The essence of technical analysis involves studying of past financial market data to forecast price trends and make an investment decision based on this. Technical analysis only takes into consideration price behavior of the market. Unlike in value investing, technical analysis doesnt care about the value of a company.
What's the use of analyzing past market data when the market is random. There can be a 50% chance of going up and another 50% of going down, why do we still need to study Technical Analysis.
As I explained in the earlier article about how psychology affects investment, investors move in a crowd approach (causing a trend) and this cause support (lowest price point of this trend) and resistance (highest price point of this trend) levels to be formed until something drives the stock higher or even lower.
Technical analysis is useful only if you want to 'predict' short term stock performance. Technical analysis is not so useful in predicting long term stock performance.
In a short run, stock prices are the effects of the actions of investors and , the prices are governed by intrinsic value of underlying business and past price movements and current or future news and rumours affects the decision of investors.
Even though technical analysis is not beneficial in a way to long term investors, i still believe its important to keep an open mind when it comes to investing and to read and learn as much as possible.
To summarise, value investors basically follows the below criterias when identifying potential stocks
1. Undervalued stocks
2. Low Price/Earnings ratio
3. Low Price/Cash flow ratio
4. Low Price/Book value ratio
5. Sound financial statements, low long term debt. The company must have enough cash flow to pay its long term debt with 3 financial years
6. Positive earnings in an upward trend
7. Strong management team and strategy
8. Competitive advantage of a company
How is technical analysis useful to value investors? Value investors can use technical analysis to identity investments who are over speculated. Over speculated stocks are hardly undervalued. They are usually overvalued due to the overcrowded speculation. Now, lets look back at rule number 1 of value investing, to identify stocks that are overvalued and have strong potential.
Now value investing is becoming too popular as its backed by Warren Buffett's success and everyone is learning and using the system of value investing. Do you still think value investing techniques will stick work since there are more people using value investing? I believe it will still work in some extend as we are dealing with long term investment as compared to short term investment. The criterias that we have identified for valued stocks for ways of identifying good companies. Good companies = strong financial potential and growth.
If you have any comments about the future of value investing, do drop me an email at keith@bewarrenbuffett.com More articles available at http://bewarrenbuffett.com