There are many paths for stock selection when building a share portfolio. Some decisions are driven by sentiment, others by herd mentality or a ‘tip’ from a friend or family member. However, there are paths that apply more rigour to stock selection.

For those looking for a more data driven approach you may like to consider technical (momentum) analysis and fundamental analysis. The former focuses on price movements and market trends, while the latter looks at the financial health and performance of a company.

Both methods can be utilised to build out a holistic understanding of potential stocks for investment. In this article we will break down the processes of these strategies, so you have the information you need to plan your portfolio strategy.

Fundamental Analysis

This involves evaluating the intrinsic worth of a company by examining its financial statements, management team, industry position, and overall economic outlook. Financial ratios play a crucial role in this analysis as they provide insights into a company’s financial health, past performance, and industry outlooks.

Initial evaluation and research of a company should include its background and an understanding of the business model, as well as the industry it operates within, the financial position and level of stability, and any growth potential on the horizon.

There are a number of analysis tools that can be utilised to better understand the valuation the market is placing on a company you are interested in, and its potential earnings and growth outlook. These include:

• Price-to-Earnings (P/E) Ratio: This is a common data point for investors to consider when evaluating a company’s valuation, as it indicates how much investors are willing to pay for each dollar of a company’s earnings. A high P/E ratio may suggest an overvalued stock, while a low P/E ratio may indicate an undervalued stock.
• Earnings Per Share (EPS): EPS measures a company’s profitability by calculating total earnings divided by the number of shares on issue. A company with consistent and growing EPS is generally considered more attractive to investors.
• Price-Earnings Growth (PEG) Ratio: The PEG ratio combines the P/E ratio with earnings growth to provide a more comprehensive assessment of a company’s valuation. By considering the growth potential of a company alongside its current valuation, investors can make more informed decisions.
• Debt-to-Equity Ratio: The debt-to-equity ratio helps investors assess the company’s leverage and ability to meet its financial obligations. A high debt-to-equity ratio may indicate increased financial risk, which can impact the value of the company’s shares.
• Return on Equity (ROE): ROE measures a company’s profitability relative to shareholders’ equity and is a key indicator of management efficiency and company performance. A consistently high ROE can signal a well-managed company with strong growth potential.

Technical Analysis

While fundamental analysis considers the company’s underlying performance and financial metrics, technical analysis involves studying historical price charts and trading volumes to predict future price movements.

Key tools used in technical analysis include moving averages, support and resistance levels, and various technical indicators. By analysing these patterns and trends, investors can make decisions based on market sentiment and momentum. Investors and traders will typically study the following three key aspects to historical price movements:

1) Price Trends examine price movements using charts and technical indicators like moving averages, support and resistance levels, and trend lines to identify patterns and trends in stock prices.

2) Volume Analysis evaluates trading volumes to gauge the strength of price movements, as high volume often confirms price trends while low volume may signal a lack of conviction or a possible reversal, and

3) Momentum Indicators such as Relative Strength Index (RSI), MACD (Moving Average Convergence Divergence), or Stochastic Oscillator to identify overbought or oversold conditions and potential trend reversals.

Relying solely on technical analysis may not always provide a complete picture of a stock’s value and can lead to poor investment decisions. A potential drawback of relying on technical analysis is that the historical price movements and patterns may not accurately reflect the current market conditions or economic events. The analysis can also overlook fundamental factors such as a company’s financial health, management quality, competitive positioning, and industry trends. Investors should also be aware that when using a number of alternative technical indicators in conjunction with each other that they can often generate conflicting patterns, leading to inconsistent predictions.

Combining Fundamental and Technical Analysis

When combining technical and fundamental analysis to select the right shares to invest in, investors should look for alignment between fundamental factors, inclusive of strong financial performance and growth prospects, with technical signals such as bullish chart patterns or positive momentum indicators to strengthen the investment thesis. In addition, alternative data points and analysis that should be considered include:

• Considering qualitative factors such as company leadership, market positioning, brand reputation, and competitive advantages can provide insights into a stock’s long-term prospects.
• Understanding broader industry trends, market dynamics, regulatory environment, and macroeconomic factors that can help contextualise company analysis, and
• Monitoring market sentiment, investor behaviour, social media trends, and news sentiment. This can offer additional data points to gauge market psychology and potential shifts in sentiment that may impact stock prices.

A well thought out framework for considering investing in a particular stock should incorporate a balanced analysis of fundamental factors like company performance and growth prospects, along with technical indicators and momentum analysis to enhance decision-making. By blending these approaches and carefully evaluating key financial ratios and industry dynamics, investors can make well-informed decisions and build a diversified portfolio to achieve their investment goals.

Important Information

The information contained in this article is gathered from multiple sources believed to be reliable as at April 2024 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. NAB does not guarantee the accuracy or reliability of any information in this article which is stated or provided by a third party. Before acting on this information, NAB recommends that you consider whether it is appropriate for your circumstances. NAB recommends that you seek independent legal, property, financial and taxation advice before acting on any information in this article. ©2024 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686.