Now that the global financial crisis seems to come to an end, most of the investors are moving back to equity markets. By doing so, you face the problem of choosing the stocks that will outperform the other shares during the upcoming time period. To find the right investment asset to purchase, you have two basic options. On one hand, you may rely on any trends and patterns in the development of the historical prices. When developing an investment recommendation based on trends and patterns, you do a technical analysis. On the other hand, you may try to figure out which firms will exceed the market by analyzing their financial performance, strategic position, or future plans. This is called fundamental analysis.
This chapter provides you an aid on how to use R to identify successful fundamental trading strategies for equity investments. We will start by applying basic statistical methods and move on to advanced and more complex ones while we cover how to translate your fundamental investment ideas into statistically testable hypotheses.
When looking for possible investment assets, a wide range of choices is offered to you by the market. You may pick bonds, pieces of art, real estate, currencies, commodities, derivatives, or probably, the most well-known asset class, equity. Equities represent ownership right over a certain part of the given firm (issuer).
However, which shares shall we buy? When should we purchase and sell them? These decisions are of key importance as they will determine the return on your portfolio. There are two different views out there on these problems.
Technical analysis is built on historical price developments and believes that certain patterns may be identified that help predict the future movements of the quotes. Fundamental analysis, on the contrary, focuses on the firm and the value of the ownership right itself rather than on the market price of it. Here, we believe that sooner or later, market price has to reflect the fair value of the share that can be calculated from the future cash flows we collect when owning it, just like in the case of any other kind of investments.
While technical analysis focuses on how investors' behavior might push prices in the future based on historical patterns, fundamental analysis identifies the trends that prices should follow due to the predicted future performance of the firm. So, when performing fundamental analysis, we have to recall our corporate finance and accounting knowledge.
Even when checking for the fair price of just one given share, we may spend several days on modeling future performance and estimating sales growth, expenses, investments, changes in financing strategy, and cost of capital to get a valid discount rate for our cash-flow prediction. When developing a trading strategy, we need to review several thousands of potential investments, so there is no chance we could do such an in-depth analysis. Even trying it may be tricky. If you create large spreadsheet models for all equities, by the time you finish, your assumptions for the first firm could be outdated, and you have to restart the process without even considering your results from the first version of the model. So, instead of really predicting future financial statements, we have to build on historical experience to identify good investment patterns. We will try to connect previous fundamental ratios to historical price developments and expect that these connections will also hold in the future.
This is the key to understand that we do not want to find good companies to invest in; we rather have to find shares that are very likely to be mispriced. So, we want to find undervalued stocks to buy, or if shorting is allowed on the market, we want to find overvalued ones to sell. For the rest of this chapter, we will focus only on the upward potential, but you may use exactly the same techniques to identify shares to sell that have a huge downward potential. Finding the fundamental characteristics of firms for which we have seen the share price increase during the last 12 months may help us identify good investments for the next year based on the current financial statements.
So, when building a fundamental equity strategy, we need to follow these steps:
- Collect financial statement data for possible equity investments.
- Calculate fundamental ratios to standardize data.
- Identify connections between ratios and future price development.
- Follow the testing strategy that is, calculate results on another set of possible equities for the same period and/or same set of shares for a different period of time.
It is not enough to perform these steps once in a lifetime. Applying a strategy that would have performed well during the last year(s) assumes that there were no radical changes, neither within the firm nor in the economy that the company is active in. As markets tend to change, firm have to do so too. This means that what was the best practice last year may be just fine or average now. As a result of this, even if our investment strategy worked well for several years, we may see a gradual or even radical change in its effectiveness. So, a regular recheck and update is vital.