Fundamental analysis is the process of developing a business evaluation of a company, specifically its future earning ability. All available information about a company is incorporated into earnings projections. Once that information is gathered, the analyst then discounts those projections back to a fair present value of the stock. If the analyst's projections show that the stock is underpriced, it is rated as a buy; if the stock is overvalued, the recommendation is to sell. One popular fundamental analysis process consists of four elements: economic analysis, industry analysis, company analysis, and pricing analysis. Each of the levels of analysis is a go/no-go screen; only companies that pass the screen are analyzed further. Once the screens are complete, the analyst has a list of stocks considered for purchase.

The first level, economic analysis, is a macroeconomic assessment of the entire economy. Because the stock market is a reflection of the U.S. economy, it will generally do well in strong economic expansions and poorly in recessions. If the future macroeconomic outlook is for stable or falling inflation, lower future interest rates, and healthy economic growth, the climate for stock investments is positive. The best time to buy stocks is during recessions, just before other investors begin to anticipate renewed growth in the economy.

Further analysis focuses on the performance of specific industries within the current economic environment. Certain industries lead recoveries and business expansions, while others lag. If you anticipate a business recovery, industries such as electronics, metals, and automobile suppliers should be considered. In the latter phase of the recovery, industries such as automobile manufacturers, consumer goods, and recreational goods should be evaluated. The purpose of the next level, company analysis, is not to identify the winners but to screen out the losers. In every industry, no matter how strong the economy is or how "right" that particular industry is, some companies are better and others are worse. Fundamental analysts use several tools here, such as company visits and ratio analysis (a technique by which key indicators of a company's financial health are compared with specific industry benchmarks). If you want to learn more about financial analysis of individual companies, consult a good text in managerial finance.

The final level of analysis is a pricing analysis of the individual stock. It doesn't matter if IBM, for instance, passes all your screens and is the finest corporation in the world. If the stock price is too high, it's not a good buy. Pricing analysis estimates a reasonable price for a share of stock and compares it with the current market price. If the current market price is less than or equal to your "fair" price, it's worth buying. If it drastically exceeds your "fair" price, let it pass. Then, among all the stocks rated as "buys," select one or more that compete well against the others.

The problem with the approach described above is that it is difficult to execute. Individual investors are not trained to make these types of assessments. This work is very time-consuming to accomplish, and the payoffs to the research are minimal, unless you have an enormous investment portfolio. Perhaps even more important, most of this research is already incorporated into the current price of the stock. By the time an investor researches and reacts to positive information on a stock, the price gains from that information have already been taken by a professional investor. Professional money managers and traders are likely to snap up the bargains long before you notice them.

An Alternative Approach

Although the top-down approach described above is the most widely used and discussed stock-picking method for professionals, many consistently successful investors attack the problem from the opposite direction — a "bottom-up" approach. Mutual fund manager Peter Lynch states that any good management team with a decent product can do well in business. With the bottom-up approach, most of your analytical effort concentrates on specific individual companies in a search for good managers to trust with your money. A much smaller amount of time goes into this analysis. The reasoning is that good people will make good money regardless of the nature of their business. Finally, many bottom-up practitioners take pride in doing virtually no macroeconomic analysis. Believing that broad cyclical moves in the economy are difficult if not impossible to predict, they feel more confident searching within the market for good relative values among individual stocks. Noticing good products and good managers before the Wall Street traders do is perhaps the only way that the individual investor can "compete" in an already overanalyzed market. Unless you commit to acquiring skills that are beyond this brief introduction, the best vehicle for making equity investments is probably mutual funds.

Next: Creating an Investment Strategy

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