How a Company’s Fundamentals and Price May Be Misaligned

By Matt Krantz

You don’t need a long memory to remember how fundamental analysis could have helped your investing. During the tech-stock boom of the late 1990s, investors were so enamored with dot-coms they were willing to pay boundless amounts for them. Just a few years later, in the mid-2000s, investors repeated their mistakes by creating a housing boom that drove up shares of homebuilders’ stocks.

What’s remarkable is there were at least two massive stock market bubbles in just one decade. Fundamental analysis could have helped you sidestep the intense pain after both these bubbles inevitably burst.

Put one of these bubbles into context, using your new tool: market value. KB Home, a southern California homebuilder, was at the epicenter of the housing bubble. Back in early 2006, investors awarded the company with a total market value of $6.8 billion. Fast-forward to the end of 2014 — long after the housing bubble burst. KB Home’s market value was pricked to $1.5 billion. Where did the missing $5.3 billion in market value go? Out of the pockets of speculators. KB Home’s market value collapsed a remarkable 78%, erasing $5.3 billion in market value.

Academics argue over why bubbles and manias occur with investing. And you can leave that heady discussion to them. Just know that sometimes, overenthusiasm for stocks can drive prices, albeit temporarily, to levels that aren’t justified by their underlying businesses. Fundamental analysis is one way to try to see when a bubble is forming and try to profit from it.

Even masters of fundamental analysis have difficulty timing bubbles just right. Many analysts had warned that tech stocks were overvalued in 1998, for instance. And they were right . . . eventually. These investors had to bear being wrong and missing out on huge gains as tech stocks continued to soar in 1999 and early 2000, even though they proved to be wildly overvalued.

Investors who pay attention to company fundamentals are often able to at least recognize when a bubble is forming. Weak fundamentals, for instance, were the tip-off for the dot-com bubble. More than a third of the 109 Internet companies that failed had business models that didn’t bring in enough revenue or had costs too high to ever make a profit, according to Boston Consulting.