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That Eternal Debate: Fundamental Analysis vs. Technical Analysis

For those who are a tad more observant, you might realise there are quite a few questions around our daily life that might spark eternal debates. Star Wars or Star Trek? Manchester United or Liverpool? Batman or Superman? Cats or Dogs? And in what might be the fiercest debate of all time… chili crab or black pepper crab!?

The raging debate

Well, okay – I’ll stop jesting here. Picking a favourite hero among Batman or Superman, or choosing the right condiments to go with cooking an aquatic crustacean does not exactly constitute ‘an eternal debate’.

However, in the financial markets, there might really be a real eternal debate raging on regarding the best way to profit in the unendingly-complicated world of finance.

Folks, meet Fundamental Analysis and Technical Analysis.

Why we’re poking the hornet’s nest

Perhaps, some of you might wonder why I would choose to poke the proverbial hornet’s nest in writing an article that might spark fierce debates. Well, the thing is, we at The Motley Fool Singapore received a very thoughtful question pertaining to technical analysis that we felt would be great to answer. The reader sent us this (question’s edited to make for easier reading):

I’m a strong advocate of value investing… Reading the balance sheets, understanding the intricacies of the company that I’m interested in investing and also trying to invest in it when it is undervalued.

However, recently, I have been trying to learn more about technical analysis and how it can help me position myself better to enter or exit the markets… Ultimately, how does The Motley Fool staff value Technical Analysis as a tool in helping your strategy of value investing and holding stocks in companies you like for the long term.”

It’s really a pleasure to receive intelligent questions like these and that’s why – at the risk of attracting unwanted ire – I’ll attempt to give my opinion.

Technical Analysis: It’s all about the charts

For the uninitiated, technical analysis, at its core, is the study of a stock’s past price-movements in order to determine its future direction. Each unique type of price-movement-pattern would constitute a signal to either buy or sell a stock.

There’s no mention of the underlying business fundamentals – earnings, balance sheets, competitive advantages, cash flows, dividends etc. all do not matter. What matters is the price of the stock, and how it has changed.

Let’s start the fight!

On the other hand, we have fundamental analysis, where investors study a business’s competitive advantages, its prospects, and its financials among others to paint a picture of its intrinsic value. A buy or sell decision then hinges on the difference between the business’s share price and that estimated intrinsic value.

Fundamental analysis has been employed very successfully by investors like Ben Graham, Warren Buffett, Peter Lynch, Shelby Davis, yes the list goes on… Philip Fisher, Ken Fisher, Seth Klarman, Howard Marks, David Dreman, John Neff, Martin Whitman, David Einhorn, Joel Greenblatt etc.

They have built up track records in successful investing spanning at least a decade or more (Buffett has famously been investing money successfully since at least 1956) and amassed tremendous personal fortunes along the way (most of them are multi-millionaires or even billionaires) by investing in the stock market based on the fundamental analysis of businesses.

Meanwhile, technical traders with decades-long track records of successful profit-making in the stock market include…. I’m sorry, I can’t find them. And that, my friends, is one of the main reasons why I personally gravitate toward fundamental analysis.

That’s not to mean that investors who study the fundamentals of a business can do no wrong. In fact, it’s quite the opposite. Every successful investor would very likely have made a litany of mistakes. But crucially, their success outweighs their errors as a study of the fundamentals of a business gives them a solid process to tilt the long-term odds in their favour.

This brings me to another important point. Fundamental analysis and a long time horizon give investors great odds of success at the investing-game. But with technical analysis, one’s hard pressed to find evidence of a greater-than-even chance of long-term success.

I’m not trying to disparage technical analysis. There’s certainly value to it and I do believe there will be stock market participants who excel at it. But like I said earlier, there are huge question marks over how it can tilt the balance in our favour.

There’s even an intriguing study done by finance professors at Massey University – a university in New Zealand – on 5,000 popular technical trading rules. The results of their study might be a shock for technical purists. These technical strategies were tested in 49 countries, and none of those rules generated returns that are better than a coin-flip. None.

So ok, perhaps one shouldn’t discard fundamental analysis entirely in favour of technical analysis given the better chances of long-run success for the former. But why can’t we combine the two?

The answer can perhaps be found in the personal experiences of the legendary growth investor Philip Fisher. In his book, Common Stocks and Uncommon Profits, Fisher wrote of his experience in trying to time the markets with short-term trades in shares of a fruit and vegetable canner California Packing Corporation (which is now likely to be defunct).

He did three short-term trades and actually made a profit on all of them. But crucially, the time and effort spent on executing those trades made him forgo the forest for the trees.

In trying to nickel and dime shares of CPG, he realised that those profits paled in significance to his long-range gains in another fruit & vegetable canner Food Machinery Corporation, which he found and steadfastly held for years based on his analysis of the share’s business.

He could have devoted the energy he spent on studying the short-term price movements of CPG on unearthing another long-term winner like FMC!

Foolish Bottom Line

Ultimately, it’s not technical analysis that can bring us long-term gains where we could more than double our money over the past 10 years in shares like what’s shown below:

Company 1 Oct 2003* 30 Sep 2013 Gains
Jardine Cycle & Carriage (SGX: C07) S$4.37 S$38.15 773%
Sembcorp Industries (SGX: U96) S$1.06 S$5.29 399%
Singapore Exchange (SGX: S68) S$1.51 S$7.26 381%
Oversea-Chinese Banking Corporation (SGX: O39) S$2.30 S$10.30 348%
SIA Engineering (SGX: S59) S$1.47 S$4.86 231%
* Prices on 1 Oct 2003 are adjusted for dividends and stock splits

Source: Yahoo Finance

It is understanding the powerful effects of compounding along with an appreciation for the underlying fundamentals of the businesses (which gives investors the confidence to hold for the long-term) that enables such long-range successes to be achieved – it’s what we do at The Motley Fool Singapore.

For investors who still wish to incorporate technical analysis into their investing activities, by all means do so. You might even realise slightly better long-term profits by timing entries better (on the very iffy assumption that you happen to be really good at exploiting technical strategies).

But even so, please, please, please do not miss the big picture when you’re sweating over the small details.

Click here now  for your  FREE subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by  David Kuo ,   Take Stock Singapore  tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead.  

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns shares in Super Group and Raffles Medical Group