Asset Management
So far, you've learned the goals of fundamental analysis and the role it plays in the investment process. Fundamental analysis, like any other worthwhile discipline, has its benefits and risks. Let's begin by discussing the benefits.
Benefit: Holistic approach
First, there's the potential to make better investing decisions by understanding a company's financial picture. Fundamental investors often take a holistic approach by examining all the company's strengths, weaknesses, opportunities, and threats. These items form the basis of an investment thesis, and they uncover areas that may require additional analysis.
Strengths are areas that the business does well, like a company with high net profit margins. Weaknesses are areas that the business doesn't do well, like carrying too much debt. Opportunities are areas that can likely be improved rather quickly. For example, a manufacturing company that has higher-than-average operating expenses could invest in more efficient equipment. Finally, threats are areas where competitors are potentially able to outperform a company, like with a newly developed product.
Compared to other approaches, fundamental analysis can provide a more complete picture of a company's health. This thoroughness can help give an investor confidence that the investment will live up to its potential.
Benefit: Long-term perspective
Next, fundamental analysis helps investors focus on long-term business trends and be less influenced by short-term noise. For example, imagine a company in an up-and-coming industry that has secured a 10-year patent on a revolutionary technology. Over time, this company might generate higher profits, growth, and cash flow. Seeing this long-term potential can help an investor feel more confident about making a thoughtful investment despite the short-term noise of day-to-day stock price movement.
Along with the benefits of fundamental analysis, there are also significant risks.
Risk: Faulty assumptions
First, there's the risk of making faulty assumptions. As you'll discover in the following lessons, estimating a stock's intrinsic value or future growth potential requires making assumptions. But a stock's market value may never catch up with the value you determine. As economist John Maynard Keynes said, "The markets can remain irrational longer than you can remain solvent." Even if your forecasts are economically conservative and sound, the market may not agree with your conclusion.
Risk: Forecasting Error
Another related risk is a specific type of faulty assumption called a forecasting error. An error can come from many sources, including inaccurate data, accounting blunders, or mathematical mistakes. Unfortunately, when dealing with long-term projections, a small error can lead to dramatically different results. While this risk is always present, you can manage it as you become a more experienced investor through repetition and practice.
In the next lesson, we'll cover the foundational knowledge you can use to find value stocks and estimate their intrinsic value.
But first, here's a video reviewing the basics of fundamental analysis.
