For many investors, picking the right shares to buy or sell can be a hit-and-miss exercise.
To a certain extent this is understandable due to the myriad factors that can influence a share price. But for those investors with long-term goals to build their wealth, having a strategic approach to identify which shares to buy and sell is a must.
Here we look at fundamental analysis and technical analysis – the two most common types of analysis used to identify which shares to buy or sell – and how you can apply them as part of your investment process.
Fundamental analysis is a very broad term, but it generally boils down to an attempt to determine the intrinsic value of a company through study and analysis of its financial statements and considering qualitative data such as management style, earnings potential and growth prospects.
The environment in which a company is operating also plays a part. All of this information can be distilled down to provide a theoretical fair value for the company and its share price.
For example, in terms of the operating environment, a mining company that has exclusive and long-term access to a site with proven mineral reserves may have a better earnings and growth prospects than another mining company that is only in an exploratory stage.
Similarly, you can look at the earnings potential in terms of what products are being produced by a company.
For example, Apple is well-known for making smart phones that attract millions of buyers on a regular basis. Fans of the product upgrade regularly, so the release of a new iPhone model is likely to provide a positive boost to the share price.
Based on those fundamental factors, you can identify shares that have the most positive growth prospects.
Here are a few things to watch out for when using fundamental analysis when picking which shares to buy or sell:
- Some company data – for example earnings potential, cashflow and growth projections – can be overstated or understated in some instances.
- Fundamental analysis can be subjective and can be biased at times.
- At the end of the day, price will determine whether or not your investment is profitable. It is not at all uncommon for investor sentiment, either positive or negative, to see prices move a long way away from the intrinsic fair value placed on a stock by analysts.
The other commonly used method to identify which shares to buy or sell is technical analysis. As with fundament analysis, the field of technical analysis is very broad and encompasses many techniques, but at its core it involves the study of market driven information such as price and volume data in order to determine the direction of the price trend, higher or lower.
Plotting price movements on a graph allows the technical analyst to identify price levels that have a tendency to provide areas of support or resistance. Charts also allow for the identification of price patterns that can give clues to the most likely direction of future price movements.
For example, an ascending triangle pattern occurs when rising prices run into a level of overhead resistance and fall back to a lower level only to rise and retest the resistance level again. In general terms, each retreat from the resistance level is shallower than the previous retreat, resulting in the appearance of a triangle pattern. A technical analyst would anticipate that such a pattern is likely to be resolved with a break to the topside and a move to higher prices.
While some people brush this aside as tea-leaf reading, it makes sense if you consider what is going on behind the scenes. A particular seller is committed to selling every time the price reaches the resistance level. The selling from this person sees prices fall lower.
However, buyers are becoming more eager to get on board so each time the price dips, they feel more urgency to buy and competition between them prevents prices slipping as low as they did on the previous pullback. Eventually, the seller is exhausted and the price will frequently break sharply above what was previously a notable resistance level.
Other common tools used by technical analysts include moving averages, relative strength and measures of volatility such as “Average True Range”. While the techniques continue to evolve, this form of analysis relies on the basic idea that human nature remains constant and that, as a crowd, we continue to respond to things in the same way.
While there is an element of art in reading chart patterns, other technical analysts attempt to remove all subjectivity from their analysis by using the market generated data to drive computer models and algorithms of varying complexity.
A few things to watch out for when using technical analysis when picking which shares to buy or sell are:
- Technical analysis is purely based on actual price movement and trade volume on particular shares.
- It does not consider potential earnings or growth of companies or any other subjective factors.
- Technical analysis can provide clues to the most likely direction of price movement but there are always exceptions to the rule.
Combining fundamental and technical analysis
While these are just some of the basics of fundamental and technical analysis, there’s no doubt that these methods can be useful in identifying which shares to buy or sell. While some investors prefer to use fundamental analysis, there are others who stick entirely to technical analysis.
Some of the most successful traders seek to combine both. For example, you may filter your universe of stocks by looking for those that are fundamentally under-priced with strong earnings and growth potentials. You could then apply the tools of technical analysis to your shortlist to determine which of those stocks are the most likely to deliver positive price movements.
There is no doubt that picking the right shares to buy or sell is a big part of your investment success, so why not use the proven methods?
So while some investors may take a hit-and-miss approach to stock picking, combining the power of fundamental and technical analysis may give you a great foundation to your stock selection strategy.