10 Things Fundamental Analysis Cannot Do - dummies

10 Things Fundamental Analysis Cannot Do

By Matt Krantz

Fundamental analysis also has its limitations. Rather than trying to ignore the shortcomings of fundamental analysis, it’s important to recognize upfront what they are and adjust your strategy accordingly. If you don’t approach fundamental analysis with reasonable expectations and knowing what the risks are, you may certainly be disappointed with the results. Following are some of the primary drawbacks to fundamental analysis.

Ensure you buy stocks at the right time

The biggest knock against fundamental analysis is that it doesn’t necessarily help you time your investment decisions just right. You might do a beautiful job analyzing a company’s financials, identify an undervalued stock, buy it, and wait to make money. And then, 10 years later, you’re still waiting and waiting.

Just because a stock is fundamentally cheap doesn’t mean it must soar in value anytime soon; in fact, it can become even cheaper. Sometimes a stock is cheap for a reason that will reveal itself in its financial statements in the future.

Guarantee you’ll make money

During a bear market, even the most skilled fundamental analyst will likely suffer losses, at least on paper. During times of extreme stock market stress, some investors might wonder why they even bothered with fundamental analysis.

Fundamental analysis requires taking a close look at many aspects of a company. Even after this, fundamental analysts can make mistakes. Sometimes the overwhelming downward pressure of a recession or bear market can punish even unsuspecting companies or investors.

Save you time when picking stocks

Fundamental analysis, though, doesn’t age well. Even after you spend hours completely studying all public information about a company, its stock and industry, you’re not done. New information continuously flies at you and may have an influence on your analysis.

Performing fundamental analysis takes time, patience, and determination. You’ll need to take the time to gather, analyze, and process new financial information as it comes in. Fundamental analysis can be somewhat time-consuming, as you’ll need to make sure you are studying every aspect of a company that you possibly can.

Reduce your investing costs

There’s no question the cost of buying and selling individual stocks has fallen dramatically. If you open an account with an online discount brokerage firm, you might expect to pay $10 a trade or less as a trading commission. At $10 a trade, the trading commissions you pay won’t make a big dent in your portfolio’s return.

But many investors make the mistake of assuming the trading commissions are the only tolls you pay when you buy and sell individual stocks. Other costs include:

  • Your time
  • Research
  • Being wrong
  • Tax hits

Although fundamental analysis has its costs, picking your own stocks could actually save you money versus investing in actively managed mutual funds. Actively managed mutual funds employ professional money managers who select stocks and decide when to get in and out. Some of these mutual funds charge large fees. These fees, disclosed as part of a mutual fund’s expense ratio, can cost you 1% of your investment a year or even more. If you’re convinced you don’t want to put your money in a low-cost index fund, and instead are invested in a fund that charges a large expense ratio, it’s possible you might save money by picking stocks yourself.

Protect you from every fraud

There’s no question fundamental analysis is one of your biggest shields from getting sucked into the next Enron or Sunbeam accounting scandal. There are tricks and techniques to fundamental analysis that help you spot suspicious activity going on at a company. Although you may not be able to pinpoint the specifics of a fraud using a company’s financial statement, you’ll probably see enough red flags to make you suspicious of the company and the way it operates.

With that said, fundamental analysts must accept, to a certain degree, the fact they must take financial statements somewhat at their face value. If a company completely fabricates the numbers on the financial statements while the board of directors and auditing firm aren’t paying attention, there’s only so much a fundamental analyst can do.

Easily diversify your risk over many investments

But generally speaking, if you’re going to go to the trouble and expense of digging into the bowels of individual companies, you will likely only be able to keep up with so many stocks. In fact, if you own too many stocks, you might miss some important fundamental details and derail your success.

Being concentrated in a few stocks, though, presents risks, too. A big and unexpected decline in revenue or earnings at one of the companies you’re invested in could depth-charge your returns. Worse yet, a massive decline by one of your holdings might make a dent in your portfolio that will be difficult to overcome.

Predict the future

Fundamentals can be poor indicators of the future. Financial statements are backward-looking, meaning they tell you how a company did in the past, not necessarily how it will do in the future.

Make you the next Warren Buffett

Given the success Warren Buffett has enjoyed at the helm of Berkshire Hathaway, it’s natural to want to take a page from his playbook. Buffett is a master at using fundamental analysis to identify businesses that generate strong returns over the long term. There are many things to be learned from the Oracle of Omaha’s long-term and patient approach.

But don’t assume that just by reading about fundamental analysis, you can expect to have the same kind of success. Remember, Buffett has an army of analysts to assist him in studying companies. Also, know Buffett’s cash allows him to get deals on stocks you, as an individual investor, would never get.

Protect you from your own biases

The discipline of fundamental analysis can keep you relatively level-headed when it comes to your investing. Instead of blindly following stock tips from a neighbor or from a guru on TV, fundamental analysts take the time to do their own due diligence. By scanning through a company’s financials, you can get a pretty decent idea of a company’s intrinsic value and how healthy the company is.

There’s still a healthy dose of judgment and estimation that goes into fundamental analysis.

Overcome the danger of thinking you’re always right

Most investors assume they’re skilled at choosing stocks, even when they don’t have any factual basis to believe that. Many investors buy and sell individual stocks, and conveniently remember their winners while somehow forgetting about all the bum investments they’ve made.

Fundamental analysis can give some investors, sadly, even more ammunition to pad their imaginary stock-picking track records. You might, for instance, accurately forecast a company’s future earnings, which is pretty difficult to do. You might, in hindsight, applaud your excellent trend analysis, and somehow forget you actually lost money on the investment because you overpaid for the stock.