Fundamental analysis

Lesson 2 of 8

How does fundamental analysis work

Rather than having one prescribed, universal method, fundamental analysis can be conducted in a number of ways. However, many analysts tend to use a top-down approach. This begins by considering the wider picture before progressively drilling down into the detail surrounding each market.

Let's have a look at how you might do this. Suppose you're thinking of trading on UK shares - here are some steps you could follow to analyse the market for potential opportunities:

Consider overall economic performance

What is the state of the UK economy, generally?
 
If an economy is in expansion, it's reasonable to suppose that the industries and companies within the country will benefit and see growth in turn. Conversely, if an economy is declining then even successful businesses might suffer.
 
To determine this, you could look at macroeconomic data such as GDP figures, manufacturing output, the Consumer Price Index (CPI), retail sales, house price indices or employment statistics. And of course, you should also consider news coverage and political rhetoric - even if sometimes it has to be taken with a large pinch of salt.

Assess which sectors will be affected

How will macroeconomic factors influence different types of business?
 
When an economy as a whole is expanding, certain industries may benefit more than others. For example, when consumers have more money in their pockets, the services industry tends to enjoy the effects of their increased spending. On the other hand, utilities businesses will usually be largely unaffected.
 
There can also be times when economic expansion has a universally beneficial effect that is felt by most sectors and companies. In this situation, the overall risk in equities could be relatively low and it might be worth considering a strategy geared towards growth. For example, you could focus on a sector such as technology or biotech, as these tend to have a high potential for rapid expansion when conditions are favourable.
 
On the other hand, if an economy is expected to shrink you might decide on a conservative approach, investing in stable companies that are geared towards income. An example would be buying energy or utility stocks.
 
Alternatively, you could aim to capitalise on an expected fall in the markets by going short - a concept we cover in the 'How trading works' course. In brief, this traditionally involves borrowing a stock, with the intention of selling it then buying it back later at a lower price. A more accessible way to take a short position is via a CFD trade, as we explain in the CFD course.

Select a sector to focus on

Which sector has the greatest potential?
 
Having identified some industry sectors of interest, the next step is to consider levels of supply and demand for the products or services in each, and the other factors affecting their future prospects. You could look at the size of the market, its overall growth rate and the sector’s significance in the economy as a whole.
 
For example, let's take the electricity component of the utilities sector. The size of this market in the UK is linked to the size of the population, so it will grow as the number of people consuming energy increases, The sector will always be supported by a certain level of demand for electricity to power everyday activities, however this can also be increased or decreased by the rollout of new technologies. So it's worth considering what innovations might soon hit the mass market.
 
By contrast, the mining sector tends to have a much more variable growth rate, tied to the cost of extracting raw materials from the earth. While new discoveries can provide a significant boost, the sector can also be hit by fluctuations in global demand. Events like a slowdown in China's economy can reduce consumption of raw materials for construction, impacting mining companies.
In the stock market, it's typical to see particular groups of shares moving together in the same direction like this. So for that reason it can be more important to choose the right industry to trade on, rather than simply the right company's share.

Narrow it down

Which companies merit further analysis?
 
Now that you've decided to focus on a particular industry, the next task is to take a closer look at its constituent companies and decide which ones to explore in more depth.
At this point it's important to take stock of the competitive landscape within the sector and any anticipated future business trends. Here are some questions that may help:
  • Which companies have the largest shares of the market?
  • Who is the recognised market leader?
  • Are there any new and disruptive players in the market?
  • Are there any imminent changes or developments that might shake up the hierarchy in the industry?
  • Will any current competitive advantages soon be under threat?
By thoroughly analysing the business environment, you should be able to see which companies have an edge over their rivals. These are likely to be the ones worth investing in, and we'll explain how to delve further into their prospects in the next lesson.

It's worth noting that when you conduct fundamental analysis like this, you should always be 'comparing apples with apples' at each stage. In other words, when looking at a country's economy, you compare it with other countries' economies. When assessing industry sectors, you view them alongside other sectors. And when you come to individual companies, you contrast them with other companies in the same sector. For example, if you were looking at Barclays you'd compare it to another bank, such as HSBC, and not to a retailer like Tesco.

Lesson summary

  • Fundamental analysts generally use a top-down approach
  • First they consider the overall economic picture
  • Then they assess the performance of different sectors and select one to focus on
  • Finally they look at companies within the sector to identify those with potential
Lesson complete