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Combining fundamental and technical analysis can boost returns and minimise losses.

By Karl Siegling, Cadence Capital

People often refer to themselves as either fundamental or technical investors and feel so strongly about one style of investing compared to another that they engage in heated academic debates.

The view at Cadence Capital is that investors should use whatever tools are at their disposal to try to beat the market, and that fundamental analysis combined with technical analysis has a greater probability of achieving that than one style alone.

Understanding fundamental analysis

When we refer to fundamental analysis we mean the process of determining accounting profits, operating cash flows, free cash flows, balance sheet debt, cash and overall balance sheet strength, as well as estimating numbers for these metrics two years into the future.

There are about 2,250 stocks listed in Australia (2.5 per cent of the world’s listed market capitalisation) and in any given year 600 to 700 of these companies actually make a profit — so about 75 per cent of Australia’s listed companies do not.

We are unable to analyse companies that do not make a profit, so we are restricted to choosing from roughly 700 companies a year to add to our core portfolio.

Of these, 5 per cent are usually cheap and 5 per cent are really expensive in any given year. This equates to a sweet spot of about 70 companies that meet our fundamental criteria. We hope to construct a portfolio of between 30 and 40 core positions in any given year.

This approach is outlined in Diagram 1 below. Importantly, since we believe there are only 70 really good opportunities in any given year, we need to have an open mandate to implement this investment strategy (that is, fewer restrictions on the fund’s investment style ). Investing with an open mandate is unusual in Australia and particularly in the superannuation investment industry.

We estimate that around 85 per cent of all superannuation money invested in Australia is invested on a restricted mandate, effectively reducing the number of really good opportunities available to a portfolio manager.

Source: Cadence

Investment managers spend much time looking for companies that meet their fundamental criteria. Cadence visits 300 to 400 companies a year trying to find stocks it can add to its core portfolio.

Diagram 1 shows that a typically cheap stock may have:

Earnings growth of around 20 per cent per annum.

A price-to-growth (PEG) multiple of more than 2 times.