Fundamental Analysis Trading Strategy — Insights and Backtest Example

You must have heard about fundamental analysis whether you trade stocks, futures, or forex. Many market pros, such as portfolio managers, hedge fund investors, and investment bank professionals, use fundamental analysis. But what the fundamental analysis strategy actually entails?

A fundamental analysis strategy is a way of evaluating the intrinsic value of an asset and its growth potential. The asset can be a stock, commodity, market index, or currency. The goal of fundamental analysis is to ascertain the asset’s fair market value and how it might move in the future so as to know the direction to trade.

To backtest a fundamental analysis trading strategy is not easy, but we present you with an example at the bottom of the article.

In this post, we take a look at fundamental analysis.

Table of contents:

What is fundamental analysis?

Fundamental analysis is a way of evaluating the intrinsic value of an asset and its growth potential. The asset can be a stock, commodity, market index, or currency. The analysis is based on macro factors (general economy and external events and influences), as well as micro factors, such as financial statements and industry trends.

Fundamental analysis is one of two main ways of analyzing the markets — the other method is technical analysis, which is based on the analysis of price movements on the charts. The key assumptions behind fundamental analysis are as follows:

The current price of an asset, a stock for example, often does not fully reflect the value of the issuing company when the publicly available financial data is assessed.
The value calculated from the company’s fundamental data, the intrinsic value, is more likely to be closer to the true value of the stock.
The stock will, in the long run, move to reflect its fundamental value.

Both the macroeconomic data and company-specific information analysts need for fundamental analysis are public. So, anyone (institutional analysts and retail traders alike) can gain access to the information and use it.

Some of the company-specific fundamental analysis indicators can include revenues, earnings, book value, return on equity, profit margins, future growth forecasts, and price-to-earnings ratios. Analysts also consider qualitative factors, such as a company’s business model, corporate governance structure, the experience of the management, and the competitive landscape.

Fundamental analysis example

Fundamental analysis can be used to evaluate all kinds of assets, such as stocks, bonds, commodities, forex, and even cryptocurrencies. The tools traders use for fundamental analysis vary depending on which asset is being traded. For example, forex traders use the figures released by central banks that allow insight into the state of a country’s economy, while stock traders focus on a company’s earnings report. In this post, we focus on stock trading.

There are various ways of performing fundamental analysis in stock trading, but the approaches are categorized into two:

The top-down analysis model: This method starts by taking a broader view of the economy and the entire market before narrowing down into a sector, industry, and finally a specific company. At the macroeconomic level, a trader studies indicators like the GDP growth rates, unemployment rates, Consumer Price Index (CPI), and interest rates. At the sector and industry level, they look at industry trends and competitors. Coming down to the individual stock, they look at the company’s earnings reports: revenue, earnings per share (EPS), projected growth, or profit margins.
The bottom-up analysis model: This method starts with a specific stock before spreading out to consider all the external factors that can impact the price of that stock, including industry trends, market sentiment, and the state of the economy.

Whichever approach is used, once the trader has determined a numerical value for the asset (the so-called intrinsic value), they can compare it to the current market price to assess whether the asset is overvalued or undervalued.

For example, let’s say a stock is trading at $50, and after extensive research on the company, the trader determines that it ought to be worth $70, and upon that, it has potential for future growth. The trade would buy the stock with the hope that the price eventually trades up, at least, to its actual worth of $70 but can go higher as the company continues to grow.

Note that while some fundamental traders focus more on buying a stock at a discount (lower than its calculated value) and are called value investors, others focus more on the growth potential and can buy a stock even if it is trading above its present value — these are called growth investors.

Fundamental analysis vs. technical analysis

Fundamental analysis and technical analysis are two different ways of analyzing an asset. Technical analysis is based on the belief that every factor that can affect the price of an asset is already priced into the asset’s price at any point in time.

With this belief, all a trader needs to analyze and predict the future direction of an asset is the market chart with past price and volume data. In other words, technical analysis predicts the future price movement by studying previous price movements.

On the other hand, fundamental analysis, as we have stated earlier seeks to understand the intrinsic value of the asset and its potential for growth. To determine that, fundamental analysis studies both the internal and external factors that can affect the value of the asset.

That said, we believe the best approach is by using quantitative analysis. That is what we base our own trading on. We gather data, make a hypothesis, and we test that hypothesis. If the backtest is promising, we make an out of sample backtest.

(If you are new to backtesting we recommend our inexpensive backtesting course.)

Advantages of fundamental analysis

Fundamental analysis helps you understand how a company is run. By going through a company’s financials, you get a clear picture of where its revenue comes from and whether it is making profits.

Essentially, fundamental analysis helps you to gather the right information to make rational decisions about investing in a stock — by basing these decisions on financial data, there is limited room for personal biases.

Limitations of fundamental analysis

Some of the limitations include:

Fundamental analysis is complex and time-consuming. There are many factors to consider.
While it is highly likely that the stock would eventually trade towards its intrinsic value in the long run, no one knows how long that would be — it could take days or years.
The results of the findings are not suitable for quick decisions, so short-term traders who want to know when to enter and exit trades may not like it.
Although fundamental analysis provides a more well-rounded view of the market, newer events, such as negative economic, political, or legislative changes, can surprise markets.

Fundamental analysis trading strategy (backtest)

We base our own trading on quantitative analysis of price data – not fundamental data. However, we have made a course that is solely based on a wide range of fundamental data. We cover topics like these:

Which dividend yield is best?
Which dividend payout has worked best in the past?
What is the best capital allocation? Dividends or buybacks?
What are the best – market-weighted or equal-weighted strategies?
Should you buy small or large caps?
Is it a good idea to invest in spin-offs?
Why do low-volatility stocks perform better than high-volatility (contrary to theory)?
Why do sin stocks perform so well?
Should you buy growth or value stocks?

These are just a few examples of what we cover in the study. To read more or order, please click on the banner below:

List of trading strategies

We have written over 900 articles on this blog since we started in 2012. Many articles contain specific trading rules that can be backtested for profitability and performance metrics.

The trading rules are compiled into a package where you can purchase all of them (recommended) or just a few of your choice. We have hundreds of trading ideas in the compilation.

The strategies are taken from our list of best trading systems. The strategies are an excellent resource to help you get some trading ideas.

The strategies also come with logic in plain English (plain English is for Python traders).

For a list of the strategies we have made please click on the green banner:

These strategies must not be misunderstood for the premium strategies that we charge a fee for:

FAQ:

How does Fundamental Analysis work?

Fundamental analysis evaluates the true value of an asset based on available financial data and market conditions. It aims to predict the future movement of the asset, guiding traders on the direction to trade. The analysis considers both macroeconomic factors and company-specific information.

What are the key assumptions behind Fundamental Analysis?

The key assumptions include the idea that the current price of an asset may not fully reflect the value of the issuing company, and the intrinsic value calculated from fundamental data is closer to the true value of the stock. It is also assumed that, in the long run, the stock will move to reflect its fundamental value.

What are some company-specific fundamental analysis indicators?

Company-specific indicators for fundamental analysis include revenues, earnings, book value, return on equity, profit margins, future growth forecasts, and price-to-earnings ratios. Qualitative factors like a company’s business model, corporate governance, management experience, and competitive landscape are also considered.