Why Fundamental Analysis isn’t Perfect
Fundamental analysis may be the preferred method for forecasting stock prices on Wall Street, but there are a few major considerations for security analysis that cause it to barely outperform the technical analysis method. Here are five reasons why fundamental analysis is not a perfect method. This blog is a part of a series written by our summer intern, Makenna. This series is based off excerpts from the well-known book, A Random Walk Down Wall Street.
1. Unpredictable Random Events
Without unpredictability, it would be extremely easy to earn a profit from the market. Unfortunately, random events happen all the time which instantaneously shift the market before any human can react. Random events, good or bad, are one of the main reasons investors should not fully trust their fundamental analysis calculations for profitable securities. For instance, Burton Malkiel, author of A Random Walk Down Wall Street, gives the example of a utility company. Seemingly one of the most stable industries, utility companies are still subject to changes in policies and fuel costs which can greatly affect the company’s stock price. Other random events that could affect stock prices include the addition of new competitors, changes in U.S. government, natural disasters, wars, and more. When you think about the volatility in the everyday, it becomes clear that the only thing you can count on is the fact that random events will happen.
2. Creative Accounting Practices
Another reason to be wary of market predictions is the truth that many companies use creative accounting practices to record revenues. Because companies want to look as profitable as possible to attract investors, they could twist the rules and report more earnings than were actually generated. In 2001, Enron and Qwest swapped assets at an inflated price, then recorded it as a sale to increase their revenues. Xerox recorded years future payments for copier leases in the current year to inflate profits. On the other hand, Diamond Foods delayed recording payments to suppliers to future years which gave the impression of a higher bottom line. These are just a few examples, and they show that companies often try to mislead investors.
3. Human Error is Inevitable
Humans are not machines and are therefore unable to make perfect mathematical calculations without fail. In fact, we often make small errors which lead to large consequences. Malkiel tells the story of a fellow coworker on Wall Street named Louie. Louie calculated that “for each 10¢ increase in the price of copper, a particular copper producer’s earnings would increase by $1 per share.” Therefore, Louie reported that copper was an exceptional investment. Malkiel corrected the calculation to show that a 10¢ increase in the price of copper led to a 10¢ increase in a copper producer’s earnings which creates a vastly different attitude toward copper as an investment. Had someone followed Louie’s suggestion, he or she would have been greatly disappointed in the lack of return for the metal. Miscalculations happen all the time, so we should be aware of this possibility.
4. Loss of Talent
One of the paradoxes of security analysis is that the best analysts often leave their jobs for higher paying positions in sales or portfolio management. This means that the best talent is often not performing. This is not to say that hardworking, talented security analysts do not still exist, but that there is a demand for their talent elsewhere that is often matched with a higher salary. Because of this demand, the already rarely successful sector of security analysts loses top talent. The best security analysts do not stay in their jobs for long, which leaves investors with little accurate guidance.
5. Conflicts of Interest
The two parties with a conflict of interest in terms of security analysis are the analysts and the investment banking departments. Analysts want to make money from their predictions, and investment bankers want their companies to appear successful in order to produce profit. Therefore, an analyst could falsely report that a certain company is a profitable investment which would help investment bankers collect investors. A notable example of the dishonest relationship between these two parties happened when an analyst recommended that Trump’s Taj Mahal bonds be sold because they were unlikely to pay interest. The firm fired the analyst because they were threatened with legal retaliation from the company even though the bonds eventually defaulted.
Clearly, there are many reasons to be wary of what security analysts report. Security analysis is already rarely an accurate way to predict future stock performance, and these considerations do not add to its credibility. While security analysis may be slightly better than technical analysis in terms of past performance, there is still no perfect method for forecasting market performance. We must not put our full confidence in any of the existing methods if we wish to make wise investment decisions.
Summer Intern / Berry College Student