Fundamentals of Research — the ground floor

Chapter 4 is the map, not the territory

Every later chapter of this workbook — economy analysis, industry analysis, company analysis, valuation, risk and return, technical analysis — is a detailed drawing of one region. Chapter 4 is the map that shows you where those regions sit and how they connect.

That makes it easy to skim and easy to lose marks on. The chapter is built almost entirely out of definitions and distinctions, and NISM tests definitions and distinctions with surgical precision.

4.1 What is investing?

The workbook's definition, worth reading twice:

Three components sit inside that sentence:

1. An upfront commitment of money — you part with capital now.
2. An investment horizon — a period over which the return is expected.
3. Thorough analysis across three dimensions: safety/risk, income, and growth potential.

Then comes the line the exam loves: "Investing is very distinct from trading or speculative activities."

Trader, speculator, chartist, day trader

A trader tries to earn a spread between selling price and buying price without a necessary change in the underlying value of the asset. Read that carefully. The trader is not claiming the business got better. The trader is claiming the price will move. Traders are motivated by a historical price pattern and its re-occurrence in future, and so a trader's time horizon is usually short.

The workbook then gives you three sub-labels, and questions are built directly on them:

Investment activity, by contrast, focuses on the potential of an asset's value to increase over a period. And the workbook gives the exact mechanism by which value increases — memorise this, because it is the sharpest sentence in the chapter:

Notice that both halves are about the cash flow / risk pair. Nothing about price patterns. That is the whole difference.

The workbook adds a number here that is easy to miss: traders profit from price patterns and price anomalies which would be corrected within a period up to 3–6 months, with no change in the fundamental value of the asset.

Active and passive investing

Once you are an investor rather than a trader, there is a second fork.

Active investing means identifying the specific security or set of securities to buy or sell. It requires constant evaluation of every security in the portfolio — sell what is priced above intrinsic value, buy what is priced below intrinsic value. It needs more effort and a greater number of transactions. The objective: a rate of return above the return generated by the broader asset class.

Passive investing means buying a broad set of securities that fairly represent the asset class. Typically this is an indexing strategy — buy all the securities in an index. The passive investor does not decide upon individual securities; the analysis is limited to the broader asset class. The objective: the rate of return that the select asset class provides.

So the difference is not "cheap versus expensive". It is a difference in objective — beat the asset class, or receive the asset class.

4.2 What a research analyst actually does

The role has two parts, and the workbook separates them deliberately:

• Research — obtaining all the necessary information to meet a set goal, objective or research question.
• Analysis — analysing all the available information to arrive at a conclusion.

Research comes first. Analysis is worthless if the information underneath it is thin.

Why is it not enough to read the annual report? The workbook gives three reasons:

1. An annual report needs very detailed scrutiny to yield real insight, and often the information in annual reports is not adequate.
2. Annual reports are published once a year, so the information starts becoming dated with the passage of time.
3. Industry conditions and the broader economy may not be covered in depth in the company's own filings.

So the analyst spends significant time on the economy, the industry and the company. That means secondary research — reports from market research firms, speaking to industry experts, tracking competitors' actions — and often primary research: visiting the company's facilities, speaking to customers, suppliers, employees and others.

The bright line: insider information versus mosaic analysis

Primary research walks you towards non-public information. The workbook draws the line very carefully.

Insider information is material non-public information that, when published, would immediately affect an investor's decision to buy or sell the security.

Whether a piece of information counts as insider information depends on three things:

• The source of the information — how reliable it is
• Its impact
• Its certainty

The workbook's own two examples:

• A CEO talking about an unpublished acquisition proposal — insider information.
• An employee talking about increasing workload in the purchase department (which may indicate higher business activity) — need not fall under insider information.

Mosaic analysis is what a good analyst does instead. Analysts collate information from different sources which individually may not be significant, but when put together with other public or non-public information may provide critical insight. The workbook is explicit: such mosaic analysis is acceptable.

The professional obligation is stated as a warning: analysts must be careful about whether an insight came from their mosaic analysis, or from being privy to a specific non-public price-sensitive information. And the underlying rule for the whole section: the research work of the analyst should not involve collating insider information.

4.3 Technical analysis in one page

Technical analysis begins from an assumption:

If everything is already in the price, then studying the company is redundant. What is left to study is the price itself. So technical analysis forecasts the direction of prices through the study of patterns in historical market data — price and volume. Its practitioners are technicians, sometimes called chartists.

The workbook names three essential elements in understanding price behaviour:

1. The history of past prices — provides indications of the underlying trend and its direction.
2. The volume of trading that accompanies price movements — provides inputs on the underlying strength of the trend.
3. The time span over which price and volume carry the impact of long-term factors that influence prices.

These three are integrated into price charts, points of support and resistance, and price trends.

