How Good is Fundamental Analysis (Part 2)

Continued from the previous post (You can read Part 1 of the post here)

So how good are those so called professional security analysts are at picking market winners? Malkiel (author of the Random Walk down Wall Street) suggests that evidence from several studies show that investing with an average mutual fund would be no better than purchasing and holding an unmanaged broad stock index.

The reasons why it is simply difficult to forecast earnings/dividends/growth or to put it simply- to conduct fundamental analysis are due to the following factors:

1. The influence of Random Events

Basically, anything can happen. The discovery of a new product, terrorist attacks, war, political crisis, competitors, irrelevance of business, natural disaster, credit crisis, tainted milk, bird flu, nick leeson.. For a good read on randomness, I personally recommend reading Fooled by Randomness and the Black Swan by Nicholas Nassim Taleb.

2. The production of dubious earnings throught "creative" accounting

The figures are simply not what they seem. When you use variables or numbers from the reported earnings , etc that are the result of creative accounting ... you simply end up with wrong numbers/forecasts

3. Basic Incompetence of the analysts themselves

Analysts lack experience in the field that they are analysing. Who can blame them? How do you value a transportation company? How do you value an internet business? How do you value a biotech company? It is simply not easy to be an expert in analysing stocks while at the same time being an expert in the industry that he/she might be covering.

4. The loss of the the best analysts to the sales desk, to portfolio mgmt or to hedge funds

Good analysts often don't stay as analysts too long. I guess the rewards are better at the sales desk and other jobs.

5. Conflicts of interest between research and investment banking departments.

In the 1990s, the ratio of buy to sell recommendations were 100 to 1. Analysts fear that negative comments like sell recommendations might offend / drive away prospective investment banking clients.

Coin Flipping Anyone??So at the end of the day, analysts/fund managers who are able to outperform the market might be beating the market simply because of luck. Malkiel gives the example of holding a contest for 1000 people who are asked to flip a coin. Those who are able to flip "heads" the most number of times win.

At the first flip, based on probability 500 would flip heads, the other 500 would flip tails.

At the second flip (out of the 500 who flipped heads previously), 250 would flip heads again.

At the third flip, 125 would be able to flip heads.

Fourth flip, 67

Fifth flip, 38

Sixth flip, 19

Seventh flip, 8

Eight flip, 4 people would have managed to flip 8 consecutive heads!!

By now the crowd watching these 4 remaining coin flippers would think that they possess some special kind of skill to flip heads 8 times in a row! But this is just all luck. Pure chance. No skill was involved.

At the tenth flip, you would get one champion who would have flipped a coin to produce "heads" 10 times in a row. The crowd will be wowed by him. This champion will go on and be interviewed by everyone. He might even write a book about "Flipping for Success".

Coin flipping anyone?

(Do take with a pinch of salt... I believe Fundamental Analysis still has a role to play in our choosing of stocks to invest in)