The Forecasting Pitfall of Fundamental Analysis

The Association methodology is ‘contrarian’ because it is quite different than most applications of fundamental analysis.

The fundamental analysis technique is generally used by banks, pension funds and the majority of security analysts.  There are different styles of fundamental investing which range from momentum and growth investing to value and contrarian investing.

In general, a fundamentalist believes that a company’s true value can be determined by analyzing financial indicators such as sales, inventory etc.  A fundamentalist believes that a stock price can diverge from the company’s true value and he is convinced that the market must recognize this discrepancy over time.

Momentum and growth investing styles are out of the scope of the Contrarian Investing Association.  Although related to value investing, contrarian investing is quite different.

For value investors, Security Analysis by Benjamin Graham and David Dodd, is the investment “Bible”.  Value techniques stress the value of capital preservation and define risk as the potential for losing your savings.  A contrarian agrees with this.

But, this is where the similarities between value investing and contrarian investing begin to diverge.  With value investing, present earning power combined with the projection of a company’s earnings into the future is the principal method of valuing a stock.  An evaluation can be done to estimate what the share price should be, based on the price earnings ratio.  Other key ratios include return on equity (a measurement of how profitable the business is), and other measurements for measuring debt and potential for bankruptcy.

The problem with most types of fundamental investing is that most investors are willing to pay a premium, and overprice companies with ‘good’ near term prospects and under price companies which appear ‘poor’.  Not too smart.

This problem is amplified when security analysis emphasizes near term outlooks andplaces a heavy reliance on future forecasting.  A contrarian believes that this method can not work, because it is not possible to forecast accurately anything past the short term, and there are  too many unknown variables to ever do so accurately.

The Pitfall of relying on ‘Experts’:

Society places a high reliance of so-called financial experts to make projections into the future.  Experts are most often wrong – and when they are right, their forecasts are only accurate for the short term.  When an expert is asked for a projection – they are in effect attempting to read the future.  The information gathering is complex, to say the least.

The number of possible outcomes, when thousands of factors interact in the marketplace, is infinite. It is simply too difficult (more like impossible) to interpret the data and present a precise estimate.

A contrarian investor simply believes that analysts cannot predict the future and therefore will not have accurate forecasts.

Experts also demand as much information as possible to assist them in their decision making.  The more information an analyst has, the more confident the analyst is.  With more information available, the analyst should make better decisions but this is not the case. More information requires more human judgment and interpretation.  More information leads to greater expert confidence. This confidence leads analysts to optimism; hence- optimistic forecasts and up-beat company analysis.  Ultimately, this results in forecasting errors.  Not too smart to follow this path.

As can be seen in the article, “Analyst in Name only”, there is tremendous career pressure on analysts.  Analysts are not judged on the accuracy of their forecasts, but judged on the amount of business and commission a firm can gain.  Sure, an analyst can tell a great story about a company and its future prospects. The problem is that this story is more often based on fiction, than reality.

The modern day stock market as represented in the media (television, newspaper etc..) reports more like an emotional hockey or baseball game than a rational arena for financial decisions. Capitalizing on this extreme opinion is the core of contrarian investing.  Investors tend to put too much emphasis on the most recent information.  If the most recent news is bad, people forget about the good information that preceded it.  If the recent information is good, people tend to downplay the bad news that came before it.

The media over-focuses daily on news-breaking stories within companies and earnings releases. The stock market is constantly adjusting to surprises as presented in the news.

Earning surprises have a consistent and predictable effect on stock prices.

For the so-called “best stocks”, analysts have confidence and investors have high expectations  that expectations will be met.  Similarly, they have low expectations and low confidence in the so called “poor stocks”.  The consistent and predictable effects of surprises, such as positive or negative earnings surprises, are the basics upon which the Contrarian Investing Strategies are built. The strategies will cover these concepts in greater detail.

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