The Limits of Fundamental Analysis

With my investment approach, I try to be as rational as is possible. If things had never worked out for Mr. Spock at Star Fleet Academy, he probably would have made a decent money manager. Sure, some work would have been needed on client relations, but you get my point. Still, it’s amazing to me how irrational people can be when they go about investing their money.

Being a rational investor, I rely on a great deal of numbers. But here’s the tricky part: even numbers can be deceiving. I’ve discussed this many times before. For example, your classic P/E Ratio doesn’t always work well with cyclical stocks. In fact, the market’s P/E Ratio is often elevated during the early phases of a bull market.

Also, not all earnings are created equal. When a company borrows money, they’re sacrificing near-term earnings for (hopeful) long-term success. Companies that have high assets relative to their profits tend to report ersatz earnings. Or a company with significant equity exposure in an overvalued stock will have its return-on-equity distorted.

All of these issues can confuse the job of attaching a proper valuation to a stock. I rely on numbers because that’s all I have. If I had prices ten years from now, I’d surely go on those. Because I don’t, I’m left with a bunch of flawed statistics. The hard part is knowing what’s flawed. But even fundamental analysis runs up against its own limitations.

I’d say there’s about 10% of stocks, maybe even just 5%, where fundamental analysis is totally useless. Take Tesla ($TSLA) for example. By any conventional metric, the stock is absurdly overvalued. Unfortunately, I’m not considered a genius for pointing that out. Everyone knows that. The reason is that conventional metrics don’t work on unconventional stocks. If a technology comes along which changes the entire ballgame, all those ratios go out the window.

Consider the case of Amazon.com ($AMZN). At its peak during the tech bubble, the stock was going for a ridiculous valuation. As it turns out, the stock was actually cheap. Since the turn of the century, Amazon has greatly outperformed the S&P 500. AMZN has more than tripled while the S&P 500 has had meager returns. The reason is that Amazon was a new business that changed the marketplace. Valuation didn’t tell you that.

How should someone have valued Eastman Kodak twenty years ago? The stock was a long-recognized stalwart of American business. It was a classic Nifty 50 stock and it paid a good dividend. As late as 2007, shares of EK were over $30. While all seemed calm on the surface, the company was quickly being made obsolete. Today, a share of EK goes for three cents. The dynamics changed and just by following the numbers, you would have been left in the dust.

I live in Washington D.C. and you can see the beautiful canal that runs through Georgetown. Where the canal hits the Potomac is the water’s gate hence the name of the Watergate complex and all the “scandal-gates” that followed.

What impresses me is that the canal was an astounding feat of engineering. It took a lot of men and a lot of money to dig this thing. Yet as soon as the canal was built, it was economically obsolete. The canal was done in by the railroad. The entire effort turned out to be a waste of time and money. This is the process of Creative Destruction identified by the economist Joseph Schumpeter. There’s always some innovation going on somewhere that threatens to upend the entire game, and fundamental analysis won’t see it coming.

Posted by Eddy Elfenbein on September 4th, 2013 at 1:17 pm

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