Investment Analysis

CHAPTER 13: Fundamental and

Technical Analysis

CSI Global Education Inc.

Chapter Highlights
• We now start to pull together what we learned in Volume 1 and
look at the ‘bigger’ picture.
• The focus of Chapter 13 is fundamental and technical analysis of
the economy and industry.
• The focus of Chapter 14 is company analysis and the use of
financial ratios.
• The objective: utilizing the tools of investment analysis for better
security selection decisions.

CSI Global Education Inc. 2

Types of Analysis
Fundamental Analysis
• Assesses the short-, medium-, and long-range prospects of
different industries and companies.
• Looks at everything and anything to best determine how
securities’ prices will change.

Technical Analysis
• Focuses on the stock market itself.
• Uses charts and patterns of past stock price behaviour to predict
future price movements.

CSI Global Education Inc. 3

Capital Market Theories
Random Walk Theory
• New information is disseminated randomly over time.
• Price changes are random; bear no relation to past price changes.

What are the implications for investors?

CSI Global Education Inc. 4

Capital Market Theories
Implications:
Technical analysis is not useful.

However:
If the market is less than perfect, the absorption of new information
may be gradual, thus producing gradual shifts in demand and
supply patterns, which can be recognized using technical analysis.

CSI Global Education Inc. 5

Capital Market Theories
Rational Expectations Hypothesis
Based on the assumption that people are rational and make
intelligent economic decisions after weighing all available
information.

1. Given two securities of equal risk, a rational investor will always

choose the one with the highest return.
2. Given two securities with the same rate of return, the investor
always chooses the one with the lower amount of risk.

CSI Global Education Inc. 6

Capital Market Theories
Implications:
• If investors act in a rational manner then current prices are
correctly priced.
• This being the case then a small investor can do just as well as a
large investor.

Counter Arguments:
• Investors are not always totally rational in their choices or
expectations.
• Psychological factors (such as fear and greed) may drive the
market or individual stock prices.

CSI Global Education Inc. 7

Capital Market Theories
Efficient Market Hypothesis
• The market price of a security fully reflects all available
information and therefore it is difficult, if not impossible, to
consistently outperform the market.
• It also assumes that a stock’s price cannot remain in
disequilibrium or be improperly priced for very long.

CSI Global Education Inc. 8

Capital Market Theories
Implications
1. If markets are efficient then an investor should spend less
time analyzing stocks and more time on reducing taxes and
transaction costs.
2. The only way to increase returns is to invest in a portfolio
of higher-risk securities.
3. If the market is efficient, one cannot use fundamental
analysis to determine if a stock is undervalued or
overvalued.
However:
Not all investors receive new information at the same time,
nor process it at the same rate, nor interpret the data in the
same light.

CSI Global Education Inc. 9

Which Theory is Correct?
• It is generally believed that the market is not 100% efficient.
• Given that new information is not always received and processed
at the same time and that psychological motives may influence
some stock or market prices – technical analysis has its place.
• While past performance is not indicative of future performance
because of random events, over time stronger companies usually
perform better than weaker companies. Hence, there is a need for
fundamental analysis of industries and companies.
• Interest rates, and economic variables do influence individual and
industry stock prices. So fundamental macroeconomic analysis
and the understanding of the underlying factors is required.

CSI Global Education Inc. 10

Fundamental Macroeconomic Analysis
Fiscal Policy Impact
• Taxation
– Impact of changes to taxes
– Time lags
• Government Spending
– Impact on aggregate spending
• Government Debt
– Impact on fiscal and monetary policy options

CSI Global Education Inc. 11

Fundamental Macroeconomic Analysis
Monetary Policy Impact
• Interest Rates
• The Bond Market
• The Yield Curve
• Flow of Funds
• Inflation

CSI Global Education Inc. 12

Company/Industry Life Cycle
• Emerging Growth Industry
• Growth Industry
• Mature Industry
• Declining

What are the features/characteristics of each?

