In my previous article, I compared the 3 robo-advisors in Malaysia and their performance. Although the results are good, you do not have full control over the portfolio. Besides, you can obtain better returns if you know how through other means of investing. In this article, we will go through the 2 main schools of investing in stock market which are fundamental analysis and technical analysis.
Many years ago, I learned fundamental analysis from KC Chong. He is very active in I3investor and has written a lot of articles. However, I found it to be too technical for me but for those that like to do calculations and understand in-depth on a company, his teachings are very good.
In Malaysia, there are several famous investors that uses fundamental analysis such as Koon Yew Yin and Fong Siling or otherwise known as Cold Eye. They both have their criteria to select stocks. There is no right and wrong but it depends which method suits you. Let’s take a look at the criteria below:
Koon Yew Yin’s Golden Rule
Koon Yew Yin’s Golden Rule has 2 important points:
- the company must report profit growth for 2 consecutive quarters
- the PE ratio must be below 10
To obtain the 2 data for the above, there are 2 ways. The 1st method which is more time consuming is by getting the financial report for the company. For example, you can obtain the report for Top Glove from their website. By comparing the Q2 and Q3’s profit net of tax to Q1’s, you can see if the company is growing for 2 consecutive quarters.
Next, PE ratio or price-to-earnings ratio which we can get it by dividing the price of the share to the earnings per share.
Photo from Investopedia which you may also learn more about PE Ratio here.
Both the items mentioned above can be found in the 1st page of the quarter report as highlighted below:
The 2nd method is by using resources that provides the data to the public. The one that I usually use is MalaysiaStock. In the website, you can easily look at the quarter earnings and PE ratio in 1 glance. Besides that, you can also use apps such as KLSE Screener which they also have a website here.
If the info is widely available on the internet, you might wonder what is the purpose to use the 1st method. By going through the report in detail, you can understand the company’s financial health and other info that might help you to evaluate the company better.
Cold Eye’s 5 Yardsticks
Based on this article written by KC Chong, below are the 5 criteria by Cold Eye in picking a stock:
- Return on equity (ROE) > 12%
- Cash flows (free cash flow/revenue > 5%)
- PE ratio <15
- Dividend Yield >3%
Return on Equity (ROE)
ROE is a measure on how effective a company uses equity to generate profit. Below is the formula gotten from Investopedia:
Generally, the higher the ROE the better. However, it is usually used to compare against companies in the same industry.
Cash flow is the lifeblood of every business. To determine a healthy free cash flow, Cold Eye set the parameter of free cash flow (FCF)/revenue to be more than 5%.
The formula for FCF is cash flow from operating activities (CFFO) – capital expenditures (CAPEX). Using the example from Top Glove, it can be gotten in slide 5 of the quarter report.
Net cash flows generated from operating activities is the CFFO. On the other hand, purchase of property, plant, and equipment (PP&E) is the CAPEX.
Compared to Koon Yew Yin’s Golden Rule, Cold Eye set the benchmark to be less than 15 instead of 10.
Dividend yield is the amount of payout a company gives out to its investors based on the stock price stated in %. As stock market is much riskier compared to fixed deposits (FD), the dividend yield should be higher than those offered in FD. Below is the formula from Investopedia to calculate dividend yield of a company:
Based on the article, if a company’s expenditure increases and the net income follows, it is a good sign of growth. However, growth also depends much on the current and future trends. For example, technology such as AI and fintech etc is the way of the future. Therefore, company that involves in technology has a lot of room for growth.
Further Studies for Fundamental Analysis
Besides Koon Yew Yin’s Golden Rule and Cold Eye’s 5 Yardsticks, there are a lot more stock selection criteria using fundamental analysis. In addition, there are a lot more ratio and calculations used in fundamental analysis such as ROA and current ratio etc which you can study here. Moreover, below are some books that you should take a look that can help in your fundamental analysis journey:
- The Ultimate Guide to Stock Valuation – Jae Jun
- The Merrill Lynch Guide to Understanding Financial Reports – Merrill Lynch
- Margin of Safety – Seth A. Klarman
In the same year that I learn fundamental analysis with KC Chong, I was also learning technical analysis with CP Teh. His teachings are no-nonsense and gives importance to cut loss when a trade fails. As I find technical analysis to be more suitable for myself, therefore I use it in my stock market journey.
In technical analysis, one of the most popular charts is candlestick charts. In the chart, you will see candlesticks like below which I obtained from Investopedia:
Depending on platforms, you might see red and green candlesticks instead of black and white candlesticks like the image above. If a stock closes higher, it will appear as green or white candle. On the other hand, it will appear as black or red if a stock closes lower.
