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Macro, Technical, and Fundamentals: 3 Layers of Stock Valuation

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

The Big Picture

Benjamin Graham, Warren Buffett's mentor and the veritable godfather of value investing, had a very succinct way of putting things in his seminal Intelligent Investor. Graham's intent is manifestly clear in his most famous quote, on whether the market should be perceived as a voting machine or weighing machine: markets are often cray cray over short durations. It's also self-evident if one studies the long history of stock performance, that "short" can be really subjective, and it can vary over time. It is because of what I'm going to call extended "short" durations that can pervade and persist that we need to consider more than just pure fundamental analysis (of the underlying business), but also need to look to two additional indicators of a stock's potential future performance: the macro picture and technicals.

Ben Graham, the Godfather of Value Investing

Ben Graham, the Godfather of Value Investing

Layer 1: Fundamentals

It certainly makes sense to start with the fundamental picture of how a company's business operates. While this involves a lot of qualitative analysis—understanding whether a management team is shareholder-oriented, how they're making their money, and so on—there's a certain comforting simplicity in an old-fashioned discounted cash flow analysis, with the end result being a number.

This number indicates whether the stock is a buy or not based on price alone, and you can quickly screen through several stocks by doing a cursory valuation in order to eliminate lemons. Keep in mind that the more conservative you are in your valuation, the more likely your stock is to perform well over time (the "weighing machine" component Graham spoke of), so eliminating the majority of stocks you screen quickly can help you whittle down your stock universe to a much more manageable level. Follow a good checklist to make sure you're asking all the right questions during this process.

Layer 2: Macro

If your valuation is pointing toward a positive picture for the future of the business, that's a great start, but it's certainly far from the last thing to consider before buying a stock. One important factor is the bigger picture as to how the stock fits into the world at large, and this is where some careful consideration comes into play. Answer some important big-picture questions during this phase of your search:

  • Will this industry be around in ten years? If not, will the business be able to pivot to an equally profitable business model? Think about energy (oil stocks in particular) and healthcare, and ask what might be different in the future due to political unpopularity or other massive sea changes in the macroeconomic landscape.
  • Are interest rates going to be higher or lower in a few years, and how will this affect the business? Remember: interest rates are like gravity for stocks; as they go up, stock prices tend to go down, especially for companies with a lot of debt.
  • Is there geopolitical risk? Could the government where the company is headquartered pull the plug on the company, or make it difficult for you, as the investor, to get your money out? Will this matter?
  • Is the country likely to go into a recession? How will this affect your stock?

Consider all of these questions and more as you think through external factors (outside of how the business is run) that might affect the stock you're interested in.

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Layer 3: Technicals

Even if you have a very good company in a great industry, there's still one more layer to consider that can really throw you a curve ball. Technical reasons for a stock to underperform, even over a long time horizon like ten years, need to be taken into account. Lest you think that I'm referring to voodoo and looking at charts for candlesticks and hammers, let me reassure you by pointing out the type of thing that can influence stock price:

  • Supply and demand, at their core, dictate stock price. While fundamentals often drive demand, they aren't always the only thing to do this. Some industries are cyclical, meaning they have their own supply and demand issues to work through as commodity prices fluctuate: companies produce tons and tons of oil, which drives the price of oil down, which makes oil companies less valuable over time; eventually the pattern reverses as companies cut back on new exploration and capital expenditures, which produces a lot less oil, which drives the price of oil up, which makes oil companies more valuable over time.
  • On the opportunistic side, a technical event like a short squeeze can give you a fantastic short term chance to take profits off the table. The ultimate supply/demand technical happened in early 2021 when Gamestop went to the moon. A short squeeze can be a great catalyst to unlock value quickly.
  • Reading charts does have some merit, but only a very small handful of people can get value from doing their own technical analysis. Ask yourself if you're one of the few people who can do long-term value investing and one of the few who can do technical analysis, and study your own abilities with a most skeptical eye.

Macro, Technical, and Fundamentals

Stock valuation is tantalizingly challenging for me. The mathematician in me is pleased by the cold, calculating DCF method, while my inner detective enjoys following more qualitative leads about the business itself. Things get really interesting, though, when the other dimensions of valuation are brought into the equation. Studying the macro and technical pictures can provide a great deal more context and color to your analysis, hopefully helping you avoid a potential money-losing pitfall. Using this combination of approaches in order to invest in higher quality opportunities over time has resulted in pleasant results: improving my total return, giving me a more satisfying research process, and avoiding a lot of inadvertent hair-pulling and teeth-gnashing. Give it a try and you can help to ensure you have greater success in the future. Happy investing!

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2021 Andrew Smith

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