CSI Global Education Inc. 13

Company/Industry Life Cycle
Emerging Growth Industries
• negative cash flows
• privately owned or controlled
• high risk of business failure

Growth Industries
• high growth in sales and earnings
• competition increasing
• most financing is from retained earnings

CSI Global Education Inc. 14

Company/Industry Life Cycle (cont’d)
Mature Industries
• slower growth with intense competition
• profit margins decline, but earnings remain positive
• revenues sustained by customer loyalty

Declining Industries
• competition from new products or technology
• growth is minimal
• cash flows are initially good as little is spent on expanding plant
and equipment but are expected to decline over time

CSI Global Education Inc. 15

Industries can also be classified as:
• Cyclical
• Defensive
• Speculative

CSI Global Education Inc. 16

Cyclical
Show sensitivity to the global economy, changes in commodity
Prices and changes in the value of the Canadian Dollar

• Commodities (mining, forestry)

• Industries (transportation, building)
• Consumer Products (auto)

CSI Global Education Inc. 17

Defensive

• Can be characterized by stable earnings, growth and dividends

• Relative immunity to poor economic conditions
• Includes blue- chip stocks and income stocks

CSI Global Education Inc. 18

Speculative

• Industries or shares in which the investment risk is high

• Includes emerging industries with rapid growth and
• company shares in which investors speculate on the future price
• Eventually a shake out consolidate the industry as leaders
emerge

CSI Global Education Inc. 19

Porter’s 5 Forces

https://www.mindtools.com/pages/article/newTMC_08.htm
CSI Global Education Inc. 20
“In business, I look for economic castles
protected by unbreachable moats.”
– Warren Buffet

http://www.kinesisinc.com/deep-moat-strategy/

CSI Global Education Inc. 21

Building a Competitive Advantage
“A deep business moat is all about the unique
way in which your company provides products
or services. It’s the intangible elements of your
approach that differentiate your brand – things
like your culture, processes, customer service,
leadership structure, values, mission, vision,
[talent] and strategy. When you weave all of
these together, you create a moat around your
castle that’s unbreachable.”
http://www.kinesisinc.com/deep-moat-strategy/

CSI Global Education Inc. 22

Building a Competitive Advantage
“Your moat makes it harder for the barbarians
(i.e. your competition) to get into your castle to
steal your customers. It also creates a unique
differentiation that makes it harder for your
customers to walk away”

http://www.kinesisinc.com/deep-moat-strategy/

CSI Global Education Inc. 23

Dividend Discount Model (DDM)
Div 1
Price 
 r  g
Where:
Price = the current intrinsic value of the stock in question
Div1 = the expected dividend paid out by the company
in one year
r = the market capitalization rate or market consensus
value for the required rate of return on
investments
g = the assumed constant growth rate for dividends

CSI Global Education Inc. 24

DDM Exercise
MAO Co. currently trades at $50 a share with an expected
dividend of $2.50. The company is expected to grow at a
conservative rate of 4% per annum into the future. Recognizing the
safety in this type of investment, investors should require an 8%
annual rate of return.

What decision would you make on this stock?

• Buy
• Short
• Write a call

CSI Global Education Inc. 25

DDM Exercise
Div1
Price 
 r – g
$2.50

 .08  .04 
 $62.50

Decision:
• Intrinsic value is greater than current market price.
• Stock is undervalued.
• Buy the stock.

CSI Global Education Inc. 26

Key Variables that Affect Price
• If Div1 increases/decreases?
• If r increases/decreases?
• If g increases/decreases?

CSI Global Education Inc. 27

Key Variables that Affect Price (continued)
Div1
Price =
(r – g)
Base Case
If Div1 was $1, r = 10% and g = 5%

……..the intrinsic value is $20.

Changing the Variables

• The company announces a decrease in dividends from the
expected $1 to $0.50.
P = $0.50/(.10 - .05) = $10
CSI Global Education Inc. 28
Key Variables that Affect Price (continued)
• The company takes on some projects that shareholders
perceive as risky. “r” increases by 1% to compensate
investors for the perceived increase in risk.
P = $1/(.11 – .05) = $16.67

• A company analyst projects that the growth in earnings and

dividends will increase from 5% to 6%.
P = $1/(.10 – .06) = $25.00

CSI Global Education Inc. 29

Key Variables that Affect Price (continued)
Variable
Decrease in expected Decrease share price
dividend
Announcement of an
increase in expected Increase share price
dividend
Increase in perceived risk
of a security Decrease share price

Increase in dividend
Increase share price
growth
CSI Global Education Inc. 30
Key Variables that Affect Price (cont’d)
Conclusion
• A decrease in the expected dividend will decrease the market
share price.
• However, an announcement of an increase in the expected
dividend will increase the market price of the share.
• An increase in the perceived risk of a security will mean a
decrease in share price (and vice versa).
• An increase in dividend growth will mean an increase in share
prices (and vice versa).

