Investment Analysis: Discovering How to Make Money in the Stock Market
This research involves discovering the most profitable methods of investment analysis. The goal is to identify the two most profitable methods of investment analysis for both categories of analysis; technical and fundamental. This has been accomplished through reviewing and analyzing prior research studies of market data in numerous worldwide stock exchanges. In reviewing said studies, the technical methods, known as indicators that were shown to be most profitable were ‘100-Day Moving Average’ and ‘RSI’, or relative strength index.
The most profitable fundamental indicators were ‘Price to Sales Ratio’ and ‘EPS Growth’, or earnings per share growth. In describing the most profitable investment analysis indicators and explaining how they are to be utilized, investors can apply this research to the stock market. Research on the profitability of technical and fundamental indicators was carried out by using previous examinations of market data. Relevant studies were found using databases such as EBSCO and Google Scholar.
First, studies were located for commonly used technical and fundamental indicators. Using the compiled analyses of market data, certain indicators were highlighted due to their more consistent profitability. Last, two indicators were chosen from each category of investment analysis. Two indicators were selected from each category because all four indicators were similar in profitability, therefore none could not be excluded. The final indicators had to first be shown to be more consistently profitable than other forms of analysis in the same category, as well as being more often profitable than not.
In other words, for an indicator to be recognized, it had to actually be profitable, as well as being more profitable than related forms. How do some of the world’s wealthiest make their fortunes? How can the average investor make a profit? The answer to both questions is investment analysis. Investment analysis has long been the key to attaining wealth in the stock market. From day traders on Wall Street to billionaires Warren Buffett and George Soros, every investor in history has utilized investment analysis in one way or another; it is absolutely essential to all investment decisions. It allows investors to make educated, intelligent investments, therefore maximizing profit and limiting risk. Investment analysis, by definition, is analyzing a company and its stock to decide whether or not it is a good investment, one whose price will inevitably rise to bring about profit.
It is divided into two distinct categories, technical and fundamental analysis. While technical and fundamental analysis play different roles in investing, technical analysis is for the short-term while fundamental analysis is for the long-term, they are both invaluable in attempting to predict the trend of stocks. A great deal of research by way of universities and financial institutions has been done on the profitability of investment indicators. While there is not enough uniformity in results to draw definite empirical conclusions, there is certainly some consistency for specific fundamental indicators, but a great deal less for technical indicators; albeit there exists a slight correlation in results. Through reviewing countless studies on decades of stock market data, the technical indicators shown to be most profitable were ‘100-Day Moving Average’ and ‘RSI’, or relative strength index.
The most profitable fundamental indicators were ‘Price to Sales Ratio’ and ‘EPS Growth’. Fundamental analysis is the most commonly used and most consistently profitable category for analyzing investments. Used exclusively for long-term investing, holding a given stock for at least several months but often much longer, fundamental analysis is predicated on assessing the overall health of a business. Fundamental analysis can be undertaken by reviewing a company’s financials, these being income statements, balance sheets, and cash flow. Attached to the aforesaid reports will be fundamental ratios, or indicators that are reviewed by an investor. A company that appears to be a prudent investment typically have a high ‘Return on Assets’, ‘Return on Equity’, and ‘Price to Sales’ ratios (Hester).
These ratios are calculated by comparing a company’s stock’s share price or return in a given period of time to the data seen in the aforementioned reports, such as equity, sales, assets, and earnings, among others. Other fundamental indicators lie in growth. These figures will be based on the growth or decline of the listed ratios. A sound investment will typically feature steady ‘Earnings per Share Growth’ or simply ‘Earnings growth’ over the time increments of the past one and five years. Positive figures of this variety will reflect the success of a company’s management, which plays a significant role in the trend of their company. If an investor is to evaluate the fundamentals of a company, they must compare these statistics to other companies in the same industry and sector.
Each sector will have different standards for what are “good” balance sheet figures, so a company exceeding sector and industry standards for many fundamental indicators is to be strongly considered. Additionally, certain macroeconomic factors must be factored into the purchase of a stock. Is recent government regulation or action bound to benefit a particular industry? Is an industry on the decline, or is it projected to grow? Macroeconomic events and the health of a given sector and industry of a potential stock must be considered in addition to the individual company. While some isolated indicators, which will be detailed later, are somewhat effective in predicting the trend in share price, fundamental analysis strategies such as ‘Growth’ and ‘Value’ investing incorporate multiple indicators to screen for stocks. A growth investor is searching for a stock that has great potential to grow.
Such a stock will typically be overvalued as indicated by a high ‘Price to Earnings’ ratio, in other words the price of the stock is disproportionately high to the company’s earnings. Other indicators that are considered are one and five year future projected earnings growth, as well as consistent earnings growth over the past one and five years. Another common and dichotomously different strategy is that of value investing, searching for undervalued companies that have potential not to grow, but for their share price to better reflect their fundamentals. These companies will typically have low price-to-earnings ratios, as well as low ‘Price to Cash Flow’ ratios (Metghalchi). While fundamental analysis as a whole has proven undoubtedly profitable in long-term investing, isolated indicators alone are less consistent. Many studies on common fundamental indicators have been assessed for this project, and with some consistency and not total consensus, the indicators; ‘Price to Sales Ratio’ and ‘EPS Growth’ are the most consistently profitable when used by themselves, not as part of a strategy combining multiple indicators.
‘Price to Sales Ratio’ is important because it is the best predictor of company growth (Bajkowski). For instance, ‘Price to Sales Ratio’ does not factor in the debt of the company, which could be leveraging sales. While ignoring debt seems illogical, a growing company has the ability to gradually pay off debt. As debt is paid off, the money loaned that was driving sales is replaced by earned capital, allowing for a smooth transition. Of course, due diligence must be done to see if the company is in fact decreasing its debt. This method focuses solely on the sales, which are seen as the most important balance sheet figure in forecasting company growth.
