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Understanding Fundamental analysis

Fundamental analysis applied to the sharemarket is a method of assessing whether a company is a good investment using information from various sources such as financial statements, company announcements, disclosures and economic and industry reports.

It is an academic approach and considers the overall economy, the industry in which the business operates and the Financial Health of the company. Fundamental analysis looks at both 'quantitative' data (eg. revenue growth, margins and financial ratios) and 'qualitative' data (eg. management strength, market position, patents and proprietary technology).

Under this method, the company's valuation is based on past performance, industry trends, growth potential management and competition. Unlike the Efficient Market Theory (EMT), which says that all information is already reflected in current prices and therefore cannot be predicted, fundamental analysis believes that an intrinsic value may be derived and that investors can profit by buying 'undervalued' shares and, where short selling is allowed, selling 'overvalued' shares.

'Undervalued' shares are those that have a higher intrinsic valuation compared to the current market price. Conversely, 'overvalued' shares are those with intrinsic valuations less than the current market price. The assumption here is that in the long run, shares will move towards the intrinsic valuation or the 'correct price'.

'Top-down' and 'bottom-up'

There are two approaches to conducting fundamental analysis: top-down and bottom-up. Both have their strengths and weaknesses and both have the same goal of choosing the best companies for investment. The important thing is to use the approach that you are comfortable with and which suits your investment style.

The bottom-up approach starts from the individual company before proceeding to the general economic and market conditions. Advocates of this approach such as Warren Buffett, Peter Lynch and Benjamin Graham primarily look for companies that are financially healthy, have a strong track record of earnings growth and good prospects. The general idea behind this is that there are the companies that can deliver profits in any market environment and thrive even under difficult conditions. Industry and macroeconomic factors are then considered, but are only secondary under this approach.

On the other hand, the top-down approach, as the name suggests, begins from the macro level (general or broad) and ends at the micro level (specific). Under this approach, one first looks at the global market conditions, then drills down to the state of a country's economy, then a specific sector and finally an individual company.

Lincoln applies a bottom-up approach to its fundamental analysis as we believe picking the best companies on the Australian Securities Exchange (ASX) gives you the best chance of outperformance over the long term.