CSI Global Education Inc. 31

P/E ratio
- Is a relative valuation metric
- The higher the multiple, the more “expensive” the stock

CSI Global Education Inc. 32

Technical Analysis
Assumptions
• Market value is determined solely by the interaction of supply
and demand.
• Supply and demand are governed by numerous factors, both
rational and irrational.
• Disregarding minor fluctuations in the market, stock prices tend
to move in trends which persist for an appreciable length of time.

CSI Global Education Inc. 33

Technical Analysis of the Market
• Uses past data to predict the future – the future repeats the past.
• Looks for recurring patterns – prices move in trends.
• Based on the premise that the market is its own best forecaster.
• Looks at stock market index or average and the volume of
shares traded.

CSI Global Education Inc. 34

The Bar Chart
• This is the most commonly used price chart.
• Each periods action is represented with a vertical bar showing
the open, high, low, close (OHLC)
• A short horizontal line to the left of the bar represents the open
• A short horizontal line to the right of the bar represents the close

CSI Global Education Inc. 35

The Bar Chart

CSI Global Education Inc. 36

The Line Chart
• Only closing prices are shown
• A line connects close to close movements
• It does not indicate what happened during the day
• For a trader, it is important to know the highs and lows for the day

CSI Global Education Inc. 37

The Line Chart

CSI Global Education Inc. 38

Price Patterns
• Analysts use price patterns to indicate reversals and
continuations of trends.
• Support and resistance levels are very useful.
• Support Level:

CSI Global Education Inc. 39

Support and Resistance Levels

CSI Global Education Inc. 40

Reversal Patterns
Head & Shoulders

Bottom Head & Shoulders – buy signal when price breaks up

through neckline

CSI Global Education Inc. 41

Head and Shoulders

CSI Global Education Inc. 42

Continuation Patterns
Continuations are pauses in price charts, typically sideways
movements.
E.g. Symmetrical Triangle:

CSI Global Education Inc. 43

 Ascending Triangle

CSI Global Education Inc. 44

Moving Averages
• Quantitative Analysis is statistical analysis enhanced by
computer
technology.
• A moving average is calculated by adding a stock or index’s
closing prices over a period of time
• The moving average is then compared to the market
• When the price moves above the moving average it can be
interpreted as a signal to buy
• When the price moves below the moving average, it can be
interpreted as a signal to sell

CSI Global Education Inc. 45

Moving Averages
• Help to identify trends and whether the market is
over-bought or over-sold
• Identifies strength and weakness in the trend

CSI Global Education Inc. 46

Simple Moving Average
• Simple MA = the sum of closing prices divided by the number of days
• p1 + p2 + p3+ p4+p5
N
• Where:
• p = closing price
• N = number of observations

CSI Global Education Inc. 47

Simple Moving Averages
For example, the price of a stock for the past five days was:
•Day 1 $70
•Day 2 $68
•Day 3 $66
•Day 4 $67
•Day 5 $68

•The 5-day moving average in the above example would be $67.80

• If the price closed at $69 on Day 6, Day 1’s price would be taken
out of the calculation and Day 6’s price added so that the
moving average would be $67.60.

CSI Global Education Inc. 48

Moving Average

Sell Signal – sell when stock price breaks through moving average
from above.