Support is a level with a lot of buying interest. Resistance is a level with a lot of selling interest. If a stock is moving closer to an established resistance level, a holder can benefit by booking profits, since prices are likely to retract. If a support or resistance is broken and accompanied by strong volumes, the trend has accelerated and the supply–demand situation has changed.

Volume is the confirmation tool. An upward or downward trend should be accompanied by strong volumes. A trend not supported by volumes indicates weakness in the trend.

Charts named in the workbook: line charts, bar charts, candlestick charts. And one specific technique: chartists use the moving average of the stock price to reduce the impact of day-to-day fluctuations that make the trend hard to see. That exact point is one of the workbook's own three sample questions.

Finally, the suitability rule:

• Short-term investors and traders largely rely on technical signals, because business fundamentals seldom change drastically in the short run.
• Technical analysis is less likely to be suitable for long-term investing, because business fundamentals may change in the long term — which makes the past trend in share price unreliable.

4.4 Fundamental analysis in one page

Fundamental analysis is the mirror image. It is focused on long-term investing.

Its premise: since equity shares reflect part ownership of a company, in the long term the value should be driven by the profits and cash flows generated by the company on its investments. When short-term price movement causes the price to significantly diverge from fair value, that divergence creates a profit-making opportunity.

The decision rule follows directly:

So profits come not only from identifying a good investment option, but also from making the investment at the right price. A great company at a stupid price is not a fundamental buy.

And here is a line that gets tested: this entire thought process is in contradiction of the Efficient Market Hypothesis (EMH), which holds that share prices incorporate and reflect all relevant information. If EMH were fully true, there would be no divergence to exploit and fundamental analysis would be pointless.

Fundamental analysis asks seven questions, and the workbook lists them in order:

1. How is the overall cyclical and secular macro-economic trend, and will it help the industry grow or decline?
2. How is the competition intensity within the industry, and is it conducive for existing players to thrive?
3. How is the company positioned versus its competitors?
4. What is the company's cost structure, and how will it affect profit under different business environments?
5. How strong is the financial position — strong enough to fund growth or withstand crisis?
6. What are the capabilities of the management — can they identify and execute the right strategies?
7. Is the right governance structure present, so that the board and management act in the best interest of shareholders?

All seven fall into three baskets: 1. Economic analysis. 2. Industry analysis. 3. Company analysis. Those three baskets are Chapters 5, 6 and 7–8 of this workbook.

4.5 Quantitative research

Fundamental research involves both quantitative and qualitative studies. Some analysts go purely quantitative, and the workbook makes an important point: the quantitative approach can be used in both technical analysis and fundamental analysis.

• In technical analysis — instead of reading charts, the analyst studies the underlying data: the relationship between price up-moves and down-moves, volume and other parameters.
• In fundamental analysis — the analyst looks for finance and operational metrics of the company, in the hope that some metric, alone or combined, acts as a leading indicator of performance.

The toolkit runs from simple to sophisticated: time series analysis and regression of historical data to extrapolate future earnings; then econometric approaches; and alongside the statistics, financial statement analysis, projections of future financials and growth rates, sensitivity analysis and simulations to see how changed assumptions move the valuation.

Now the limitation — this is the workbook's own third sample question, so learn it verbatim:

Conclusion: pure quantitative research is not often employed in fundamental analysis.

4.6 The behavioural approach

Investment decisions must be based on analysis of available information, so that they reflect expected performance and risks. Very often they are not — they are influenced by behavioural biases of the decision maker, leading to less than optimal choices.

The behavioural school's assumption: securities' prices go away from their fair values, either upside or downside, because of the fear and greed of market participants. That is the whole premise, and notice it cuts both ways — mispricing is not only downside.

The workbook defers the list of biases to a later chapter. When you meet them there, the ones named are loss-aversion bias, confirmation bias, ownership bias (the endowment effect), gambler's fallacy, winner's curse, herd mentality, anchoring and projection bias.

4.7 Fundamental analysis of commodities

Commodity fundamentals are a different discipline. The workbook's definition:

It focuses on supply and demand factors, seasonality, macro-economic conditions, news, currency movement, interest rates, weather, inventory level, government intervention and so on.

Supply-side factors (4.7.1):

• Production — from farms, oil wells, mines
• Weather condition — floods, drought, cyclonic effect
• Government policies — tariffs, levies, trade restrictions and promotion, subsidies
• Geopolitical events — sanctions, wars, trade disputes
• Input costs — energy cost, input cost, wages, technology

Demand factors (4.7.2):

• Global economic growth — improvement in GDP creates additional demand for metals, energy and agri-products
• Population growth and urbanisation — increases food and energy consumption
• Substitution effect — switching between commodities
• Seasonal demand — higher fuel demand in winter/summer, festive food demand
• Consumer preferences — shift to organic foods, renewable energy, electric vehicles

Macroeconomic indicators (4.7.3):

• Inflation — commodities, especially gold and silver, act as an inflation hedge
• Interest rates — higher rates strengthen the USD, lowering commodity prices
• Trade balance and industrial data — Purchasing Managers' Index (PMI) and industrial production affect metals and energy demand

4.8 The workbook's two case studies

Gold

Uses: jewellery, industrial, investment, central bank reserves.

