MONEY MATTERS: Fundamental analysis and security selection

By Jonathan Citrin

CEO, CitrinGroup

With gold, the Dow, and mergers on everyone's minds, it is quite tempting for investors to follow the hot stock or recent headline. Optimistically, both investors and their advisors have a process to follow when selecting investments that is something other than a simple method of fear and greed. Rather than gut instincts or jumping on the most popular trend, those truly looking to beat long-term major market performance better have more than reactive hope. To that, with many methods of portfolio construction available, one might select an oldie but goodie: fundamental analysis. Fortunately, at its core are principled methods built on good sense and process. Unfortunately, fundamental analysis is one of the most difficult forms of portfolio construction due to quickly changing conditions and our ever-present propensity for subjectivity. To adequately carry out this perilous endeavor and attempt to succeed where most others fail, an investor must take a brutally honest look at current market conditions and be prepared to trust their process, even if it goes against the grain.

Absolute honesty

Today, professional and novice alike are overwhelmed with information. Everyone is clued-up instantly on changes in unemployment, corporate profits, and protests in Egypt and Libya. We all know what is going on around us, perhaps too well. And, we all have notions of how the world will affect our portfolios. As a result of today's information landscape how many of us take an actual honest, brutal look at economic conditions without any bias? Not many.

In the hierarchical order of evaluation, practiced fundamental investors often begin an analysis with macro (the economy) and end with a security (an individual asset). Much more difficult to execute than it seems, an important and frequently forgotten element in this top-down approach to selection is simply having an impartial large-scale view of economic trends and conditions. Unknowingly, we view things through a jaded lens-too focused on a particular detail or experience to see the big picture. To best assess the situation, we must not only be aware of the world, but do so in a non-judgmental and pure way. Investors must clear their mind of political opinions, rid it of paradigms and erase the compounding effects of yesterday.

A brutally honest view of our existing environment finds many forces -- positive and negative. Currently, unemployment is stuck near double-digits (albeit moving down slowly), the political environment is polarizing, housing prices are severely depreciated, the national debt is strikingly high and still growing, inflation is a reality in nations around the world and a viable threat in ours, the future landscape in the Middle East is wholly unknown, and Europe is anything but stable. Our lives are filled with realities that are potentially fatal to a portfolio.

However, one must also recognize the positive momentum underway. Corporate profits are rising, asset purchases and stimulus are working, policy makers are determined to help small businesses and reduce government spending, tax extensions created a respite from uncertainty, U.S. markets are amidst an unprecedented bull run, and investor sentiment is high and still appreciating.

Like anything, there is good and there is bad. From a financial perspective, is it bull, bear, neither, both? Perhaps more than ever, our abundance of information creates a world seemingly unable to be navigated. Nonetheless, to eventually select an investment primed to perform, one must take an objective stance.

Abandon 'Groupthink'

As difficult an undertaking presented in attempting an honest economic analysis, acting on your findings will prove more challenging. After impartially concluding the overall direction of markets, time has come to pick an actual security to invest in. That is, just as you analyzed the major economic trends, your same unbiased attention turns to finding an asset that will benefit if your analysis hold true.

As you approach this important decision, vital to note is a major deficiency in the construction of any portfolio- our tendency to follow the masses. Safety in numbers only works when the heard is acting with instinctive sanity. In investing, your instincts are your worst enemy. Perhaps misery does like company, but a savvy investor prefers long-term outperformance. Being part of a heard that is constantly migrating in the wrong direction is not a group worth belonging. Thus, trusting your economic research and findings, you must identify the proper investment regardless of what others are preaching.

Finally armed both with knowledge and understanding, your selection begins. Perhaps your view sees inflation and economic turmoil on the horizon, making commodities such as gold attractive over volatile equities and inflation-unprotected fixed income. Alternatively, your insight may find global demand mixed with political turmoil to make oil attractive. Or, quite possibly, calmer domestic conditions and a friendlier Washington could lead you to find Corporate America a boom.

The key to successful investing, including fundamental analysis, is not in the actual outcome, rather within the objective method itself. Subjectivity and marginalized performance are in abundance in today's markets. Salesmen can be found on both ends of most transactions. We want what we cannot have and the "good stuff" is always hard to acquire. But remember, though gold, the latest IPO, or newest headline may seem worth fighting for, objectivity in finance is the scarcest commodity of all.

Jonathan Citrin is founder and CEO of CitrinGroup, an investment advisory firm located in Birmingham. He is an adjunct professor of finance in the School of Business at Wayne State University. Contact him at (248) 569-1100 or jcitrin@citringroup.com.

Published: Thu, Mar 10, 2011