Security Analysis: Technical vs. Fundamental Methods

TAKEAWAYS:

• Technical analysis predicts price trends using historical market data and chart patterns, while fundamental analysis evaluates intrinsic value via financial statements and macroeconomic factors.
• Technical analysis relies on indicators like moving averages, RSI, and Fibonacci retracements, whereas fundamental analysis uses ratios like P/E, EV/EBITDA, and DCF models.
• Nepal Stock Exchange (NEPSE) traders use both methods: technical analysis for short-term trading (e.g., Daraz’s stock volatility) and fundamental analysis for long-term investments (e.g., Ncell’s debt-to-equity ratio).
• Industry analysis involves comparing sectors (e.g., banking vs. tourism) using Porter’s Five Forces or PESTEL frameworks to identify growth potential.
• Technical analysis is subjective and reactive, while fundamental analysis is objective but slower to adapt to market changes.
• Both methods are used in margin trading (Unit 10) to justify leverage decisions, but technical analysis is riskier for inexperienced traders.

1. Introduction to Security Analysis

Security analysis is the process of evaluating investments (stocks, bonds, derivatives) to determine their value and potential returns. It splits into two broad schools:

• Technical analysis: Studies price and volume trends to forecast future movements.
• Fundamental analysis: Assesses intrinsic value using financial and economic data.

Both methods are used by traders on NEPSE, brokers at Khalti, and even Pathao drivers (who analyze ride demand like supply-demand trends).

2. Technical Analysis: Tools and Techniques

Technical analysis focuses on price action and volume to identify patterns. It assumes markets discount all known information into prices.

Key Concepts

• Trend: The general direction of a security’s price (upward, downward, or sideways).
• Support/Resistance: Price levels where buying/selling pressure accumulates.
• Candlestick Patterns: Visual representations of price movements (e.g., hammer, shooting star).
• Indicators: Mathematical tools to identify trends or reversals (e.g., Moving Averages, Relative Strength Index (RSI), MACD).

How It Works

1. Chart Patterns: Recognize shapes like head-and-shoulders, triangles, or flags.

   flowchart TD
     A["Uptrend"] --> B["Breakdown below support"]
     B --> C["Bearish reversal"]
     C --> D["Sell signal"]

2. Moving Averages: Smooth price data to identify trends (e.g., 50-day vs. 200-day MA crossover).
3. RSI (Relative Strength Index): Measures overbought/oversold conditions (14-period default).
   • RSI > 70 → Overbought (potential sell).
   • RSI < 30 → Oversold (potential buy).

Example: Daraz Stock Volatility

• Scenario: Daraz’s stock (if listed) might show a downward trend with declining volume, signaling weak investor confidence.
• Technical Tool: A bearish engulfing candle on its daily chart could trigger a sell signal for short-term traders.

Advantages & Disadvantages

3. Fundamental Analysis: Valuation Methods

Fundamental analysis evaluates a security’s intrinsic value by analyzing:

• Financial statements (income, balance sheets, cash flows).
• Industry and macroeconomic trends.
• Management quality and competitive advantage.

Key Ratios and Models

Industry Analysis

Investors compare sectors using frameworks like:

• Porter’s Five Forces: Analyzes competition in industries (e.g., NEPSE’s banking sector vs. tourism).
• PESTEL Analysis: Political, economic, social, technological, environmental, legal factors (e.g., Nepal’s remittance dependency affecting banks).

Example: Banking vs. Tourism in Nepal

• Banking (e.g., NMB) is stable but faces low interest rates.
• Tourism (e.g., hotels like Hyatt) is volatile but high-margin.

4. Comparing Technical vs. Fundamental Analysis

5. Practical Applications in Nepal

Real-World Example 1: NEPSE Margin Trading (Unit 10 Tie-In)

• Scenario: A trader buys Ncell stock on margin (50% leverage) using technical analysis (e.g., RSI > 70 signals overbought).
• Risk: If Ncell’s stock drops 10%, the trader loses 50% of their margin (due to leverage).
• Fundamental Check: Before margin trading, they should verify Ncell’s debt-to-equity ratio (fundamental analysis) to ensure solvency.

