Learn how basic fundamental analysis can improve your trading and transform your profits (with step-by-step instructions)…
Are you a trader using technical analysis?
Do you want some easy-to-follow tips to help you get started improving your stock trading results?
Well, you’ve come to the right place!
In this detailed article I’m going to show you a few easy techniques you can use right now to improve your technical trading strategies by adding a little fundamental analysis.
And don’t worry…
I’m going to keep this VERY simple. So even if you don’t know the difference between a balance sheet and an income statement, I’ve got you covered.
But first, let me share one little caveat – because this isn’t a silver bullet that works every time. You gotta be realistic. Thus…
Here Is When You Should Ignore Fundamental Analysis:
If you’re like most of my website visitors, you’re always looking to improve your edge in the markets.
And the thing is, most of the time, fundamental analysis CAN help.
When it comes down to it, a lot of traders completely ignore fundamental analysis. And I get it.
Fundamental analysis is not nearly as actionable as technical analysis.
So that’s why I still use technical-based criteria to plan my specific buy and sell levels before I ever trade a stock or make an investment.
You see this all the time in my weekly trend following stock picks. Here’s an example:
Even though this stock pick is fundamentally vetted, you can see I’m using a hard stop-loss based on a technical input (in this case, average true range).
So for planning your entries and exits, I encourage you to continue using a technical trading method. I’ve even written detailed guides on when traders should sell stocks.
On the other hand…
I’ve also been able to improve my trading performance by eliminating the worst fundamental stocks from my trading universe. Now as you might have guessed, this has made a BIG difference to my bottom line.
And I strongly believe this approach can help you too.
Adding some basic fundamental analysis to my trading methods has really helped me avoid buying the biggest losing stock picks. And let me tell you, this alone is worth the price of admission.
But before I show you the exact steps to follow to improve your trading results with fundamental analysis, I want you to see a new way to think about this bottom-up approach to investing.
How Technical Traders Can Easily Understand Fundamental Analysis:
Most new traders start with technical analysis. And if you ask me, the reason why is pretty obvious.
It’s because we are primarily visual people, and technical trading off charts is therefore highly intuitive.
Makes sense, right?
And actually, our brains are primed for pattern recognition. BigThink.com actually claims this skill gave us humans our evolutionary edge. They even call the brain the worlds best pattern recognition machine. Needless to say, most of us take to technical analysis like a duck to water.
Technical trading is easy to use no matter what your time frame. I’ve met intraday scalpers and long-term position traders who use very similar trading rules (just adjusted for their time frames).
On the other hand…
Fundamental analysis is pretty laborious. It requires hours of reading, in-depth analytical models, and you can never really be sure over what time period your investment thesis will play out.
To make matters worse…
Fundamental analysis is fuzzy about risk management, which can leave a lot of investors exposed to over-size losses.
In short: for traders trying to conquer the equity markets as fast as possible, in-depth fundamental analysis isn’t that practical or effective.
So why should you consider it?
Well, in my personal experience trading stocks the last eight years, I have found that fundamental analysis can help in one very important way.
“Fundamental analysis can help you create a better universe of stocks to trade in.”
Do you see what I mean?
As a technical trader, you can think about it like this:
Instead of analyzing companies one at a time, you can use fundamental-based screens to help you avoid some of the riskiest stocks… all with a few clicks of a button!
And remember, by eliminating the worst stocks from your pool of potential trade ideas, you will have a much better chance of success.
Do you see how this could help tip the odds in your favour?
There’s even academic research to support the idea.
For example, the Fama-French Three-Factor Model is a well-known academic theory that supposes (amongst other things) traditional value stocks, as measured with low price/book ratio, tended to outperform.
But in my personal experience, it also makes practical sense….
By avoiding buying the worst fundamental companies – even just for a swing trade – you reduce the risk of waking up to an implosion in one of your portfolio positions.
Let me ask you…
Have you you ever woke up to see one of your stocks downgraded by an investment bank analyst? Or announcing an unexpected secondary issuing?
Well, then you know what I’m talking about!
And once again, I’m not saying this approach is perfect. You WILL still have losing trades.
A little fundamental foresight will help you avoid the most expensive trading errors.
And by the way, I’m going to share long-only examples in this blog post (because that’s how I trade).
But the same concepts could definitely be applied to the short side: just do the opposite!
Now, that said, you still might be wondering…
What Type of Traders Can Benefit from Fundamentals?
Well, let me answer your question with another question: What kind of technical trader are you?
Because when it comes down to it…
Most traders are either trading a mean reversion or trend following system.
And here’s what you need to know:
Trend following is all about going with the momentum, while mean reverting traders hunt for reversals and turning points in hopes of a quick scalp. Make sense?
Great. Because the best part is, it doesn’t matter what kind of technical trader you are! Fundamental analysis can help you either way.
So with this backdrop in mind, let me show you exactly how to put this idea into action.
Basic Examples of Fundamental-Analysis-Driven Stock Screens:
For most traders, the best way to use fundamental analysis is as a tool to eliminate poor-performing companies that could be hiding a big risk. As I said before…
It’s all about creating a universe of high quality stock picks, and then trading the companies in that pool.
So what are the steps you can follow to do this yourself?
It’s actually pretty simple.
And for longtime readers of IntelligentTrendFollower.com, you might remember I’ve written before about how to use FinViz to find trade ideas. This is just going a step further.
