The Death of Fundamental Analysis

If Ben Graham or some other proud, dearly departed purveyor of brick-by-brick, fundamental analysis were to emerge from the great beyond and dial up, say, this chart of the market's action over the last year, you could hardly blame the venerable value hound for scratching his head and saying, "Hey there, youngster! What's with this Facebook thing I keep hearing so much about?"

Irrationality is painful -- and painfully boring. And when you have a passion for investing (as opposed to speculation), your capacity for patience is sometimes trumped by an impulse to throw up your hands and make other time-occupying arrangements while the market finds its proverbial bottom, comes to its senses, and revives an apparently moribund interest in corporate fundamentals as opposed to, say, big macroeconomic attacks.

Just don't do it
Still, as great investors like Graham have always known and taught, the time to go stock shopping is when you can buy quality on the cheap. Which is precisely where we seem to be, if the chart I linked to above is any indication.

The chart's big-picture story is of a market gripped by fear and panic. A closer look, however, reveals that that particular dynamic was accompanied by a proverbial flight not to quality (as represented by the large-cap-dominated S&P 500's anemic red line) but rather to the seemingly riskier little fish that comprise the Russell 2000 (represented in royal blue).

Virtually everything has tanked over the last year, of course. But in relative terms, small caps have trumped the big boys. That's surprising enough in the aggregate, but it's positively shocking when you dig into particular names.

Consider, for example, the following grade-A lineup -- rock-solid companies with financial strength, ample free cash flow, and long-haul track records of overachievement -- and how they've fared relative to both the S&P 500 and the Russell 2000 for the past 12 months.

Company

+/- S&P 500

+/- Russell 2000

Applied Materials (Nasdaq: AMAT  )

-9.6

-11.1

Schlumberger (NYSE: SLB  )

-10.4

-11.9

Berkshire Hathaway (NYSE: BRK-B  )

-1.1

-2.5

UnitedHealth (NYSE: UNH  )

-3.8

-5.3

Texas Instruments (NYSE: TXN  )

-9.1

-10.6

eBay (Nasdaq: EBAY  )

-14.9

-16.4

Honeywell (NYSE: HON  )

-6.7

-8.6

That's a hit list of companies that, in my view, strike the right profile for folks in search of a clutch of companies to use as the centerpiece of their portfolios. That's particularly true for Fools who may be closing in on retirement and wondering how they're going to glue their nest eggs back together before their permanent tee time comes around. The upside potential of these titans relative to their downside risk -- at least in terms of these companies' currently attractive valuation profiles -- seems Goldilocks perfect.

My, what big market caps you have
Still, it certainly pays to mix it up when designing your portfolio, diversifying across the market's valuation spectrum and its cap ranges as well. Indeed, if the recent history charted by my Fool colleague Ilan Moscovitz holds true, small caps may have more room to run when the economy finally turns the corner.

The good news, of course, is that investing is not an either/or proposition -- and that fundamental analysis isn't dead. Once you've settled on the asset-allocation breakdown that works for you -- i.e., the right ratios of stocks to bonds, large caps to small, international to domestic -- your best bet is to fill in that personalized pie chart with vehicles that sport attributes similar to those I called out above in connection with our magnificent seven: companies that are firing on all fundamental cylinders as evidenced by robust financial health -- and wealthy long-term shareholders.

We're working hard
At the Fool's Ready-Made Millionaire, we've designed a five-star portfolio that matches the profile sketched above -- a lineup comprising a power trio of world-class mutual funds, an undervalued ETF, and four individual stocks that we think will whip up on the market over the next three to five years and beyond. The Fool itself has invested a million bucks of its own capital in our Ready-Made selections, and starting next Tuesday, you'll be able to as well.

That's the day we'll reopen Ready-Made Millionaire to new members, who'll be able to emulate our set-and-forget lineup at prices that, thanks to the market's irrational despair, are even more attractive that when we invested last July. Click here to be notified when our doors swing wide again -- and to snag our special 11-Minute Millionaire special report as an immediate download now.

Hope to see you Tuesday!

Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire and doesn't own any of the companies mentioned. The Motley Fool owns shares of Berkshire Hathaway and UnitedHealth. Berkshire, UnitedHealth, and eBay are Motley Fool Stock Advisor and Motley Fool Inside Value recommendations. You can check out the Fool's strict disclosure policy.


