A Discussion of Technical versus Fundamental Analysis

Many investors, when first deciding to buy individual stocks, have an experience that is often unpleasant. They hear that their friends are making a fortune in Dura Pharmaceuticals or Complete Business Solutions, and they want some of the action, too. They hear that Complete Business Solutions have gone from 12 to 36 since April and they decide that mutual funds are too "tame". So they call up a broker (usually at the top of a rally) and they buy whatever he suggests. And naturally, since they buy what's hot, the smart money is already leaving.

The more sophisticated investor buys some sophisticated stock-picking software. The premise behind much stock-picking software is to buy high and sell higher. It measures momentum. This is often called accumulation or price momentum or price relative strength, etc. This is the premise behind Investor's Business Daily's ABCDE ratings and their numerical ratings of earnings per share and relative strength. Investor's Business Daily tells you only to buy stocks that are rated A or B. But the problem with this is by the time they're rated A or B, they've gone up quite a bit. And by the time they're rated C, D or E and you decide to sell, they've already gone down quite a bit. And if you buy a stock with high relative strength, say one rated 99, then it won't stay 99 for very long. Now admittedly, people make money with the stocks they pick out of Investor's Business Daily charts. And they make money from stock-picking software. But they don't often get something that makes 10 for 1 or more. To do that, another game plan is needed. It's called fundamental analysis.

Investors who rely on fundamental analysis pick stocks solely based on their perceptions of the economy and a particular stock or industry within that economy. On Wall Street, they are paid huge salaries for their analysis. You will notice that they will attempt to guess earnings each quarter to the penny for many of our major companies. In fact, the more analysts that follow a company, the less likely you are to find one that will give you 10 for 1. And the reason is too many people are watching the same thing. So a company that's followed by too many analysts can never be truly undervalued. A funny thing happens with these earnings estimates. After the stock price goes down, sold by the technicians, the fundamental analysts lower their earnings estimates. It's sort of like locking the barn after the horse is gone. The greatest fundamental analyst of all time is Warren Buffet. He is a closet market technician. By this, I mean he buys low, not only when the stock is low, but when the market is low. And if recent history is any guide, he also sells high. But he doesn't like to talk about it. The reason is, he'll tell you what he bought after he's bought it and you'll help to drive up the price. And you'll only find out what he's sold when he's gotten rid of as much of the position as he wants. Now if I tell you that he buys low and sells high, that's technical analysis. It's what we try to do when we determine if OEX or XAU is overbought or oversold and about to turn.

Now, if we're going to try to do a good job picking a winner, we need several things.

  1. The stock has to be extremely undervalued.
  2. Some extraneous event must come within 1 or 2 years to change the public's perception of the company.
  3. There must be some hidden factor that could propel the price to a 10 to 1 gain, but if this hidden factor never materializes, the price should still rise based on the fundamentals.
  4. The company should not be followed by many analysts, preferably by none.
  5. The company should have large cash assets.
  6. The company should be on the verge of a change in the fundamentals.
  7. The company should be in an industry that is currently despised. It should be a "throw the baby out with the bath water" situation.
  8. The company should be run by an experienced management team who are not terribly interested in publicity.
  9. The company should have assets that are not currently recognized, and these assets should be many times a multiple of the share price. These assets should be easily convertible to cash within 1 or 2 years.

When this occurs, the intelligent investor places the company's stock on the watch list. As a technician, he draws a price channel, the longer the better. One of the most brilliant technicians of all time, Ted Warren, looked for extremely long down channels followed by price breakouts. He wanted all the sellers possible washed out of the stock.

Now let's look for a real life example. It's important to state here that this company was picked more or less at random, and that nobody on this site has any stake or financial interest in this company, and nobody is receiving financial renumeration. The analysis is done from publicly available sources available on the Internet and from newspapers. It's also important to stress that THIS IS NOT AN IMMEDIATE BUY RECOMMENDATION!! This is an example of a stock that one would place on one's watch list.

Now let's examine the above points 1-9.

  1. The price is in the $1.40 Canadian area. Based on scope-only estimates, the company should show earnings that climb to 77 cents a share by 1999 as it brings 2 mines into systematic production.
  2. The company presently doesn't have earnings, but is nearing earnings and production.
  3. The company will be drilling a target in the Thompson Belt to the north of a present Inco full production facility. The Thompson Belt is much larger than the recent Diamond Fields discovery, and with success, the price gain could be similar to the recent Diamond Fields discovery. Without any discovery in the Thompson Belt, the share price is still extremely undervalued.
  4. The company is not followed by many analysts. After all, the price is falling. After Bre-Ex, no one wants to follow mining companies, especially ones considered juniors.
  5. The company has between $1.5 and $2.5 million in the bank.
  6. Deposits from the Werner Lake property have measured as much as 15 to 20% cobalt. Many mining companies are excited with a 2% cobalt discovery. Werner Lake will come on-line, and earnings from it will start to appear in strength in 1998 and 1999. There will be $59 million of cash flow in 1999.
  7. The company is presently in the most despised industry - mining. And nothing exciting like gold, just cobalt and nickel. To people who are not mining analysts, 20% cobalt doesn't mean anything. To miners, it makes their jaw drop. After Bre-Ex, unless a company is in the Inco class, companies on the verge of significant production are treated just like companies that have one guy on a phone in a closet in Vancouver and nothing else.
  8. The company has never placed an ad in Investor's Business Daily or any other financial publication (to my knowledge - and I read most of them!)
  9. The company's present deposits, which are next to production facilities and roads, are already on the verge of production, with much of the development process already complete.

Now, the intelligent investor places this company on a buy watch list. The 4 likely price patterns that can occur from now are:

  1. A continuation of the down channel of the above chart,
  2. A breakout and sideways and retesting action, (the "W")
  3. Sideways action for a prolonged period,
  4. A "V" explosion upward.

Now these price patterns are easy to see on the chart, so the intelligent investor makes a bookmark to the price chart site (http://quote.yahoo.com/q?s=CMR.TO&d=3m) and the company's website (http://www.canmine.com) and then he trolls the net for similar situations.

Here is our best analysis of the internal technical situation of this stock.

  1. MACD and Price Phase. Both are pretty flat and trying to turn, it is so close they could go either way.
  2. Price Volume confirmation uses the Positive volume index and that is still in a downtrend.
  3. On Balance volume is still in a downtrend.

Here is an analysis of On Balance Volume and other technical indicators for those of you who don't know what these terms mean. Here is a longer term chart of Canmine.

The conclusion is a partial long position can be taken when the up rating is over 95 (as it is now) without any other confirmation, but this is for speculators only. Here is a detailed listing of our technical indicators. Conservative types should wait for confirmation by Price Phase. Most conservative types should wait until both price phase and the volume confirmations are there. Take a look at these two indicators below the cmr plot. Note how flat they have been since July. Also note that anyone who has bought it since May '96 has a loss in it. That might mean it will suffer the tax loss selling syndrome during this quarter and not bounce until after the first of January. Notice for short term traders in the lower plot of the above chart (CMR plot) that buying comes in on a cross above the green line, and selling comes in on a cross from above to below on the purple line. Buyer beware! Always check out company information with independent sources, like their competitors! You're more likely to get the truth from companies that do business in the same field that have no vested interest in the company being studied.

Our best estimate of the share price of this company based on the fundamentals and scope-only estimates would be $3.35 to $7 in 1999.