prospects and earnings outlook. The fundamental analyst
calculates financial ratios based on data available from the
balance sheet and income statement of a company. From these
ratios, he deduces the financial strength and earnings trend
of the company. Then he will meet the company's management
to affirm his deductions, to understand the business and to
learn of any new development of the company and the
industry.
A widely used tool in fundamental analysis is the
price-earnings ratio or PE ratio. It is calculated using
the stock price pided by the earnings per share (EPS) of a
company. As a general rule, a stock with a low PE ratio is
considered cheap although there are difficulties in applying this principle. PE ratios of two companies can only be compared if the companies are similar. It is believed that companies in different industries deserve different PE ratios. For example, Singapore Telecom is believed to deserve a higher PE ratio than many other stocks because of its position in the telecommunication business. However, analysts have not yet agreed on what PE ratio each industry or company deserves and there is no one way to determine the right PE ratio. Both approaches attempt to predict the future price movement of a stock. Fundamentalists study the cause of market movement while technicians believe that the effect is all that they need to know. Despite their differences, both approaches try to increase your probability of picking up the right stock at a right price. However, these methods only increase your chances but do not guarantee complete success. Some believe that fundamental analysis is good for picking the right stock while technical analysis is appropriate to decide the right price or time to buy. For the professional investor, he has to take another step of deciding the sequence of analysis. This will have an impact on how the investor pides his money among different countries and stocks. Basically, the investor decides whether the market as a whole or the company itself is more important in determining stock prices. Both factors definitely influence stock prices but the degree of influence is the issue. The top-down approach or sometimes known as the Economy-Industry-Company (EIC) model emphasises the market over the company. It starts with the analysis of different economies to determine which country could offer the investor better returns. In the selected economy, it searches for industries that provide better prospects and it picks the best companies within these industries. The top-down approach offers a systematic and structured way to analyse stocks. It advocates that the economy and industry effects are significant factors in determining the total return for stocks. The bottom-up or stock picking approach believes in finding stocks that are undervalued which can provide superior returns irrespective of the market and industry factors. The company effect is the dominant factor in determining stock return. There is no overwhelming evidence to suggest which approach offers superior returns to the investors. The most important thing is that an investor is comfortable with a particular method, understands its strengths and limitations, experiments with it, finds that it works for him and abides by the method. (The writer is Investment Manager of Tat Lee Asset Management Limited. This column has the support of Investment Management Association of Singapore and the Stock Exchange of Singapore.)