Finally, Numbers That Matter: Fundamental Analysis for Traders

When it comes to analyzing stocks, there are two primary schools of thought: fundamental analysis and technical analysis. Fundamental analysis involves poring over income statements and balance sheets, whereas technical analysis involves poring over charts to identify patterns or trends. Technical analysts often resist the notion that fundamental analysis matters. “It’s already built into the charts,” they cry. And fundamental analysts often write off technical analysis as voodoo. But the two may complement each other. Yup, even die-hard technical traders may find useful fundamental nuggets that can help with their trading analysis.

So, What Is Fundamental Analysis?

In a nutshell, fundamental analysis of stocks involves evaluating and researching companies to determine if a company is healthy. There’s no one right way to go about analyzing companies. Look at two well-known investors, Warren Buffett and Peter Lynch. They each have a different approach. Buffett looks for great companies that trade at a fair price (value investing). And Lynch believes in researching the companies whose products you already enjoy. It comes down to your personal objectives or what you want to achieve.

How do you become your own analyst? Company Profile, a fundamental analysis tool on the thinkorswim® platform from TD Ameritrade, opens the door to the world of fundamental investment analysis to help you focus on the fundamental data that matters to you. That could mean price-to-earnings ratios, company earnings, or key economic indicators such as housing, jobs, and interest rates. 

Fundamental Stock Analysis, Trader Style

Investors who base their decisions on fundamental analysis tend to approach the markets in two ways: top down and bottom up. The approach you use often depends on your goals. So put on your analyst hat and start by asking yourself, “What am I looking for?”. If you prefer a top-down approach, you might start with global economics, make your way to sector analysis, then to industry analysis, and finally to a couple of stock picks. A bottom-up approach starts with the stock picks and then a broader analysis of each stock.

Stock analysts are notorious for building out complex equity models that let them adjust a company’s valuation based on pulling certain “levers.” For instance, suppose sales of widget X are up 10%, advertising pricing is decreasing by 1%, and operating margins are increasing by 2%. The Company Profile tool lets you automatically adjust these levers to make your own projections. You may want to know if there’s anything about the company (or companies) you’re about to trade that could potentially give you an edge.

Let’s look at how you might benefit from using the tool. 

Hypothetically Speaking ...

For example, imagine it’s the start of the new year. You promise to hit the gym, and with that, you figure millions of wishful thinkers will not only be going for six-pack abs; they’ll also be shopping for new workout clothes. So, you look for a company that specializes in “performance apparel.” You’ve narrowed your selection to two companies. Both have diversified businesses, so out of the gate, you’re looking for one where there is a higher concentration of revenue in performance apparel. In addition, you’re looking for the brand that’s squeezing out higher margins in its apparel business. Finally, you’re looking for the company that’s trading at a discount to its valuation. In about 45 seconds, you should be able to zero in on what you think looks like the better opportunity. How?

Fire up thinkorswim, select the Trade tab, and enter a stock symbol. Then select Company Profile at the top right to bring up the tool (see figure 1).

Pulling the levers:

1. On the blue vertical bar at the left of the tool window, select the division of the business you’d like to analyze.
2. Notice the right column of “Most important forecasts for this division.”
3. Drag estimates of these forecasts (the “levers”) based on your own findings. Suppose you believe that with increased demand for performance apparel, there’ll be a near-term sales spike resulting in a greater market share. By moving that lever up slightly, you can see the impact it would have on the valuation estimate.

Finding divergence: When there’s a difference between your projections (which you adjusted with the levers), analyst estimates (available in the thinkorswim platform by selecting Analyze > Fundamentals > Overview), and the current market price, you've found what’s called divergence. And divergence is where you can often discover some helpful directional-trading potential—both to the upside and downside.

Does It Really Matter?

There are still plenty of ways fundamentals—along with the Company Profile tool—can help.

1. Before betting the farm Suppose you discover an exciting new product. You research the company and everything checks out. The technicals seem to indicate that the time is right for entry, so you pull the trigger, only to learn that the product you adore adds 3% to the company’s bottom line. In this scenario, the tool can help you validate or disprove your assumptions. It can help you understand how much revenue is attributable to the bottom line from the company’s combined revenue drivers.
2. Pairs trades When two companies trend in lockstep, they’re said to be “correlated.” You’ll typically find correlated stocks among a pair of stocks in the same sector. When one of the stocks diverges in price from the other, and correlation breaks up, you might put on a pairs trade by buying one stock and shorting the other, with the hope that the stocks will again converge and resume their normal correlation. In this case, to help you assess correlation, use the tool to validate the pair itself. In other words, a chart may show that a pairs trade looks great, but the tool could help you understand if there’s too much risk in one business over the other. For example, you may have two giant energy companies that appear to be in the same business, but maybe you favor one over the other for technical reasons. By digging deeper into their business divisions, you may find there’s a high amount of natural gas drilling that could either threaten the correlation, or simply tell you it’s not a great pairs trade to start with.
   
   Equity pairs trading is not suitable for all investors and requires active monitoring and management as the special risks inherent may expose investors to potentially unlimited losses.
3. Finding soldiers In longer-term position trades, the tool lets you compare “generals to soldiers.” First-tier companies (generals) that serve as sector proxies tend to have lower volatility and might not offer the ideal opportunity. However, if you're anxious to be in this sector, you might look for the second- and third-tier companies (soldiers) that have room to grow. Do they have similar business units to the generals, and a similar makeup of those units? Are the growth projections of those units what you’d expect? The tool is your secret weapon and can help keep you armed and battle-ready.

No Textbook Required

Remember in high school when Cliffs Notes were your BFF? With so much great technology in the trading world these days, the thought of fundamental analysis no longer has to provoke anxiety attacks and extreme dread. Think of the Company Profile tool as the Cliffs Notes of the trading world that can give you some quick hints. You can potentially save yourself countless hours wading through beefy analyst reports and speedily get the insights you need to trade companies whose products and services make you want to profile with joy.