Sunday, November 22, 2009

A Random Walk Down Wall Street: Chapter 5

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Investment professionals base their decision-making process on one of the two methods discussed in the first few chapters: castle-in-the-air, or firm-foundation. Castle-in-the-air theorists use what is called 'technical analysis' while firm-foundation theorists use 'fundamental analysis'.

Technical analysts make predictions of future stock prices based on historical price charts. They look for trends in a stock's previous prices (is it going up or going down?) and resistance levels (does the stock get stuck repeatedly when it hits a certain price?). These analysts tend to be short-term traders, as opposed to long-term investors.

There are some reasons to believe why technical analysis could work on some levels. When prices go up, investors do tend to jump in and make a continuing upward trend a self-fulfilling prophecy (as discussed in the chapter on asset bubbles). There may also be unequal access to information that causes insiders to buy first, followed by friends/family of insiders, followed by institutions etc. such that it makes sense to jump on an upward trend even if there is no fundamental reason yet released.

Resistance areas may be created when investors who purchased at a certain price level are psychologically tied to that level. For example, if the price was at $50 for a while, several investors may have acquired the stock for that price, and if the price subsequently drops to $40, a great number of those investors may decide to sell when it returns to $50, in order to break even. In this way, a resistance level is created.

According to Malkiel, technical analysts are not well-regarded on Wall Street, but nevertheless they have a strong following. Some of the arguments against charting are the fact that sharp reversals in trend can occur, and some of the techniques are self-defeating (i.e. if all analysts buy on the same signals, the price will skyrocket to the point that no profit can be made).

Fundamental analysts, on the other hand, try to estimate the firm's future earnings and dividends. To do this, the analyst estimates sales levels, costs, taxes and other items that impact cash flow. The most common tools the analyst will use to do this are the company's past record, its income statements, balance sheets, and a visit and appraisal of the company's management. Furthermore, because the industry plays a large role in determining a company's prospects, analysts will often study a company's industry.

One of the arguments against fundamental analysis is the suggestion that the costs of acquiring the information gathered by analysts is larger than the benefit that is obtained, as it is very difficult to determine how much to weigh each piece of information gathered among the boatloads of information that can be obtained. Another argument is that even if the analyst makes predictions of the company's record that are superior to those of the market, his value estimate of the stock could still be faulty, since the market's willingness to pay certain multiples can change very quickly.

Finally, some analysts combine some elements of both approaches of investing. Such analysts look for good undiscovered growth stories that the market may come to like, but don't recommend purchases unless the price of the stock trades below their estimate of intrinsic value.

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