Can you make money trading with fundamentals?

Case Notes 25. Traders generally rely on price action to identify stocks to trade. The article makes the case that fundamental analysis can be a useful tool in the traders’ toolkits. 

 

I am a bottom-up long-term value investor with an average holding period of about 8 years. Before I consider a stock for investment, I would carry out a fundamental analysis of the company. This involves first looking at the business prospects, financials, and management. With this information, I next estimate the intrinsic value of the company.

My decision on whether to invest is then based on the results of such an analysis. When I buy, I do not expect to sell until several years. As such I tend to relate fundamental analysis to long-term investing.

However, I recently wrote an article for Seeking Alpha where I used fundamental analysis to determine a pair of stocks to trade. When you trade you have a much shorter investment time horizon. The trading mentality is also different from that of a long-term investor.

This then begets the question. Can you make money trading with fundamentals?

Join me as I explore this concept. The answer is yes. Should you then use my fundamental approach to trade? Well, read my Disclaimer.

Contents

• Trading vs Investing

• Trading with fundamentals

• One example of a fundamental trade

• Can you make money?

• Conclusion

Trading vs Investing

While often used interchangeably, there are differences between trading and investing. There are several dimensions to consider when differentiating between them:

• Time horizon.

• Approach.

• Risk management.

• Mindset.

Time horizon

“Investing and trading are two very different methods of attempting to profit in the financial markets…investors seek larger returns over an extended period through buying and holding. Traders, by contrast, take advantage of both rising and falling markets to enter and exit positions over a shorter time frame, taking smaller, more frequent profits.” Investopedia

“The goal of investing is generally to build wealth over the medium to long term. By contrast, the goal of trading is to generate profits in the short-term.” eToro

“With trading, you're hoping to earn quick returns based on short-term fluctuations in the market. Long-term investors, in contrast, tend to build diversified portfolios of assets and stay in them through the ups and downs of the market.”  Business Insider

The general view is that investing involves a longer holding period than trading. However, within trading itself, there are several ways to trade depending on the time frame. According to Investopedia:

• Day trading entails opening and closing positions within the same trading day.

• Scalping entails identifying and exploiting bid-ask spreads that are a little wider or narrower than normal due to temporary imbalances in supply and demand. Since the level of profit per trade is small, scalpers look for relatively liquid markets to increase the frequency of their trades.

• Swing trading. At the end of a trend, there is usually some price volatility as the new trend tries to establish itself. Swing traders buy or sell as the price volatility sets in. Swing trades are usually held for more than a day but for a shorter time than trend trades. 

• Position trading requires investors to hold securities slightly longer, requiring patience as the trade develops. Some consider position trading to be a buy-and-hold strategy and not active trading.

Conceptually I see the various forms of trading and investing as lying on a continuous-time frame as illustrated in Chart 1.

Chart 1: Trading vs Investing Continuum

There is some overlap between position trading and investing in terms of the holding period. But each approaches the stock market differently. Position trading is more likely to be based on trend following whereas investing is more likely to be based on fundamentals.

Approach

The goal of investing is to gradually build wealth over an extended period through the buying and holding of a portfolio of stocks. While the market may be volatile, you would ride out the volatility. You expect that prices will rebound and any losses eventually will be recovered. 

However, the trading approach is different. According to Investopedia:

• Trading involves more frequent transactions. The goal is to generate returns that outperform buy-and-hold investing. While investors may be content with annual returns of 10% to 15%, traders might seek a 10% return each month. 

• Trading profits are generated by buying at a lower price and selling at a higher price within a relatively short period. The reverse also is true. Trading profits can be made by selling at a higher price and buying to cover at a lower price (known as "selling short") to profit in a falling market.

Risk management

There are 2 schools of thought when it comes to risk:

• Those that view it as volatility.

• Those that view it as a permanent loss of capital.

If you have been following my blog, you will know that as a long-term value investor, I follow the latter school of thought. I have covered the various ways to mitigate risk in my blog. Refer to:

• How to mitigate risk when value investing.

• The best way to reduce investment risk.

• Baby steps in assessing permanent loss of capital.

Because of the short holding period, traders generally look at volatility as a risk. Then to mitigate risk, they use a different set of approaches. These include considering trade size, stop losses, profit-taking, and optimal risk-reward ratios.

• Trade size. The first step is to place a sensible-sized trade relative to the funds that you have available. The general rule is to risk 1 % to 2 % of your account on any one trade. 

• Stop loss. This is an order which automatically closes out your trade when the market price moves beyond a predetermined price level. 

• Take profit orders will close the trade at a pre-determined profit level. Planning this level prevents emotions from creeping into the trade and will make you set an optimal risk-reward ratio.

