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Technical versus fundamental analysis in equity markets

Investors have many different characteristics. At one extreme, high frequency traders rely on technology to place orders with lightning speed and eke out a small percentage profit on huge numbers of small trades in the margin between buyer and seller. At the other extreme, patient, long-term value investors are happy to leave a good stock in the bottom drawer for years or decades, and allow compound returns to work their magic. In between these extremes, there are perhaps as many different investment styles as there are individual investors.

Work out where you sit

One of the major differences divides technical investors (or chartists), who work on the assumption that historical price movements reveal likely future movements, from fundamental (or value) investors, whose focus is future profitability and cash flow. Certainly, there are investors who employ both styles, but most people tend to identify with one or the other. Working out where you sit is one of the more important choices an investor makes.

The two approaches enjoy different levels of acceptance in different parts of the market. Charting can be a relatively simple way to assess the investment merits of a company. Time-poor investors can make decisions more easily and entrepreneurs can design trading ‘systems’ for such time-poor investors. As a result, charting enjoys good support amongst retail investors, and receives quite a few column inches in mainstream media.

In the professional funds management arena, the norm is for analysts and portfolio managers to spend large amounts of time studying the details of company financials and business models. Montgomery Investment Management, along with most of our colleagues in the industry, sits firmly in this fundamental camp. We do this with the expectation that investing time and effort into having deeper insight into a business will yield better investment decisions.

A good question for investors and fund manager clients to ask is: does this extra effort and cost add enough value to be worthwhile? If a simple approach delivers reasonable results, why bother with the hard way?

There may be no single right answer. Any investment approach needs to fit the personal style of the investor using it. For example, if you have perfectionist tendencies and time on your hands, you will want to follow a different path to someone with a short attention span and other things to do. However, there are some reference points that are relevant to all investors.

Firstly, returns. How much value can be delivered by charting? Many people have a strong view that it adds either: a) zero value, or b) quite a lot of value, but based on academic research, the correct answer is probably: c) neither (depending on exactly what we mean by charting).

A role for momentum and reversal

Over the years, charting has generally not enjoyed a high level of credibility in academic circles, but a seminal piece of work was published in August 2000 by Andrew Lo, Harry Mamaysky and Jiang Wang at MIT. Using sophisticated techniques, these researchers examined the merits of a wide range of shapes and patterns, and they found a few surprises.

Their work confirmed the widely-held view that traditional charting concepts like support and resistance do not have practical value. However, they showed that two technical indicators – momentum and reversal – do have value. Put simply, they (as well as other researchers) confirmed that stocks that have performed well in the recent past (typically up to 12 months) tend to perform well in the future, whereas stocks that have performed well over longer periods of time (3-5 years) tend to underperform in future. These so called ‘anomalies’ are now widely accepted as real, and it is possible to construct profitable trading strategies that exploit them.

On this basis, there is value in technical analysis. However, that value is somewhat limited. Different studies show different results, but as a general observation, after allowing for trading costs and risk it is not entirely clear that reversal strategies work in the real world, and there have been extended periods when momentum strategies haven’t worked, notably around the time of the GFC.

While esoteric concepts like ‘head and shoulders’ patterns are unlikely to help much in the real world, there probably is merit in the old adage ‘the trend is your friend’, and having a disciplined approach to trend-following appears to be a simple and legitimate way to generate returns that beat the market by a noticeable margin. However, the upside is less than compelling, and there is another saying about rich chartists being a very rare breed.

While it is easy to draw up a long list of spectacularly successful and wealthy fundamental investors, coming up with a list of comparable technical analysts would be rather more challenging. Accordingly, if your aspirations for investment success lie beyond ‘a noticeable margin’ then you may be better off putting in the hard yards of fundamental analysis, or find a good manager to do it for you.

 

Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able


 

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