Contemplating the potential of a company doesn't have to be as difficult as solving a black belt Sudoku puzzle. The key is to look under the hood of a company and not just at the glitzy interior. Looking under the hood is known as fundamental analysis on Wall Street.
I spent my teenage years riding the subway system of New York to get around, so by the time I learned to drive a car and finally purchased one, I was too intimidated to look under the hood. I've been driving for over two decades now. I know how to check the oil and add windshield wiper fluid, but I'm still in the dark about engines, drive trains, and exhaust systems.
Over those last two decades I bet I could have saved thousands of dollars if I'd known more about what's under the hood. Instead I have been victimized by repairmen and sales guys—I knew it, but there was nothing I could do about it.
Investors have a lot more at stake than the price of a used car and yet they continue to put themselves into a position to be victimized by the stock market. I'm not talking about unscrupulous operators touting shaky stock picks, or waiting for slow-moving Wall Street analysts to lead you down the right path (which is all too often too little too late). Most individual investors aren't making the money they should in the stock market because they're afraid to look under the hood.
Unfortunately, many individual investors don't use or understand fundamental research. They rely on charts, scuttlebutt from chat rooms, convictions based on fuzzy information like a positive article in a newspaper or magazine, or a good yarn from their drinking buddies. They should be looking at the facts—the trends and the abilities of management of the companies in their portfolio. By evaluating income statements, cash flow statements, and balance sheets you can better understand a company's ability to generate cash and profits (the ultimate goal of any business) and to compete with rivals to either take market share or protect it.
At the end of the day, the success of the stock will depend on management's skill set in various economic conditions to deliver on promise. These elements are the underpinnings of fundamental analysis, and they can't be determined by looking at chart patterns.
Don't get me wrong—there is a place for technical analysis, the analyzing of charts to assist in investment decisions, but too many investors rely solely on charts. I see online brokerage firms touting their interactive charts as "research tools," and far too many investors believe that simply reading charts is doing research.
Folks, you have to look under the hood of a company to understand its true value. The share price means nothing and the chart pattern will tell you more about the near-term parameters and possible ways the stock could break. As a self-directed investor, however, you must know the fundamentals.
I think fundamental work is fun: You learn so much about industries, the economy, and neat things about the future.
Consider this: Trends in trucking tell us about spending habits at home and abroad.
If steel companies are making money it's a reflection that the overall economy is doing very well, and it could have implications, good or bad (after all, if steel prices are higher, wouldn't that have an adverse effect on companies that make products that use a lot of steel?), for your portfolio.
Through fundamental analysis we can connect the dots and form an opinion on the broad economy and even micro niches of the economy. I know about movies, toys, and hip new products long before they come out, and sharing that information with my kids gives me a ton of cool points—not to mention this information gives me confidence to be an investor.
In fact, one of the main goals of the article is to make you more of an investor, a person willing to hold a stock for more than 48 hours or through a down period for the share price. Knowing the fundamentals helps me see through the hype and avoid emotional mistakes.
The system I want to share with you in this article is how to do fundamental analysis to the point that you have a great handle on the business background of the stock you own. There are some forms of fundamental analysis that are extremely complicated.
In fact, the trend on Wall Street is to make fundamental analysis more complex than it needs to be. For me, fundamental analysis tells me what to buy and technical analysis tells me when to buy. However, if you only use the charts to signal when you should be a buyer or seller, then you will take unnecessary losses in good companies and make the stock market a merry-go-round without cute horses and joyful smiles. There will always be angst when your portfolio is heading in the wrong direction, but in the long run few things feel worse than taking a hit on a stock that comes back, and then some.
After two decades of hand-holding, it is my mission to make sure investors (defined as people who plan to be engaged in the stock market for the rest of their lives) stop panicking so much that they take large losses on stocks that come back in short order. I'm not just talking about stocks roaring back days after you've taken a big hit, but hanging on to stocks that will rebound weeks and months after you could have taken a big financial hit.
There are times to toss in the towel and there are times to hang on because the fundamentals are still intact and the company has the ability, and management the skills, to do wonderful things that will eventually be reflected into the share price.