• Risk-reward ratio. Once you know your stop loss and take profit points, you can estimate the risk-reward ratio for the position. As a general rule, successful traders will not consider trades that have a risk-reward ratio of less than 1:2. Some will only go for trades with a risk-reward ratio of 1:3.

Mindset

I tend to associate trading with buying and selling pieces of paper. It is mainly a market-sentiments-driven approach. For the short duration associated with trading, business fundamentals are not likely to change much. This is especially for scalping, day trading, and even swing trading. Looking at fundamentals does not make sense.

However, when you invest for the long term, you would likely base it on fundamentals. Some will emphasize macro factors while others will focus on the micro or company-specific factors. 

The traders and investors look at different things because they have different mindsets. 

According to the Corporate Finance Institute, successful trading is not about having better strategies. It is also about developing a winning mindset. Psychologically, the very best traders share the following characteristics:

• They are all comfortable with taking risks.

• They are capable of quickly adjusting to changing market conditions.

• They are disciplined in their trading and can view the market objectively.

• They don’t give in to being excessively excited about winning trades or excessively despairing about losing trades.

• They make the necessary effort to be self-disciplined with strict money and risk management rules.

I would like to illustrate the difference from the above by referring to the mindset of a value investor. In my book “Do you really want to master value investing?” I have summarized the value investing mindset as follows.

• Be patient. You are relying on the success of the underlying business to make money. Company performance changes slowly and you may have to wait years for the market to re-rate the company. 

• Be a contrarian. You are buying bargains. The nature of investing is such that a stock is only selling at a bargain if there is low demand. This will happen only if the crowd is not interested in the stock.

• Be the tortoise rather than the hare. You should not seek excitement from your investments. Fundamental analysis takes time and it takes more time for the market to come around. 

• Have confidence in yourself. If you are going to be a contrarian, you need to be confident that your analysis is correct and that the market is wrong. You are a contrarian based on analysis.

• Be resilient. In looking for the value stocks to invest in, the process eliminates far more stocks than it uncovers. It can be a frustrating way to invest during a bull market. Many stocks that you dismiss during your search will keep rising in value in bull markets. 

Trading with fundamentals

A stock's fundamentals are the factors that are thought to contribute to the underlying company's value or worth as a business. Fundamentals can include quantitative data such as financial ratios and qualitative factors like the business model and competitive advantages.

When you trade with fundamentals, you incorporate such information into your trading analysis. 

“Trading on the fundamentals – also referred to as trading the news – is the study of news events and economic statistics to determine trading opportunities. Referred to as fundamentalists, these traders pay close attention to changes in economic indicators such as interest rates, employment rates, and inflation.”  OANDA

According to Investopedia fundamental trading focuses on company-specific events to determine which stock to buy and when to buy it. These events include earnings announcements, analyst upgrades and downgrades, and corporate exercises – share splits, M&A, and re-organizations.

Looking at Chart 1, you may think that trading with fundamentals only applies to the longer time frame-type of trading. You would be surprised. There are many articles about how traders with a short time frame can adapt fundamental analysis to their trading plan. 

• How to Pick Stocks Using Fundamental and Technical Analysis – Charles Swab. The advice is to first use fundamentals to screen for stocks to trade. Technical analysis is next used to identify stocks to hold from a few days to a few weeks.

• Stock Trading: How to Use Fundamental Analysis – The Tokenist. The gist is to use fundamental analysis to identify overvalued or undervalued stocks to short or go long.

• How to adapt fundamental analysis to your day trading plan – Day Trade, The World. The article opined that fundamental analysis is a useful process used by all types of traders. However, it is usually more useful for swing and long-term traders. 

• The Daily Routine of a Swing Trader – Investopedia. The article describes combining fundamental and technical analysis to catch momentous price movements while avoiding idle times.

When you trade, you are trying to identify the stocks whose prices will change within your trading time frame. You focus on market sentiments or crowd behaviour rather than fundamentals. 

Traders generally rely on price action via charts, trendlines, or other technical indicators to help gauge market sentiments. Fundamental analysis provides another perspective. It does not replace the analysis of market sentiments or crowd behaviour. 

The cons of using fundamentals

“The whole idea that the stock market reflects fundamentals is, I think, wrong. It reflects psychology. The aggregate stock market reflects psychology more than fundamentals.” Bob Shiller, Nobel Prize laureate.

While I am a fundamental investor, I also recognize that there are short-coming with this approach that makes it difficult to use when trading. 

• You cannot determine position quickly.

• It takes a lot of time.

• It can be subjective, especially in the qualitative analysis part.

• You have to dig for the information for fundamental analysis, especially the qualitative ones. It is not readily available as price and trading volume information.