There are several candlestick patterns that all investors that use technical analysis should know.
In a bearish stock where the price keeps going down, if a hammer appears, it indicates a possibility of reversal.
2. Inverted hammer
Similar to a hammer, it shows a chance of reversal in a down trending stock.
3. Hanging man
The opposite of hammer, if a hanging man appears in a bullish stock, the stock might start going south.
4. Shooting star
Similar to a hanging man, a shooting star indicates a possibility of reversal.
5. Morning star
Morning star is a 3-sticks pattern where the ‘star’ appear after a long red/black candle and followed by a green/white candle. It shows a potential of rebound after a downtrend.
6. Evening star
On the other hand, the opposite of morning star, the evening star is lead by a long green/white candle followed by a long red/black candle. It shows the possibility of an ending to an uptrend stock.
To learn more about the candlestick patterns, you may take a look at this website where I have gotten the images above.
Support and Resistance
In technical analysis, there are a lot of psychology that happens among the investors. Based on the images from Investopedia below, you can see that you can easily draw a line in the chart to determine the support and resistance of a stock price.
If a price breaks above the resistance level, it shows a possible buy signal. On the other hand, if a price breaks below the support level, it shows a possible sell signal.
To look at past prices and draw support and resistance, I uses Chartnexus. It is free and easy to use, and you can apply stock indicators which lead us to the next topic.
There are a lot of technical indicators you can use but we shall go through the few common ones.
1. Moving Average
In moving average, there are simple and exponential moving averages. In simple moving average (SMA), it calculates the average of price data. On the other hand, exponential moving average (EMA) gives more weight to the current data. To understand more on the differences, you may refer to this article.
The commonly used moving averages are 10, 20, 50, 100, and 200 days. Depending on your investment time frame, you would use a shorter moving averages for short term trade and vice versa.
You can use it as a buy or sell signal as per the example below from Investopedia. When the shorter moving average (50 days) crosses above the longer moving average (200 days), it can indicate a buy signal. This is because it indicates that the current trend is going upward. However, the opposite is also true where the sell signal is when the 50 days line crosses below the 200 days line.
2. MACD (Moving Average Convergence Divergence)
MACD is a tool that is used to identify a possible new trend which could be bullish or bearish.
One basic interpretation of MACD is it indicates a possibility of an uptrend when the MACD lines crosses above 0 in the histogram.
Besides that, based on the image from Investopedia above, when the fast black line crosses above the red line, it indicates a potential buy signal which is shown with the blue arrows. On the other hand, when the black line crosses below the red line, it shows a potential sell signal.
3. Relative Strength Index (RSI)
RSI is an oscillating indicator where the movement is contained between 0 and 100.
In the image above from Investopedia, the 70% red line is the overbought zone and the 30% green line is the oversold zone. If the line crosses below the green line, a bounce might happen. On the other hand, if the line crosses the red line, a pullback might occur.
Besides that, RSI divergence can be used to indicate a possible reversing trend. For example, based on the image below, when the stock price has lower low price but the RSI has higher low trend, it shows possibility of a trend reversal.
Further Studies for Technical Analysis
In technical analysis, there are a lot of chart patterns and indicators. From the simple moving averages to more complicated indicators such as Ichimoku Cloud, it is good to understand them but pick only a few in your stock selection criteria. Here are some websites to help you get started:
- 16 Candlestick Patterns Every Trader Should Know
- The 5 Most Powerful Candlestick Patterns
- 21 Easy Candlestick Patterns
- Top 10 Trading Indicators Every Trader Should Know
- 7 Popular Technical Indicators and How to Use Them to Increase Your Trading Profits
- Trend Trading: The 4 Most Common Indicators
In conclusion, fundamental analysis and technical analysis have their own strengths and weaknesses. In general, long term investors usually uses fundamental analysis while short term traders usually uses technical analysis. However, there is no right and wrong. As long as the method is suitable for you and it helps you to generate side or passive income, it would be the best method. You can even use fundamental analysis to do the 1st round of selection, and then uses technical analysis to time the suitable price.
For myself, I uses fundamental analysis to avoid companies with negative EPS (earnings per share) or PE ratio. After that, I uses simple moving averages and support & resistance to set my buying and selling point. As there are so many ratios, patterns, and indicators, less is more. This is because if you use too many formulas or indicators, sometimes they might show opposite results. For example, if MACD shows a buy signal but the RSI shows a sell signal, what action would you take?
Between fundamental analysis and technical analysis, which do you prefer to use to purchase stocks? Feel free to share in the comments section below.