Fundamental Analysis
By Bernard Joffe (Editor, The "Richesse Letter")

The term "fundamentals" as applied to stock market analysis refers to the study of the myriad background factors which affect the value of securities and hence their price. Fundamentals include the following two fields, macrofundamentals and microfundamentals.

Macrofundamentals

This term refers to the financial, economic, political and social environment in which stock markets function. The term embraces such factors as inflation, interest rates, fiscal policy, foreign investment, currency fluctuations and so on. Let's briefly consider some of these factors and their likely influence on the stock market.

Inflation

Escalating inflation, of the type seen all over the world during the seventies, is a consequence of the "over-production" of paper money, in comparison to the available supply of goods and services. In such an environment all "things" with a paper money value will become more expensive. This applies particularly to precious metals such as gold and silver.

Conversely when countries bring inflation more under control, as happened in the major industrial centres during the eighties, the prices of these metals decline. Insofar as an increase in the money supply may prove stimulatory to business, and generate improved corporate profits, inflation has also tended to favour investment in sound non-mining shares such as Industrials and Financials. Note however that there are many exceptions to this rule.

Interest rates

Stock markets love declining interest rates, particularly short term ones, and as a rule react positively to them. The general reason for this is that individuals and companies decide that they can receive a higher return on their savings by investing in the markets. Conversely when the monetary authorities allow these rates to rise (to cool off inflationary pressures in the economy) the stock market tends to decline, as happened in 1969 and again in 1987.

Fiscal policy

With increasing taxes, consumers have less money to spend, hence shares of consumer-oriented companies usually become adversely affected, whereas a tax-reduction is often stimulatory to the stock market.

Foreign investment

A developing country like South Africa is unable by itself to generate sufficient capital to produce economic growth commensurate with the expansion of the population. The amount of capital foreign entrepreneurs invest here (considering the ongoing violence, strikes, civil disobedience, etc.) will largely determine our economic well-being, and may clearly impact negatively on share prices and influence the progress of the stock market.

Another aspect to consider is the possible lifting of exchange controls at some point in the future. Even minor adjustments to these laws could produce net outflows of capital as a result of the larger corporations' ability to transfer capital to destinations outside SA, where the risk versus reward ratio is likely to be more favourable.

Currency fluctuations

Political stability and the rate of inflation are two of the factors in a country that influence the supply and demand for its currency, which in turn determine its value.

A decline in the currency will often cause a country's exports to become cheaper to foreign buyers, and hence will be beneficial to the shares of export-oriented companies. On the other hand, imports become more expensive, and this tends to adversely affect the profitability of import-oriented companies. Of course if the country's trading partners have equally weak (or equally strong) currencies, then it will lose this relative advantage.

An example is the devaluation of the British Pound when Great Britain withdrew from the European Exchange Rate Mechanism (ERM) in 1992. The Pound devalued by around 14% relative to its major trading partners in Europe and the US. The impact on the stock market was positive, because Britain's exports became less expensive and therefore more attractive to foreign buyers. In 1992, 33 billion dollars of foreign investment flowed into the country. In Europe at that time only Spain could boast such a substantial amount of foreign investment.

Microfundamentals

This term refers to those factors affecting the profitability of individual companies or groups of companies. Included in this category are such factors as quality of management, net asset value, debt and equity ratios, new product research, etc.

Indeed virtually all the parameters normally disclosed in a company's financial statements fall within the ambit of the microfundamental analyst.

Product-demand

Also very much a part of this section is the question of product-demand. For instance: In recent years the health allegations against asbestos-producers and their products have adversely affected their shares.

Similarly reports of the development of cheap non-platinum-based catalytic converters for motor-car emissions have depressed platinum shares from time to time.

Obsolescence

Microfundamentals further concerns itself with the question of obsolescence - for instance the development of the fax machine was a tremendous setback for the manufacturers of telex machines.

Timing

Perhaps the major problem confronting the fundamental analyst is that of timing, since the stock market nearly always makes its major turn before the economy does. Historically, one can show that bull markets (upward market-price surges) start when the tide of business is low and at an ebb and gloom is all-pervasive.

Conversely bear markets (downward price-surges) start at times of great prosperity, when the economy is so to speak bursting at the seams and optimism reigns. It is therefore not difficult to see how anyone who relies solely on the fundamental approach to stock market analysis is prone to be late in calling the turns in the market.

Herd instinct

Finally the fundamentalist also frequently has difficulty in coping with mass (or group) psychology, otherwise known as "herd instinct." This implies that when the public base their investment decisions on high profile statements by political or business leaders, such action is almost invariably "too late," since the market will have already discounted them.

This is one of the reasons for "overheating" of the market. Sentiment will buoy (or depress) the market until it is no longer a true reflection of value, at which stage a correction becomes a distinct possibility.

To quote one example: In 1949 the price/earnings ratio of the Dow Jones Industrials on Wall Street reached a depressed level of 8. This means in effect that investors would only pay $8 for $1 of future earnings. Contrast this with the position in November 1991, when the same parameter reached a level of 29. Investors would pay $29 for $1 of future earnings!

In brief, the fundamentalist may be able to work out what a given company will earn, but has no way of determining what the investment community will be prepared to pay for those earnings.

Problems

Fundamental information is of course quite easy to come by. Newsletters, newspapers, financial magazines, brokerage house letters, etc. are all full of information and opinions at both the macro- and microfundamental levels.

Few people however have the time to read all this information, much less weigh up the often contradictory evidence and opinions presented. Furthermore even if they do, will they have the courage to stick to their conclusions when others voice their equally forceful but opposite opinions?

Another problem facing the fundamentalist is possible bias from the person presenting the information.

Investment publications

Appended below is an alphabetical table of South African sources (printed and electronic) which may contain fundamental information of use to the investor. Following these are two worldwide publications, one from Britain and the other from America.

  

Name Frequency Content
Advice on Diagonal Street Weekly Market Advisory
Business Day Daily General Information
Electronic Investors Guide On-line Co. Fundamentals
Finance Week Weekly Business Financial
Financial Mail Weekly Business Financial
Finansies an Tegniek Weekly Business Financial
JSE Handbook Twice Yearly Co. Fundamentals
McGregors Quick Ref. Yearly Co. Fundamentals
Personal Finance Monthly Investment Letter
The Investors Guide Quarterly Co. Fundamentals
The Richesse Letter Monthly Market advisory
WEN's WOT! Weekly download Latest annual reports
The Economist (British) (World) Weekly World Affairs, Business & Financial
Barons (American) (World) Weekly Business & Financial

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