Read/Post Comments (21) | Recommend This Article (56)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 11, 2009, at 6:16 PM, malawny wrote:

    I don't understand how you can say a stock is cheap if you can't predict what its earnings will be. If the earnings are cut in half, is it still cheap at today's price? Until you can accurately predict what will happen in the next year or two, which you can't, but you can expect high volatility, calling a stock cheap is just a cheap exercise in filling up a page and calling it advice.

  • Report this Comment On February 11, 2009, at 7:04 PM, Cardinals37 wrote:

    Based on malawny's verbiage there will never be a cheap stock because we can never predict. I'm not sure I buy that thought process. If the company has good products in good markets why not take a look at some history to help determine if it's cheap.

  • Report this Comment On February 11, 2009, at 7:36 PM, UzhasKakoi wrote:

    I don't believe that author read Ben Graham or, if read, understood him. Buying stocks that fell more than indexes is NOT Graham definition of value.

  • Report this Comment On February 11, 2009, at 7:42 PM, JWD26 wrote:

    Wow...look at this chart. It shows the S&P 500 beating small caps (The Russell 2000) since 1987. Am I reading this right?

    http://finance.yahoo.com/charts?s=^RUT#chart4:symbol=^rut;ra...

  • Report this Comment On February 11, 2009, at 8:04 PM, tebrooks wrote:

    Congratulations. I think you just stepped over the line from the Motley Fool to the Motley Moron.

    Uzhaskakoi is exactly right. Being able to spell Ben Graham is not the same as understanding him.

    You might want to try reading "Security Analysis" before invoking his name. (I recommend you start with the 3rd edition. Then, do the 1st edition if you want a historical perspective on the crash, or the 2nd edition if you want better examples of the points he makes.)

    Don't forget - Ben Graham knew all about market crashes. He had a front-row seat on the 1929-32 fall of 89% in the DJIA. It was 2 years *after* that bottom when he published Security Analysis.

    He's also the one who coined the "Mr. Market" analogy - which essentially states the market is not rational - it's manic-depressive.

    By the way - you should *never* use the phrase "the death of fundamental analysis" and Ben Graham in the same breath. Especially when it's just a teaser to get someone to read your article. The title doesn't even make sense in the context of the article.

  • Report this Comment On February 11, 2009, at 8:08 PM, southard wrote:

    I think the point the author was trying to make is that there is a disconnect when well established strong most blue chips fall even more than the indexes. That is they are being thrown out with everything else and that should spark your interest.

    Its true we can't predict future earnings which is why we must speculate. Speculating on the basis of a one week time frame is difficult. Speculating on a 20 year basis is also crazy in my mind because the odds that any business will be around after 20 years is low. Especially with technology changing the playing field so quickly.

    I think the best way to speculate is with a one year time frame to 6 months. This way you can pick up strong companies who have obviously been beaten down to low relative to their 2 -3 year prospects which are fairly easy to predict.

  • Report this Comment On February 12, 2009, at 2:32 AM, JR119 wrote:

    Lost lots of money on fool advice. Need I say more?

  • Report this Comment On February 12, 2009, at 3:16 AM, rider00 wrote:

    The chart looks at the blue chips relative to S&P and Russell for the past 12 months. However, the bear market started more then 12 months ago... more like 16 months ago. I havent run the numbers, but isnt it likely that these indices fall faster at the onset then the blue chips (i.e. from Q3 2007 to Q1 2008), and the performance over the past 12 months is simply the blue chips catching up?

    I think a more relevant comparison would be the relative declines of the blue chips and indices from their bull market highs.

  • Report this Comment On February 12, 2009, at 11:14 AM, unremitting wrote:

    Stop the analysis of what doesn't work for now (was your childhood always happy?). Forget about the past.

    The Motley Fool is all about making money, not remaining the perpetual student. If you've got a family, you gotta have a job that pays income.

    Take some good option courses that give you monthly cash flow. Simple option strategies ARE making money!

  • Report this Comment On February 12, 2009, at 1:48 PM, Mthirsty1 wrote:

    Why compare any stocks or markets.I have to laugh at how someone can say if you invest in this portfolio you are only loseing 10% a year rather than the other portfolio that is down 15% for the year.No matter what they are both loseing money.I like my stratagey better than any i have read.I shifted 90% of my assets into money markets and i have not lost a dime.Yes i know,i'm not makeing any money,but it sure feels good at the end of the day when the market has dived another 300 points,my portfolio has not.