An investor will notice that the company has a low share price considering its sales figures, hoping the share price will later rise to reflect these figures. As opposed to ‘Price to Sales Ratio’, ‘EPS Growth’ takes into account other factors in a company such as its equity and operating margin. EPS represents how well the stock price represents the company’s earnings, so a high figure tells the investor that the company is worth more than its share price shows, forecasting an increase in share price to better reflect the company’s value. ‘EPS Growth’, typically over five years, will show if the company is being increasingly or decreasingly undervalued. A consistently rising EPS over the course of five years shows that the company’s growth and therefore its value are being increasingly undervalued (Metghalchi). An investor will recognize this as the stock being a “bargain”; the share price is extremely low considering the company’s sales and earnings.
With this in mind, the investor hopes the share price will correct itself to better reflect the company, rising to create a profit. Seen as the investor is predicting growth years into the future, ‘EPS Growth’ must be used in long term investing. Fundamental analysis, analyzing a company and its share price, is certainly different from technical analysis. Technical analysis is the other half of investment analysis; less common used than fundamental analysis. Technical analysis is used exclusively for short term trading, which could be anywhere from holding the stock for several months to as short as minutes.
It is not used as much as fundamental analysis, because it is far more complicated, requires a great deal of time, and is less profitable than fundamental analysis. How does one conduct technical analysis? Specialized software is often used to sift through, or screen for stocks that match a certain pattern, although individual stocks can be checked by the trader. These patterns show the increase and decrease of certain stock measures, such as trading volume, the amount the stock is being bought and sold, and share price. The aim of the trader is to capitalize on the beginning of a pattern, for instance a steady fall in volume over several hours than a sharp increase, hoping the trends they witness will soon lead to a sharp increase. Simply put, a trader uses software that shows them certain “events” that are characteristic of the beginning of a pattern.
The trader’s responsibility is to purchase the stock in the pattern’s early stages, before the stock price rises. A common example of a technical indicator is ‘Cup and Handle’, so named for its apparent shape on a graph. This indicator consists of a stock’s trading volume forming a “U” by steadily declining than steadily increasing to return to its original level, than sharply decreasing, forming the “handle”. This pattern in volume represents the first half of the pattern. At this point, the stock screening software will screen for stocks that are following this pattern.
Seen as the supposed next movement is a sharp increase in volume, which drives up share price, the trader will quickly purchase the stock before it enters the sharp rise. Another common example of technical indicators is ‘Moving Average’, or MA followed by the amount of days being observed (MA50, for example), strictly in the short term. Moving average consists of the change in share price between each day being plotted on a graph. When the change in share price consistently increases over a given number of days, a stock is considered to follow the moving average pattern. The second part of a moving average, the period in which the share price is supposed to rise, will differ depending on the length of time being observed.
MA100, looking at the trend in increase and decrease in share price over 100 days, will only differ MA50 in that the latter half of the pattern will reach its peak (The point at which the share price will begin to decrease and should be sold) over a longer period of time. The length of time that the stock is in the latter part of a pattern is proportional to that of the beginning, the amount of days the stock is observed. While many moving averages exist, ‘100 Day Moving Average’ or MA100 has shown to be most consistently profitable. This was observed in testing numerous forms of the moving average on data collected from the S 500. Not only was MA100 more profitable, it was more consistently profitable; most stocks were profitable, and they were more profitable than when using different moving averages (Courter). MA100, in observing the stocks over a fairly long period of time, proved to screen for stocks that were generally less volatile, meaning these stocks did not rapidly rise or fall in share price.
These stocks were generally healthier companies; the rises in share price were shown to be genuine, occurring over and over again. The same positive results for MA100 were shown in analyzing market data from the Greek stock market. MA100 was shown to be more profitable than all other moving averages, as well as other technical indicators tested (Glasure, Metghalchi). Similar to a moving average, RSI can measure how fast a stock is rising. Another profitable short-term technical indicator is ‘Relative Strength Index’, or RSI. RSI measures the speed of the change in share price by day, comparing this to the daily change in volume.
RSI represents the change in share price over a period of days relative to the rate at which it is increasing, essentially finding the momentum of the stock. A stock with a great amount of momentum indicates the speed and force by which the stock price will increase (O’Shaughnessy). In experimenting with many various technical indicators, RSI was shown to be the most accurate in predicting the trend of stocks, specifically when applied to larger companies (O’Shaughnessy). MA100 and RSI, while shown to be the most profitable technical indicators, do not have unanimous support from research. Unlike fundamental analysis indicators, both stated indicators have shown starkly different results in other research (Friesen, Weller, and Dunham). RSI and MA100 are simply the more consistently profitable than other indicators, despite a lack of conclusive evidence of profitability.
In summation, fundamental and technical analysis have proven to be profitable. As evidenced by studies, fundamental analysis as a whole and its individual indicators are far more consistently profitable than technical analysis. With that said, technical analysis has proven extremely successful in studies (Courter), while poorly performing in others (Bessembinder, Hendrik, and Chan). The lack of consistency in data for such an extensively researched topic is quite dumbfounding, although studies of strategies combining multiple indicators of the same category have shown somewhat more consistent profitability. The most influential fundamental indicators; ‘Earnings per Share Growth’ as well as ‘Price to Sales’ should undoubtedly be factored into long-term investment decisions. Conversely, the technical indicators; ‘100-Day Moving Average’ and ‘Relative Strength Index’ should be utilized in short-term trading.
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