As such many think that it is not useful as exemplified by the following quote:

“… So, who uses fundamental information when trading? It only can benefit investors, who hold positions for months at a time… fundamentals do not help traders make money, but traders often mention them because of tradition on Wall Street. They are afraid that their peers might respect them less for being purely technical traders.” Brooks Trading Course

One example of a fundamental trade

In my Seeking Alpha article, “Meritage Homes And KB Home: Fundamental Trading Opportunities” I identified a pair of trades - one long and one short - based on fundamental analysis. 

I looked at 2 factors – business fundamentals and margin of safety. I hunted for a pair trade from the homebuilding sector so that all the companies face the same economic situation. As the homebuilding sector is cyclical, the analysis and valuation were over the cycle.

The long position is the home builder with the best combination of good fundamentals and the best margin of safety. The short position is the home builder with the worst fundamentals and no margin of safety. Refer to Chart 2.

Chart 2: Margin of Safety vs Fundamentals of top US Home Builders

The result of such an analysis shows that you should buy Meritage Homes Corporation (NYSE: MTH) and short KB Home (NYSE: KBH). The rationale is that the price of MTH would go up as value investors pile in. Given the current economic situation and the news about the possible recession, investors in KBH would seek to get out.

Can you make money?

The main purpose of investing or trading is to make money. As such the most important aspect of using fundamentals for trading is whether it can improve the prospects of making money.

But this is a very challenging question to answer.  I have to find evidence that traders who used fundamentals performed better than those that did not. I could not find any study of such a comparison. 

The other way to answer the question is to search for successful or famous traders that used fundamental analysis. Yes, I equate success and fame with making money. 

Unfortunately, I could not find any information when I did a Google search for successful or famous fundamental traders. This is unlike a search for successful or famous investors where names like Warren Buffett, John Templeton, and Peter Lynch, to name a few, pop up immediately. 

I then resorted to looking for famous traders and then dug deeper to see whether there was any mention of them using fundamentals. Investopedia listed the following as the 10 of the world's most famous traders of all time:

• Jesse Livermore.
• William Delbert Gann.
• George Soros.
• Jim Rogers.
• Richard Dennis.
• Paul Tudor Jones.
• John Paulson.
• Steven Cohen.
• David Tepper.
• Nick Leeson.

I found that a number of them have been associated with fundamental analysis.

“People sometimes make the mistake of believing that Jesse Livermore was a purely technical trader… At other times though – as explained in Reminiscences of a Stock Operator – he would act on his understanding of the fundamental economics of a situation.” Jesse Livermore, Stock Trader Extraordinaire

“George Soros is a short-term speculator. He makes massive, highly-leveraged bets in the direction of the financial markets. His famous hedge fund is known for its global macro strategy, a philosophy centred around making massive, one-way bets on the movements of currency rates, commodity prices, stocks, bonds, derivatives, and other assets based on macroeconomic analysis.” Investopedia

“Paul Tudor Jones is an inspiring trader and fund manager with tonnes of experience under his belt and a strong investment approach following global macro fundamental trading.” Logikfx 

“David Tepper uses a value investing strategy that is very much like that of Warren Buffett. Tepper focuses his efforts on fundamental analysis to identify quality stocks then he concentrates on a handful of good ideas and invests the lion’s share of his portfolio there.” Financhill

What is the moral of the story? There is some evidence that fundamental analysis can be a useful tool for traders to make money.

On a personal basis, I would like to think that my pair of trades using fundamentals can be another piece of evidence. But this is a long-term trade and would time. I must admit that there was one Seeking Alpha reader who disputed my shorting of KBH. 

He opined that KBH’s price would rise given its good business fundamentals. However I had subsequently  carried out a detailed analysis of KBH and maintained my conclusion. Refer to the Seeking Alpha article "KB Home: This Is A Cyclical Stock. All Signs Point To A Short Opportunity."

Conclusion

There are several differences between investing and trading. Apart from the holding period, they differ in the way they approach the stock market and how they manage risk.

Traders tend to rely a lot on price action via charts, trendlines, and other technical indicators to guide their trade. On the other hand, investors rely more on fundamental analysis.

However, I have shown that some traders do use fundamentals as well. But these are mostly to complement their technical analysis. I have not come across a trader that focuses only on fundamental analysis.

As such I would conclude as follows:

• Fundamental analysis can be another tool in the trader’s toolkit.

• Successful traders who have made money using fundamentals did so under specific situations. In other words, there are times when trading on fundamentals delivered enormous returns.

So, can you make money trading with fundamentals? Yes. But you have to apply it to specific situations rather than use it as routine strategy. 

End

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If the above article was useful, you can find more insights on how to make money in my e-book. The e-book is now available from Amazon, Kobo and Google Play.

PS: If you are in Malaysia or Singapore, the e-book can only be download from Kobo and Google Play. 

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