  • Report this Comment On February 12, 2009, at 1:53 PM, cubanstockpicker wrote:

    if this article is titled death of fundamental analysis, maybe we should also write a few more articles titled "the Death of EMT", "The death of technical trading".

  • Report this Comment On February 13, 2009, at 11:50 AM, bbeerme wrote:

    I must be really slow, because I don't get it. First my disclaimer: I am a relative newby, having only a year or so under my belt.

    Let me get this straight, I'm supposed to put money into this market with a buy and hold strategy? It seems to me that fundamental analysis only works in the proper context.

    It also seems to me that fundamental analysis of any individual companys stock is only applicable to the market it is in. So the first thing to do is a fundamental analysis of the entire market or economy, looking at the big picture first. Once this is done, then you can begin looking at an individual stock.

    And my take on the economy, in a broad sense, is that the fundamentals do not support any sort of a recovery in the fore seeable future. The global economies to not support it. Our current monetary system does not support it. And the agendas within the current newly appointed administration do not support it.

    I would think that any prudent investor would accept the fact we are in a bear market, and that it is more likely than not to stay that way for quite some time to come. Possibly longer than any of us are willing to admit at present.

    In early 2008, Warren Buffet said that we are headed for a depression. And that it would be longer and deeeper than anyone was willing to imagine at the time. This was at a time when the 'R' word was forbidden to be spoken in our main stream media circles.

    Maybe I'm a contrarian, but used properly, I believe fundamental analysis is alive and well. It just doesn't paint a pretty picture.

    Fool on . . .

  • Report this Comment On February 13, 2009, at 3:31 PM, freddyv3 wrote:

    That 20 P/E ratio on every major index is REALLY cheap, especially when you consider that the best experts such as Meredith Whitney and Nouriel Roubini, people who actually have been on top of this financial crisis from the start, say that we have a long ways to go before the deleveraging is through.

    Let's see, earnings dropping by 40% and accelerating downward; a tapped-out consumer; historically high P/E ratios...YES! A BUY IF I'VE EVER SEEN ONE!!!

    Fred Voetsch

    http://www.acclaiminvesting.com/

  • Report this Comment On February 13, 2009, at 8:17 PM, jstreet2 wrote:

    It seems clear from history that technological changes have not been correctly predicted. In 1900, for example, there was a famous proposal to Congress, by the head of the U.S. Patent Office, that the Patent Office be closed down because everything had already been invented.

    We can't really predict the future and we can't know when and if the United States will enter into a serious period of decline as almost every world empire, from the Roman and Greek empires to the French and English to mention only four, have done before.

    It is astonishing to me that so few people take history into account and stupidly assume that recent history will repeat itself.

    That is dangerous nonsense, of course, and any advice based on the history of the past 60 years is doomed to failure.

  • Report this Comment On February 14, 2009, at 12:24 AM, gtav wrote:

    Compete? Dream on.

    I don't believe that any hard worker can get a good paying job.

    How does America compete with chinas an indias 1.3 billion each, slave I mean low cost laborers, 22 cents an hour average,no benefits,no minimum wage laws.

    Everyday, 18 chinaese coal miners are killed. Its cost effective.

    They don't need cars. They live next door to the refinery.

    The way America use to be.

    Toyota, down 50%. However when they annouced there earnings, the worse in there history or hertory, 1937, 5 billion lose, the stock just kept going up in value. Hows that for fundamentials.

  • Report this Comment On February 14, 2009, at 1:00 AM, gtav wrote:

    Last week, I made 650% in 2 weeks on amzn calls.

  • Report this Comment On February 14, 2009, at 2:09 AM, gtav wrote:

    Remember, God or Godess gave to us for free the power of the sun, the planets natural recourses, to be born.

    All god wants is a good show.

    Die with no hate or stupidity in your soul.

  • Report this Comment On February 14, 2009, at 2:10 AM, gtav wrote:

    The planets natural resources.

  • Report this Comment On February 14, 2009, at 3:29 AM, gtav wrote:

    One of these days, the sun is going to explode. This planet will be turned into space dust. All your going to own is your memorys.

  • Report this Comment On February 14, 2009, at 3:55 AM, gtav wrote:

    I have a 4 digit memory. The average is 7.

  • Report this Comment On February 16, 2009, at 11:16 AM, fibreoptik wrote:

    keep signing up for all these things and you will have no money left to invest! :p

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