There is a long-standing debate in the world of finance as to what works and what does not. It is usually between participants who believe only fundamental analysis works and those who believe that only technical analysis works. Well, in my opinion, whatever makes money, works. It is unwise to be very rigid about the methods that one employs for trading and investment. Evolution requires flexibility and the willingness to accept new methodologies. Trading and investment produce significant results when components of both, fundamental and technical analysis are used to create an approach towards the markets and strategies.

In my previous newsletters, we have only discussed about the technical aspects of my approach towards the markets. In today’s newsletters, we will explore the fundamental side. We will discuss how the metrics of sales, earnings and margins help us in selecting stocks that could have the potential to produce amazing returns.

Why Fundamentals are important for trading

We must first understand the concept of Intrinsic value. Intrinsic value refers to the true price of a stock. It is the price that truly reflects the fundamental factors of a stock. The stock price is not just numbers without any reason. Fundamental factors include the assets, the liabilities, the earnings, the ability to generate cashflow, and the items that directly or indirectly affect these factors.

Different market participants look at these fundamentals and try to ascertain their own intrinsic value of the company and buy or sell accordingly. The price quoted in the stock market is a result of the transactions done by the market participants.

When trading a particular stock, we want it to be a super performer. That is, we want that stock to be a better performer than others. For this to be true, the stock needs to be an excellent business. Excellent business can be defined as the company which has growth in its fundamentals, especially its earning potential.

These super performing show their strength through growth in sales, net profit and margins. These companies show growth in their quarterly results which are better than what the stock market expects.

Reasons to look at sales, earnings, and margins

As I mentioned earlier, sales, profit and margins growth are important fundamentals to look at. Let us understand why these are important fundamentals to track and what the growth of each of these factors means.

Sales reflects the ability of the company to sell its product or service at a particular price. When there is more sales, more money is coming into the business. Increase in sales can be in 2 ways: Selling more quantity or increasing the price of the product or service. When the company sells more quantity, it must be desired that this is a result of increased customer base. When the increase in sales is as a result of increase in price, it is desired that the company has pricing power. These two cases of improved sales shows that the growth is sustainable and high-quality.

Producing the product or service costs money. This cost is called cost of goods sold. This expense is deducted from the sales. This results in the operating profit. Dividing this operating profit with sales results in Operating profit margin (OPM). This is the profit margin on the sales. The percentage of sales that was profitable. When OPM is improving and is seeing growth, it means that the cost of producing the goods or services is reducing. Costs can be reduced through 2 ways: Cutting costs and Improving productivity. Cutting costs means to be able to reduce the cost of the raw materials used to produce the cost. Improving productivity refers to the producing a greater number of goods at the same cost.

Net profit is the bottom line. This item shows the overall profitability of a company after deducting the depreciation, non-recurring item, the interest to the lenders, and the tax to the government. This is the final earnings of a company. It is desired that improving net profit is consistent over the previous years and quarters. It should also be kept in mind that improved net profit should not be as a result of non-recurring items. Non-recurring items once in a while is okay but if they are a consistent part of the fundamentals, then it is a worry.

How to trade using these fundamental metrics?

A major use of these fundamental metrics in my approach to trading is in stock selection. I am always on the lookout for stocks whose fundamentals are improving. Then I check whether these improving fundamentals are reflected in the price. This is checked on the charts. We must remember that technical price charts are the effect rather than cause. That is, technical charts show the effect of improving fundamentals and not the other way around.

Here is a small exercise that a trader can do: Go to Radar website (by Definedge securities) and run search for “TNT - Improved Financials”. Go to the charts of the companies and observe how the price reacted when the metrics discussed above were improving.

This discussion on fundamentals is only a bigger picture. Different strategies require to look at different fundamental metrics. This discussion was an introduction to something that I have been planning as a part of TNT one for the exclusive members. Stay tuned and check out TNT one.😉😉