Real-World Example 2: Kathmandu Traffic Routes (Analogy)

• Technical: Like traffic cameras predicting congestion (e.g., Ring Road jams at 5 PM).
• Fundamental: Like analyzing road capacity (lanes, signal timings) to reduce bottlenecks (e.g., widening Ring Road).

6. Exam Tip: How to Score Full Marks

1. Differentiate Clearly:
   • Start with definitions (e.g., "Technical analysis is price-based; fundamental is value-based").
   • Use a table (like above) to compare methods.
2. Apply to Nepal:
   • Mention NEPSE, Ncell, or Daraz in answers (examiners love local relevance).
   • Example: "Technical analysis is used by short-term traders on NEPSE to spot breakouts, while fundamental analysis is used by institutional investors to buy Ncell’s shares at a discount."
3. Show Worked Examples:
   • For industry analysis, pick a Nepalese sector (e.g., tourism) and apply PESTEL.
   • For technical analysis, describe a candlestick pattern (e.g., "A shooting star on Ncell’s chart signals a reversal").
4. Link to Other Units:
   • Margin trading (Unit 10) often uses technical analysis for entry/exit points.
   • Capital market efficiency (Unit 6) debates whether fundamental analysis still works in efficient markets.
5. Avoid Common Mistakes:
   • Don’t confuse technical analysis with chartism (they’re the same).
   • Don’t ignore risks (e.g., overfitting in technical analysis or ignoring macro risks in fundamental analysis).

In the Real World

1. Khalti’s Payment Processing:

   • Technical Analysis: Khalti’s app uses real-time transaction volume data to predict peak hours (e.g., 6 PM) for server scaling.
   • Fundamental Analysis: Khalti’s management reviews Nepal’s GDP growth to forecast remittance inflows (key revenue source).

2. NTC’s Infrastructure Projects:

   • Fundamental Analysis: NTC evaluates Nepal’s telecom market size (PESTEL) before expanding 5G coverage.
   • Technical Analysis: NTC monitors traffic data on its fiber-optic network to optimize bandwidth allocation.

3. Daraz’s Inventory Management:

   • Technical Analysis: Daraz’s algorithms track order volume spikes (e.g., during festivals) to adjust warehouse staffing.
   • Fundamental Analysis: Daraz analyzes Nepal’s e-commerce penetration (fundamental) to decide whether to enter new districts.

Worked Example: Valuing Ncell Stock (Fundamental Analysis)

Given:

• Ncell’s P/E ratio = 20.
• Industry average P/E = 15.
• Ncell’s EPS = ₹1.20.
• Discount rate = 12%.

Steps:

1. Calculate Fair Value:

   • Fair P/E = Industry average = 15.
   • Fair price = EPS × Fair P/E = ₹1.20 × 15 = ₹18.
   • Current price = ₹20 → Overvalued by ₹2.

2. DCF Projection (Simplified):

   • Project Ncell’s free cash flows for 5 years, discount at 12%, and sum terminal value.
   • Example projection:

     Year | FCF (₹) | PV Factor (12%) | PV (₹)
     1    | 0.8     | 0.893           | 0.71
     2    | 1.0     | 0.797           | 0.80
     3    | 1.2     | 0.712           | 0.85
     4    | 1.5     | 0.636           | 0.95
     5    | 1.8     | 0.567           | 1.02
     Terminal Value (Year 5) | 2.5 / (12% - 5%) = 37.5 | 0.567 | 21.3
     Total DCF Value = 0.71 + 0.80 + 0.85 + 0.95 + 1.02 + 21.3 = **25.63**
     

   • Implication: Ncell’s stock is overpriced at ₹20 (DCF suggests ₹25.63 is fair).

Visual Summary: Security Analysis Workflow

flowchart TD
    A["Start: Define Investment Goal"] --> B{"Technical or Fundamental?"}
    B -->|"Technical"| C["Analyze Charts/Indicators"]
    C --> D["Identify Patterns (e.g., RSI, Moving Averages)"]
    D --> E["Predict Short-Term Moves"]
    B -->|"Fundamental"| F["Review Financials & Industry"]
    F --> G["Calculate Ratios (P/E, EV/EBITDA)"]
    G --> H["Estimate Intrinsic Value"]
    E --> I["Trade Based on Signals"]
    H --> I
    I --> J["Monitor & Adjust"]