Introduction and approaches

Determining Investment Worth

Security analysis is a vital process for anyone involved in financial markets. It helps investors sift through the vast array of available securities and make informed decisions.

• Definition:

  • Security analysis is the process of systematically examining individual securities (stocks, bonds, etc.) to determine their:

    • Value: Their intrinsic worth or fair market value.

    • Risk: The potential for loss and the factors that could affect their performance.

    • Potential Return: The expected gains or income an investor can anticipate.

  • This allows the investor to compare that security with other assets, with regards to risk profile, expected performance, and time horizon.

• Purpose:

  • To assess the suitability of a security for a particular investment goal
  • To make informed decisions about buying, holding, or selling
  • To construct a diversified and well-balanced portfolio
  • To evaluate the price of the investment compared to its "intrinsic" value.

Approaches to Security Analysis (as provided):

1. Fundamental Analysis:

   • Description: A method of evaluating securities based on their intrinsic value, which is derived from underlying economic, industry, and company-specific factors.

   • Key Elements:

     • Economic Analysis: Evaluating macroeconomic factors (GDP growth, inflation, interest rates) to assess the overall investment climate.
     • Industry Analysis: Examining industry-specific factors (competition, regulation, technological changes) to understand the industry's growth potential and profitability.
     • Company Analysis: Scrutinizing company-specific factors (financial statements, management quality, competitive advantages) to determine its financial health and future prospects.

   • Goal: Identify undervalued or overvalued securities for long-term investment. The expectation is that in the short term, an investment may be improperly priced, but in the long term, it will eventually gravitate towards its fair value.

   • Data Sources: Financial statements (balance sheets, income statements, cash flow statements), earnings reports, annual reports, economic indicators, industry reports, and company news.

   • Strength: The most common approach that has had the most study. The most common and accessible data is generally that for fundamental analysis.

   • Limitation: The data is generally backward-looking rather than future-looking.

2. Technical Analysis:

   • Description: A method of predicting future price movements based on the study of historical price and volume data.
   • Key Elements:
     • Charts and patterns: Identifying recurring patterns in price charts that suggest future price direction.
     • Technical indicators: Using mathematical calculations based on price and volume data to generate buy and sell signals (e.g., moving averages, Relative Strength Index (RSI)).
   • Goal: Identify short-term trading opportunities and profit from price fluctuations.
   • Suitable for: Short-term trading strategies, such as day trading or swing trading.

• Limitation: Cannot be used for long-term valuation. Ignores the actual performance of the investment. Based purely on charts.

3. Efficient Market Hypothesis (EMH):

   • Description: A theory that asserts that stock prices already reflect all available information, making it impossible to consistently outperform the market through any form of analysis.
   • Forms of EMH (as provided):
     • Weak Form: Prices reflect all past data, implying that technical analysis is ineffective.
     • Semi-Strong Form: Prices adjust instantly to publicly available information, making fundamental analysis ineffective.
     • Strong Form: Prices reflect all public and private information, making it impossible to achieve consistently superior returns.
   • Implication: If EMH holds true, the only way to achieve market-average returns is to invest in a passively managed portfolio (e.g., an index fund).
   • Arguments Against Emh: Insiders and market manipulators may prevent the market from being at 100% equilibrium and thus, opportunities for return may exist.

Summary Table of Approaches:

*A great wealth manager is skilled in all approaches, since each one offers a new perspective on any assets for portfolio management. In Conclusion:

Security analysis is a multifaceted process with different approaches, each with its own strengths and weaknesses. Investors should understand these approaches and choose the ones that best align with their investment goals and risk tolerance. Keep in mind that many investors and fund managers use a blend of these for better-informed decisions.