Fundamental Analysis is primarily concerned with determining the intrinsic value of a financial asset. It involves studying the factors that may influence intrinsic value such as financial statements, economic conditions, industry trends, and management quality. By evaluating a company's financials, industry position, and economic conditions, analysts can estimate a fair value for a stock, bond, or other investments. Comparing this estimation with current market price can provide insights about potential over or under valuation. Due to the tendency for market prices to diverge from widely accepted views of intrinsic value for long periods of time, fundamental analysis is particularly relevant for long-term investing. The approach taken by Warren Buffett to buy undervalued companies and hold them for long periods of time is the most well-known evidence of the efficacy of fundamental analysis. Over long periods of time it is reasonable to expect a company's valuation to converge with an accurate assessment of intrinsic value. Fundamental analysis employs a causal approach to valuation by determining the factors that will lead to profitability for a given company. Investor demand for profitable companies will eventually converge to the subject company by natural selection or the process of elimination. ## What is Value? A company can be valued intrinsically today, but the future value may be much more or less depending on qualitative factors such as investor sentiment. Value in this sense is subjective and changes over time. Different appetites for risk, different costs of capital, different investing horizons are all investor-dependent inputs to the determination of value. Therefore, the concept of a true intrinsic value for a company differs greatly from the value the market may assign to it at any given time. Value is in the eye of the beholder. Fundamental analysis is a point-in-time analysis of a company and companies change over the course of time. Just like a used car depreciates immediately after you drive it off the dealer lot, fundamental analysis is outdated once it is complete. While it does incorporate some causal analysis it fails to recognize the lack of symmetry in statistical analysis. Fundamental analysts will tell you that a company with a strong balance sheet has a lower probability of default, however all companies with strong balance sheets do not have a low probability of default. For example, a strong balance sheet in a highly cyclical industry will have a higher probability of default. ## Portfolio Construction Tradeoffs The goal of fundamental analysis is to measure intrinsic value and buy companies at a discount to that creating positive expected (+EV) value situations. If we were to assemble a portfolio of companies that we can buy below intrinsic value it would be logical to assume that portfolio would have a +EV. However, this portfolio will likely be less diversified than a broader market index and likely exhibit greater volatility, and a lower sharpe ratio, despite the favorable valuation of the holdings. [[Parrondo's Paradox]] shows us that we can assemble a portfolio of -EV investments that can have better risk-reward characteristics than one with +EV. This undermines the central aim of fundamental analysis and also changes investor utility which can further water down the efficacy of fundamental analysis. ## Long Feedback Loop Intrinsic value changes over time and tends to change much more slowly than market prices. This creates a long feedback loop for the fundamental analyst. It could take years for a company to gain the market share that a fundamental analyst has projected it to take and even if it does the market may not reward the company for that gain with a higher stock price. In this way fundamental analysis struggles to differentiate between a value stock and a value trap. The economy and investor utility, which are key inputs to fundamental analysis, are high-level abstractions that fundamental analysts struggle to model due to the immense complexity in defining and measuring them. The error rate in estimating these is much higher than other estimates of drivers of fundamental value such as revenue and profit growth. This environment presents a unique challenge for a fundamental analyst because it does not present a good environment for [[learning]] and improvement. A fundamental analyst is at risk of running a faulty process for many years before getting the feedback that informs them that their process is broken. ## The Liquidity Bridge These challenges for fundamental analysts originate from a single cause: the desire for liquidity. In a simple world where you can only invest in a company and receive capital and dividend distributions then the profitability of your investment will be determined only by the performance of the company you invested in. However, the minute you seek to buy more or sell your investment you introduce someone else's opinion of value which may differ from your opinion and reality. The desire for liquidity introduces the [[Complexity]] and the [[Uncertainty]] that we see in the financial markets. Without liquidity you would buy companies based solely on their earning power and wait to get paid back in dividends and return of capital. But when you want liquidity you need to get it from someone else and you give up agency to their opinions about your investment. The majority of the financial services industry is built around this and these opinions have a tendency to be far more volatile and uncertain than actual fundamentals. ## Connectivity Parrondo’s Paradox shows us that -EV bets can be combined to create +EV portfolio. In this way a company can be valued at a premium to its intrinsic value based on its connectivity to other businesses. For example, Amazon was able to buy Whole Foods for more than the premium grocery business was worth based on fundamental analysis because of Amazon’s ability to integrate the real estate into their same-day delivery business. The endless possibilities and accretive connections available rely on foresight and execution, two things that fundamental analysis and all analysis for that matter struggles to measure. This leads to the false dichotomy between growth and value that is so embedded in modern day financial theory. ## Time The common element that we have run into throughout this exploration of fundamental analysis is the challenge of time. The desire for liquidity is inherently an issue of timing. The ability to connect poorly performing business to create a growing business relies on the time to execute the plan, and finally the distinction between a value stock and a value trap reveals itself over time. Most financial advisors acknowledge this by encouraging their clients to be long-term investors like Warren Buffett but the reality is our nature makes this very difficult. In my opinion fundamental analysis is a philosophical exercise as its focused on the abstract concept of value. Even in our simple case of zero-liquidity investors may care more about investing in a company that does not make money, but makes the world a better place. At the most basic level of fundamental analysis, the concept of money is philosophical in nature. ## Wrapping Up Fundamental analysis is often relied on as the long-term foundation for a sound investment strategy and this is not wrong. It is contrasted against [[Technical Analysis]] which is far more short-term in its focus. Some combine the two disciplines in constructing their portfolios which is also a good strategy. The idea that market prices fluctuate around fundamental value which changes over time is a central part of my own [[CHG Macro Model|investment approach]] but as we have seen the concept of value is abstract at best. While we have shown that pure fundamental analysis in a zero-liquidity world provides a good baseline to understand how our desire for liquidity and investor utility impacts market pricing, even in that special case fundamental value is subject to consumer preferences and utility which are highly irregular. In the markets and the economy it is hard to escape the irregularity of human nature and the complexity it imposes on us. Explore Further: [[Growth-Inflation Tradeoff]] | [DCF as a lower bound](https://medium.com/@moontower/dcf-as-a-lower-bound-196d30437564) | [[Ergodicity]] Tags: #Disciplines Your support for Cedars Hill Group is greatly appreciated <form action="https://www.paypal.com/donate" method="post" target="_top"> <input type="hidden" name="hosted_button_id" value="74PGN8ZXHQVHS" /> <input type="image" src="https://www.paypalobjects.com/en_US/i/btn/btn_donate_LG.gif" border="0" name="submit" title="PayPal - The safer, easier way to pay online!" alt="Donate with PayPal button" /> <img alt="" border="0" src="https://www.paypal.com/en_US/i/scr/pixel.gif" width="1" height="1" /> </form>