CSI Global Education Inc. 49

Moving Averages

CSI Global Education Inc. 50

Using Two Moving Averages
• Technical analysts will often use two moving averages:
one short term and one long term.
• Buy and sell signals are given when the shorter term average
crosses the longer term average
• This method helps to reduce the chances of false signals
• The key is to find the moving average length that works best for
a particular security

CSI Global Education Inc. 51

Momentum Indicators
• Moving averages are trend following.
• An alternative is Oscillators as they measure
momentum.
• The MACD (MOVING AVERAGE CONVERGENCE
DIVERGENCE) is the most popular oscillator

CSI Global Education Inc. 52

MACD
• It takes the difference in two moving averages and measures
the shift in trend over a period of time

• The standard MACD parameters measure the difference

between
a 12 day and a 26 day moving average.
• That difference is then smoothed by a 9 day exponential
moving average called the Signal Line

CSI Global Education Inc. 53

Sentiment Indicators
• The most popular is contrarian indicators. When everyone is
selling
it is time to buy. When everyone is buying, it may be time to sell
• When 75% of the market is bullish, the market is considered
over-bought and it is time to sell
• When 75% of the market is bearish, the market is considered
over-sold and it is time to buy
• Contrarian indicators should only be used as evidence to support
other indicators

“Be greedy when others are fearful and be fearful when

others are greedy” ~ Warren Buffett

CSI Global Education Inc. 54

Sentiment Indicators
• Put/Call Ratio
• VIX – Volatility Index
• Public Short Ratio

CSI Global Education Inc. 55

Put-Call ratio
• One of the most popular tools used to measure stock market
sentiment is the put/call ratio.
• The most popular calculation shows the relationship between the
volume of puts traded to the volume of calls traded daily on the
Chicago Board Options Exchange (CBOE).
• a range of 0.35 to 0.80 is considered. A reading under 0.35 is
considered bearish (a low number of puts per calls), while a
reading over 0.80 is considered bullish (a high number of puts
per calls)

CSI Global Education Inc. 56

Put-Call Ratio

Optimism is low. Contrarian buys.

Optimism is high. Contrarian sells.

Average = 0.93 over this time period.

Latest reading = 1.03 – January 14, 2013
CSI Global Education Inc. 57
VIX
• The VIX (Volatility Index), remains the most widely followed
• Reflects the volatility of 30-day options on the S&P 500 Index
• It increases with investor anxiety and is commonly referred to as
the “fear index.”

CSI Global Education Inc. 58

Public Short Sales
• Calculated by taking the number of public short sales and
dividing
this figure by total short sales.
• This is a contrarian indicator
• A high public short ratio is considered bullish, meaning that a
majority of public investors are bearish, which is why they are
shorting.
• When the ratio is low, it is considered bearish, meaning that a
majority of public investors are bullish.

CSI Global Education Inc. 59

Cycle Analysis
• This analysis helps to forecasts a market’s most probable
direction and extent of the move
• Cycles can be a few days to decades.
• It can be complicated as a number of cycles are operating
concurrently
• Long Term > 2 years
• Seasonal – 1 year
• Primary/intermediate -9 to 26 weeks
and trading 4 weeks

CSI Global Education Inc. 60

Cycle Analysis
• Elliott’s principal contribution was to reveal the recurring nature
of price patterns and to categorize them into impulse and
corrective waves.
• Waves 1, 3 and 5 are impulse waves in the direction of the main
trend, whereas waves 2 and 4 are counter-trend reactions.
• Each five-wave impulse sequence is then corrected by a
sequence that takes a three-wave a-b-c form or variation

CSI Global Education Inc. 61

Elliot Wave Theory

CSI Global Education Inc. 62

Elliot Wave Theory

CSI Global Education Inc. 63

Other Indicators
• Volume – more buying – bullish, more selling bearish

• Breadth – The Advance / Decline Line

• The number of new high prices and new low prices are divided
by the number of Stocks traded
• It is considered strong when new highs are increasing and
new lows are decreasing

CSI Global Education Inc. 64

Advance Decline Line

CSI Global Education Inc. 65

Conclusion
• At any point in time, a stock is worth what investors are willing to
pay for it.
• To some the prevailing market price may be too high, to others it
may appear as a bargain.
• While valuation models play an important role in the investment
process, there is absolutely no assurance that the actual
outcome will be even remotely similar to the forecasted
behaviour.

CSI Global Education Inc. 69