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The fundamental things apply

Created:

25 April 2008

Updated:

19 November 2008

Written by:

Rakesh Shah

Fundamental analy-sis is a long-term approach to investing. It helps identify differences between an asset's intrinsic value and its current price. Trading CFDs is, by its very nature, a short-term activity, typically concerned with periods of less than a month. However, fundamentals do still have their uses in taking short-term positions.

Fundamental data can be classified as either qualitative or quantitative. The former includes such things as the structure of management and corporate strategic issues and have little relevance to traders. Quantitative information – the hard facts and figures – can be helpful over the short run.

Knowing that an asset is significantly over or under-valued is potentially a worthwhile insight for the trader. At critical moments, the market suddenly becomes sensitive to these facts, having ignored them for a long time previously. At such times, we often get the sort of sharp movements in the market which short-term traders aim to exploit.

Ratio analysis in CFD trading

The price-to-earnings (P/E) ratio is one of the most simple but effective tools of fundamental investment. A high P/E ratio tells us that a share, sector or market is probably expected to produce high earnings growth. For that reason, we would naturally expect big sell-offs in the event of any disappointments. Conversely, a low P/E ratio indicates weak forecast earnings growth and perhaps even a risk of bankruptcy. Even a little positive surprise can produce a big rally in these circumstances.

Comparing a share's P/E ratio to that of its peer group or indeed to the wider market can be instructive. The further away from the sector or market average, the higher will be the overall expectations of tremendous growth. As this reaches extremely high levels and then begins to fall, it can be the sign of the end of a bubble.

A good example of this can be seen in Google's stock last November. At that time, the P/E ratio accelerated from 40 to 60 in the space of a few months. This information could help a CFD trader plan a short position, based on the message about sentiment that it conveys.

The fundamental time lag

Both general and specific newsflow drive individual share prices. If the news is stock-specific, will it give the company a competitive advantage over its peers? Or is it a general news item that will have little effect?

Even if the news suggests a new competitive advantage, the share price may take some time to fully reflect a change in the underlying fundamentals of a company. This is partly due to the cash-flow position of fund managers.

They may be well disposed towards a particular stock and wish to buy it for their portfolios, but need to exit an existing position in another stock in order to free up cash.

Fundamentals and News

There's no doubt that fundamental news flow can have a regular impact on asset price moves. An obvious example of this how the publication of US unemployment data impacts upon the market for Treasury bond futures.

By looking back at a particular asset's history over time, we can gauge what is likely to make it move. Some services – such as Bloomberg – allow users to click any point on a price-chart to see what news items coincided with a movement on a given day.

For example, we might observe that on days where Tesco announces its results, its share price tends to go down even if the results were very good and the presentation and outlook statement from management sounded great. This type of reaction may seem strange to a novice trader. However, by grasping the company’s fundamental situation, we can learn if the market has already priced in very high expectations for the company's share price.

You can get a feel for what analysts are anticipating by checking out their published forecasts on the internet. A site such as Yahoo! Finance tells you not only the consensus forecast, but also shows whether analysts have been adjusting their forecasts upwards or downwards over recent months.

If we assume that the market is pricing in a high number and the actual numbers on the day are the same as those that have been forecasted, the market will price Tesco lower when the results are announced. If a stock has a high P/E ratio, it generally needs to deliver results right at the top of the market's expectations or above if it is to rally on their release. This is just another way of expressing the old market adage: 'buy the rumour and sell the facts'.

Look at the accompanying chart (above) to see how Tesco has reacted on the last two announcements indicated by the green arrows.

Fundamentals and market timing

When a news announcement is made, it can be interpreted in many different ways. One skill is to analyse whether news items will have a short-lived or longer-term effect on the company price.

For example, an oil company reveals that it has found new reserves. This will result in a sustained rally until the market factors the new oil revenues into the profitability of the company, thereby boosting the market capitalisation. Look at the share price of British Gas after the announcement by the Brazilian energy regulator that an oilfield discovery would be the biggest seen in the world in the past 30 years.

However, upon reading the details of the announcement the next day in the Financial Times, it became apparent that this was only an exploratory well and more conclusive data would only be available when full assessment took place at a later date. The price gapped up overnight from 12.21 to 13.20, with a subsequent pullback into a box between 13.00 to 12.75. Another example of buy the rumour and sell the fact.

Over the following days, the market presented a number of opportunities to sell BG Group in the trading range for a 1.9 per cent unleveraged return, which equates to a 15 per cent net return on a CFD traded with a 10 per cent margin requirement offering a healthy return.

News events and short-term timing for CFD trading

Often, your analysis may be very good, but the price of the stock fails to rally because of the general market. If good news arrives during a bearish cycle in the market – similar to that during the first three months of 2008 – it may be appropriate to use a long/short strategy where you go long of the share and sell short an equivalent amount using a FTSE 100 CFD. This will act as a hedge against any general market movements and you should expect the share to outperform the index on the upside.

For short-term CFD trading, we need to make snap judgements after big news events. The first part is to understand how corporate news affects share prices after the announcement and then to see if the market is trading on a rumour or a fact.

The next step is to see which stock is the leader or laggard in the relevant sector by looking at the P/E ratios compared with the sector average. This then gives the trader a good opportunity to select the correct share for trading either bullish or bearish sector news. This will give the fundamental trader a good number of CFD trading opportunities each week.

Having worked as a trader and investment banker for ABN Amro, Barclays, and Credit Agricole Indosuez, Rakesh now trades for himself and provides training to others. You an visit his website at www.tenpointtrading.com and e-mail him at rakesh.shah@tenpointtrading.com

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