Combine charting with fundamentals for better stock-picking

Charting – aka technical data – and fundamental analysis are often considered forbidden partners when it comes to investing in stocks, however by cleverly combining the benefits of both, you can become a timelier stock-picker.

What you get from combining charting with fundamental analysis is a more complete picture of a company and what's happening on the share market.

Start with value

Until you know what a company is worth, it's impossible to take a 'value investor' approach to stock selection. This is where fundamental analysis – if used properly – can be well worth the effort. By analysing historical financial data, along with forecast earnings and profit projections, you're simply in a better position to predict future company performance and growth.

Remember, if you're investing in the share market based on a company's fundamentals and not just taking a punt on share price momentum, you are actually buying a piece of a business, and as such, you should know what kind of business you've bought into.

Key financial indicators

By drawing on financial ratios – like return on equity (ROE), earnings per share (EPS) growth, and net debt to equity; plus key qualitative indicators like management's track record, core earnings stability and the sustainability of a company's competitive advantage – you can get a pretty good idea of what a company is actually worth.

It's only once you know what's a company's true value is that you can determine whether the current share price makes for an attractive entry point, relative to future projections.

Don't pay too much

What you actually pay for a company's shares is the single most important determinant of future returns, so avoid paying too much.

Just because a stock might have an investment grade balance sheet and quality earnings, doesn't mean you should buy it at any price. Similarly, taking a 'buy and hold' strategy – the way investors' did during the 20 year bull market run – is no longer a good idea.

It's equally dangerous buying 'falling daggers' within a down market on the pretext that price and value are mutually exclusive. They're not, and the direction within which a share price is heading is often a good determinant of whether it's a 'value-play' or a 'value-trap'.

Overlay fundamentals with charting

As a value investor, you should be looking to buy quality stocks trading at a discount to their true value. That's because over the long term, share prices typically reflect the value of the underlying business.

Sooner or later the market will present you with opportunities to capitalise on negative announcements or unfavourable macroeconomic data, which can and do trigger share market corrections.

We saw this early in 2016, when share market jitters in China, left many stocks on the ASX mispriced due to panic selling.

This creates an opportunity to buy after a major correction or on more frequent yet less volatile dips. It's not unusual for the share market to move well over 200 basis points – aka 2% – in any trading week and on occasion on any single day.

Better time trading decisions

The mispricing thrown up by market corrections or dips can represent some tantalising buying opportunities, and we're still seeing many stocks trading at significant discounts to their recent highs and intrinsic value; including Super Retail Group (ASX: SUL), Cover-More Group (ASX: CVO) and iSentia Group (ASX: ISD).

Technical indicators – which focus on volume and price – try to accurately determine the direction in which share prices might be heading. This technique can help you time your entry into quality stocks when they're likely to be cheaper.

It's true, technical analysis by itself won't help you identify the best stocks to buy. However, it will let you draw conclusions from trading patterns, company charts, graphs and trend lines to help you pick the best time to act on a stock.

What's unique to technical analysis?

What exactly can technical analysis add to your stock research that fundamental analysis can't?

Fundamental analysis can't tell you what the market thinks of a stock you want to buy. That's where the 'technical stuff' like volume indicators can help.

Notable spikes in traded volumes typically suggest that a stock has attracted abnormally high attention from the trading community and that its shares are under either an 'accumulation or distribution' phase.

Volume indicators can help confirm whether other investors agree with your fundamental outlook on a stock. They can also help gauge whether a stock is gaining or losing momentum – if it's the latter then a reversal could be around the corner.

This serves to remind you that a stock's inclusion in or out of an index will have a material impact on the market's interest in it, and can directly impact share price momentum. The same can be said for a share buy-back programme.

Buying signals

What you're looking for from charts is confirmation of what the market and fundamentals might already be signalling to you. In the case below, upward pressure on price is telling you when it could be time to enter the stock.

Description: Technical chart for CodanDescription: Technical chart for BTEM

 

The left hand side reveals a stock reaching what typical value investors might consider a good buying price, while the right hand side reveals what could be considered a good buying price.

The trick is to let the fall play itself out, and then step in once the stock is supported by buyers.

Tactics

Once you've found a top stock you're interested in buying based on fundamentals, find a monthly chart of the stock, and plot a three-period moving average and a seven-period moving average.

What you're now waiting for is the three-period moving averages, to cross over and close above the seven-period moving average.

But remember to check that the stock's share price is still trading below its intrinsic value when you buy. Ideally you'd like it to be at least 20% below, but given the nature of the ASX, that's not always a reasonable expectation.

Handy technical charts

If you like the look of a stock based on what the fundamentals are telling you and seek to time a trade or solidify a favourable entry (or exit) point, the following technical charts can be extremely useful:

Intraday chart: Let traders watch for spikes in volume, which often correspond with block trades. Intraday charts can be extremely helpful in deciphering exactly when large institutions are trading.

Short-term movements: While most fundamental investors tend to focus on longer time frames, they still want to obtain a favourable buy-in price and/or a favourable selling price upon liquidating a position.

That's why it's important to pay particular attention to when a stock pushes through what called its 15- and/or 21-day moving average, as this typically indicates what's expected to follow in the coming term.

Similarly, you can also use 50 and 200 day moving averages to determine longer-term breakout patterns.

Reactions over time

By looking at a chart of a specific stock, industry, index or market, you can determine how that entity has performed over time when certain types of news have been released. Remember, these patterns tend to repeat over time.

How they add value

Fundamental Analysis

Technical analysis

Select stocks to include in your investing universe or 'watch list'

Time the entry into an already filtered fundamentally sound stock.

Determine whether a stock is overvalued or undervalued relative to its intrinsic value.

 

Manage the investment execution.

 

Avoid overvalued stocks or high debt companies to lessen risk.

Time an exit for the investment.