So here are some specific ideas:
- Remove companies with too much debt. While a little operating leverage never hurt anyone, too much debt is a massive burden to shareholder returns. It’s simply impossible to expect that companies with more debt than equity are likely to earn outsized returns for shareholders over the short to intermediate term. Personally, I like to avoid trading companies that have a debt/equity ratio over 1 (or 2 if you’re feeling more aggressive).
- Positive return on equity is a good indication that the company in question is making money. On the other hand, negative ROE companies could be at risk of having their business model attacked by competition, regulation or both. Avoid companies with an ROE below 10%.
- Growing earnings are key to a higher share price. If you buy companies with expected earnings growth, you’re more likely to see a higher share price over the next couple of quarters. On the other hand, if you’re buying companies into the teeth of an earnings decline, sustainable profits will be harder to come by because rallies are more likely to be faded. Make sense?
Of course, this is by no means an exhaustive list. But it should help you start thinking about the value of fundamentals.
Put another way:
Do you think you’d be more confident buying the dip (or breakout) on your next trade if you knew the company had no debt, a history of positive returns and growing earnings?
“Can you see how only buying this kind of stock could help your performance?”
All I can tell you is that for me, this smarter approach to trading has made a big difference.
I also promised you that I’d make this easy. So…
You can bookmark it yourself, and then just add whatever technical indicators you personally prefer to help you find higher-value trade ideas.
Do you see how it works?
Great. And now that you understand this basic concept of augmenting trading results by eliminating fundamentally bad companies, you can go a step further.
It’s time to let your imagination run wild…
How to Find Your Own Trading Ideas Using Fundamentals:
In the example above, I talked about some of the most popular fundamental data for sorting and ranking companies. I even gave you a stock screen to do this automatically.
But this is just the tip of the iceberg…
There really is NO limit to how you can overlay a few fundamental criteria to help weed-out the worst stocks from your trading universe.
So here are a few more of my favourite ideas that can help you start thinking in the right direction…
- Price to book value: by looking for stocks with low price to book ratios you can focus on some of the cheapest stocks in the market (which in some cases may even be takeover targets). You can also avoid overpaying for expensive stocks that might be liable to collapse back down to earth should they have an earnings miss. Try playing around with a price-to-book value below 1 or 2.
- Cash flow positive: this is another metric that’s easy to screen for. And eliminating companies with negative operating cash flow can help you avoid some really expensive mistakes. That’s because positive cash flow companies are able to finance their growth with the profits from their operations. On the other hand, if a company is bleeding cash on a regular basis, they are more likely to raise debt or issue more shares to fund the activities of the business. This kind of surprise announcement can really derail even the best laid trading plans. That’s why I personally prefer to focus on companies with positive cash flow.
- Market capitalization: the stock market has thousands of companies of all different sizes. Depending on your preference, you may want to narrow your universe to omit stocks that are too small. Often these microcap stocks lack liquidity and volume, making them difficult to trade. On the other hand, if you’re a growth or momentum trader you might want to screen out the slower-moving mega-cap stocks. Do you see how finding the right size companies could be of help?
Now let me ask you: Are you starting to get a feel for how fundamental criteria can help your technical trading?
I sure hope so.
By simply peppering in some fundamental factors to your technical trading screens, you can eliminate the noise and better focus on the stocks and trading signals that are the best fit for you.
And by the way, if you’re totally unfamiliar with stock screening, I encourage you to check out my primer on stock screening with FinViz.
FinViz is truly a wonderful free financial website, and my post above shares some pre-built screens with both fundamental and technical criteria to help you find the best stock picks and trade ideas. I really love that you can see the results as charts.
Now before we wrap this up, I just want to manage your expectations.
Although fundamental analysis is helpful, there are still some things it simply cannot do for you.
So let me give you one last word of warning…
Constraints of Fundamental Analysis Traders Need To Know:
As you probably guessed by now, I’m a big fan of fundamental analysis. I encourage you to try experimenting with adding fundamental metrics to your stock screen.
But remember, no stock trading or investing system is ever going to be perfect.
And in the case of fundamental analysis…
- Fundamental analysis will not eliminate all bad stock picks. It’s a step in the right direction, but some crap companies are likely to sneak through. That’s why I recommend using these techniques in conjunction with an objective technical trading method.
- Fundamental analysis will not predict the future. The reality is, anything can happen in markets and nobody knows what tomorrow holds. Anyone who says they know what will happen is lying to you. Period.
- Don’t overdo it with fundamental analysis. I recommend picking a few specific criteria based on your personal preferences and then start experimenting in the market. If you add too many fundamental criteria you will eliminate ALL stocks and you won’t have anything left to trade. So there’s no need to go overboard, just overlay a few fundamental filters, like the ones I mentioned above.
- Do what works for you! It’s always dangerous when someone tries to prescribe a trading system. Your experience is different from mine, so use a critical eye when deciding how to incorporate these ideas into your own trading. You know yourself best, so keep your tendencies and preferences in mind when adding fundamentals to you technical trading strategy. Make sense?
The bottom line is this:
- Fundamental analysis can be a great tool to help traders find better opportunities in the stock market.
- It’s not perfect, but it’s easy to get started with pre-built FinViz screens you can modify to suit your style.
- Use this information in coordination with what you’re already doing. There’s no need to reinvent the wheel here. And on the flip side a steady incremental improvement can really help results over the long term.
So there you have it! By now I hope you can see how fundamental analysis can be both valuable to you as a trader and easy to use (no balance sheets required!)
Before I let you go, I just want to remind you that I also offer a free 2-week email course about how to combine fundamental and technical analysis to make smarter stock decisions. You may want to take a closer look if you found this article interesting.