Fundamentals of Research

1What investing is: active and passive

Investing is committing money upfront to earn returns over an investment horizon, after analysing the security's safety, income and growth potential. It differs from trading:

• A trader seeks to profit from the spread between buying and selling prices, usually over a short period, without any change in the asset's underlying value. A trader betting on short-term moves on a calculated guess is a speculator; one relying on price patterns and charts is a chartist; one who opens and closes positions the same day is a day trader.
• An investor focuses on an asset's value rising over time, which happens if it generates more cash flow without proportionately more risk, or less risk without proportionately less cash flow.

Active investing: picking specific securities, constantly re-evaluating them, buying those priced below intrinsic value and selling those above it. More effort and more transactions; the aim is to beat the asset class.

Passive investing: holding a broad, representative set, usually by indexing. The aim is to earn the asset class return; analysis stays at the asset-class level.

Remember

• Speculation: short-term, leveraged. Investment: long-term, disciplined.
• Active aims to beat the index; passive aims to match it.

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2The role of research, and insider information versus mosaic analysis

Research gathers the information needed for a question; analysis draws conclusions from it. Annual reports are rich but published once a year, become dated, and cover industry and economy only lightly. So analysts also use secondary research (expert conversations, market research reports, competitor tracking) and primary research (visiting facilities and speaking to customers, suppliers and employees).

Research must never involve collecting insider information: price-sensitive information not available to the public, held by people close to the company or their relatives.

Insider information is material non-public information that would immediately affect an investor's decision to buy or sell. Whether something counts depends on its source (reliability), impact and certainty. A CEO mentioning an unannounced acquisition is insider information; an employee mentioning a heavier workload in purchasing (a hint of more activity) is not.

Mosaic analysis pieces together many items, public and non-material non-public, none significant alone, into a meaningful insight. It is acceptable. Analysts must be careful to know whether a conclusion came from their mosaic or from being given specific price-sensitive information.

Remember

• Insider information: material, non-public, price-sensitive.
• Mosaic analysis is allowed.

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3Technical analysis

Technical analysis assumes that all information is already reflected in prices and forecasts direction from historical price and volume patterns. Its three elements:

1. past prices show the trend and its direction;
2. volume shows the strength of the trend;
3. time span captures longer-term influences.

Technicians study up, down and sideways trends, support (where buying interest is strong) and resistance (where selling interest is strong). Near resistance, holders may book profits; a break of support or resistance on strong volume suggests the trend has accelerated. Trends not backed by volume are weak. Charts used: line, bar and candlestick. Moving averages smooth out day-to-day fluctuations.

Technical analysis suits short-term traders, since fundamentals rarely change quickly, but is less reliable for long-term investing, when fundamentals can change.

Remember

• Moving averages smooth daily noise.
• Volume confirms a trend.

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4Fundamental analysis

Fundamental analysis is long-term. Because a share is part-ownership, its value over time should follow the company's profits and cash flows. When the price strays from fair (intrinsic) value, there is an opportunity: buy when price is below intrinsic value, sell or avoid when above. Returns come from picking good investments and buying at the right price. This view contradicts the efficient market hypothesis (EMH), which says prices already reflect all relevant information.

Questions fundamental analysts ask:

• Is the cyclical and secular macro trend helping or hurting the industry?
• How intense is competition?
• How is the company positioned against competitors?
• What is its cost structure and how will profits behave in different conditions?
• Is its financial position strong enough to fund growth and survive a crisis?
• Is management capable of choosing and executing strategy?
• Is governance good enough to make the board and management act for shareholders?

These fall into three layers: economic, industry and company analysis.

Remember

• Fundamental analysis vs EMH: it assumes prices can stray from value.
• Three layers: economy, industry, company.

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5Quantitative research and the behavioural approach

Fundamental research mixes quantitative and qualitative work, but some analysts are purely quantitative:

• In technical work, they study the data behind charts (relationships between up moves, down moves and volume).
• In fundamental work, they look for financial and operating metrics that may lead company performance, using time series and regression to extrapolate earnings, more advanced econometrics, and sensitivity analysis and simulations of valuation assumptions.

Limitation: comparable data is hard to get because accounting standards, business models and regulations keep changing, so past data is less useful. Pure quantitative research is therefore rarely used in fundamental analysis.

Behavioural approach: decisions are often distorted by biases; its followers believe prices move away from fair value because of fear and greed. (Biases are covered in Chapter 11.)

Remember

• Quant limitation: changing standards and structures reduce comparability.

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6Commodity fundamentals

Commodity fundamental analysis studies the economic, political and natural factors behind supply and demand: seasonality, macro conditions, news, currency, interest rates, weather, inventories and government action.

Supply factors: production (farms, wells, mines); weather (floods, drought, cyclones); government policy (tariffs, levies, trade restrictions, subsidies); geopolitics (sanctions, wars, trade disputes); input costs (energy, wages, technology).

Demand factors: global growth (more demand for metals, energy and farm goods); population growth and urbanisation; substitution between commodities; seasonal demand (fuel in winter or summer, festive food); changing consumer preferences (organic food, renewables, EVs).

Macro indicators: inflation (gold and silver as inflation hedges); interest rates (higher rates strengthen the dollar and tend to lower commodity prices); trade balance and industrial data such as the PMI and industrial production.

Remember

• Higher US rates → stronger dollar → weaker commodity prices.

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7Case studies: gold and crude oil

Gold (uses: jewellery, industry, investment, central bank reserves) is an inflation hedge and safe haven, tending to move inversely to stocks, bonds and currencies. In the workbook's figures, demand is about 47% jewellery, 24% investment, 23% central banks and 6% technology. Major producers include China, Australia, Russia, the US and Canada; major consumers China, India, the US, Germany and Saudi Arabia.

Crude oil ("black gold") is used for fuel, plastics, lubricants, naphtha and bitumen; supply shocks fuel inflation worldwide. Quality depends on density (API gravity) and sulphur content. Benchmarks: WTI (US, high quality, about 39° API and 0.24% sulphur, traded on NYMEX) and Brent (North Sea, the benchmark for Europe and Africa, about 38° API and 0.4% sulphur, traded on ICE). Supply is dominated by the US and OPEC+ (13 OPEC members plus Russia); the Middle East holds about 48% of known reserves. Major producers: US, Russia, Saudi Arabia, Canada, China; consumers: US, China, India, Germany, Japan.

Remember

• Weak dollar helps both gold and oil.
• WTI on NYMEX; Brent on ICE.

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8Historical events in oil

On 20 April 2020, WTI crude futures went negative. The May contract expired the next day, demand had collapsed with most of the world in COVID-19 lockdown, and WTI is physically delivered at Cushing, Oklahoma, where storage and movement were constrained. Holders who could not take delivery rushed to sell.

The first major post-war oil crisis came in 1973, when OPEC members quadrupled prices to almost $12 a barrel and stopped exports to the US, Japan and western Europe.

Remember

• April 2020: WTI negative because of delivery and storage problems at expiry.

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9How commodities affect equities

Many listed companies use commodities as raw materials, so commodity prices hit their margins: rising prices raise input costs and squeeze profits; falling prices help. Rising crude helps oil producers but hurts airlines and logistics companies. Because commodities trade globally, their prices also signal global demand: falling copper prices may point to slowing industry and weigh on metal and infrastructure stocks.

Remember

• Same commodity move can help producers and hurt users.

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