of TA has a competitive advantage over the other approaches here.

Moko Social Media (MKB) on the other hand is a micro-cap (SP $0.004) I’ve been posting about the past few days where I’ve invested primarily on an FA basis (although I did do a TA post and it’s also supportive). There is a huge discrepancy between the market pricing and fundamental value in this stock with near term catalysts coming up. I have enough business and market experience to form an independent view and build a position without market validation, but I know from my “Stock Promotion” knowledge that it will take a bit of work before spec traders will jump in. As Jesse Livermore said, the best form of stock promotion is activity in the share price. It takes an active, volatile price to attract punters like bees to honey, whether that’s because people get the validation of other investors, can get in or out easy, can pip trade it, are attracted to volume moves or whatever is probably the subject of another post.

So Johnny, your best approach is to build your skills in one or more of the knowledge areas and then apply that to the appropriate type of stocks where it’s possible to get a competitive advantage. (Of course, continuing to broaden your knowledge thereafter over time). On this basis, applying your FA only skills to this STT small cap end of the market is absolutely appropriate. If you have other knowledge, then combine all your skills to the extent applicable to what you're trading, but you can make money on FA alone.