Gold is one of the largest traded commodities across the globe on commodity exchanges. It is an inflation hedge and a safe-haven asset because of its store of value. During economic turbulence, when equities, bonds and currencies underperform, investors turn to gold. Historically and statistically it is proved that gold carries an inverse relationship with stocks, bonds and currencies.

Demand by sector: Jewellery 47%, Investment 24%, Central Bank 23%, Technology 6%.

Major producers: China, Australia, Russia, USA, Canada. Major consumers: China, India, USA, Germany, Saudi Arabia.

What pushes gold up (and what pushes it down):

Gold is the anti-asset. Almost everything that is good news for the economy is bad news for gold.

Crude oil

Uses: fuel, polymers (plastic), lubricating oil, naphtha, bitumen.

Crude oil is called the mother of the global financial market and black gold, because of its importance to global economic growth. It is a naturally available, flammable liquid found in rock formations in the earth. Distilled at different temperatures it produces bitumen, lubricating oils, fuel oil, diesel, paraffin, naphtha and gasoline. It is the lifeline of the global economy, and any supply–demand imbalance results in inflationary concerns across the globe.

Quality of crude oil is based on two things: (1) density and (2) sulphur content.

(The workbook prints those API figures as 390 and 380 — they are degrees API, 39° and 38°, with the degree sign lost in typesetting. What the exam can test is the pairing: WTI–0.24%–NYMEX and Brent–0.4%–ICE.)

Who controls supply: the United States and OPEC+, where OPEC+ = 13 OPEC members + Russia.

The four supply numbers to memorise:

• The Middle East has the majority of the world's oil reserves — 48% of all known and identified reserves
• OPEC owns almost 40% of the world's crude oil
• OPEC accounts for 75% of proven oil reserves
• OPEC exports 55% of the oil sold worldwide

Major producers: USA, Russia, Saudi Arabia, Canada, China. Major consumers: USA, China, India, Germany, Japan.

What pushes crude up (and what pushes it down):

Compare the last row against gold's last-but-two row and you have the single best trap in this chapter. A bullish stock market is positive for crude and negative for gold. Crude is a growth asset; gold is a fear asset.

4.9 Historical events

20 April 2020 — WTI goes negative. The workbook records that WTI crude oil prices fell into negative territory, and explains exactly why:

• The May contract was expiring the next day.
• There was no demand for crude across the globe, because 90% of the world was under lockdown to control the spread of coronavirus.
• WTI is a deliverable contract at Cushing, Oklahoma, and lockdown-induced restrictions on oil movement meant buyers of contracts were not ready to take delivery upon expiry.
• So buyers went on a selling spree that day, which resulted in negative pricing.

The lesson the workbook wants: a negative price is not a statement about the cost of producing oil. It is a statement about delivery obligation plus full storage plus an expiring contract.

1973 — the first oil crisis. Looking back at global oil crises, there are two major crises post World War II. The first happened in 1973, when members of OPEC decided to quadruple oil prices to almost $12 a barrel, and prohibited export of oil to the United States, Japan and western Europe, which together were consuming more than half of the world's oil.

4.10 Why a commodity move shows up in your equity screen

Commodity and equity markets carry a strong relationship, for a very ordinary reason: some of the companies listed on stock exchanges use commodities as raw material. So a price move directly impacts the profit margins of those companies, which in turn results in price movement of those stocks.

The rule, in the workbook's words:

• A rise in commodity prices increases input costs, which reduces profit margins of companies.
• Conversely, falling commodity prices can improve profitability and boost stock valuations.

But it is not one-directional across the market, and the workbook's own example proves it: rising crude oil prices improve the profitability of oil producing companies and at the same time reduce the profitability of airline and logistics companies, because of the high input cost. Same commodity, opposite effect, depending on whether the company sells it or buys it.

There is a second channel too, which is about information rather than margins. Commodities are globally traded, so changes in crude, gold or copper prices often signal shifts in global demand and supply. Equity markets, being sensitive to growth prospects, react to these signals. The workbook's example: a fall in copper prices may signal slowing industrial demand, dragging down metal and infrastructure stocks.

That is two distinct mechanisms — the cost channel (margins) and the signal channel (what the price tells you about global demand). Questions can test either.