To judge from the record of professional investors presented in chapter 1, fundamental research has been no more successful than technical analysis. This seems strange, because the fundamental school appears to build on a much more solid foundation. Graham and Dodd, always skeptical of growth techniques, gave good reasons why this branch of analysis may not work. The first problem lies in the nature of the analysis itself. They believe that a forecast based on the measurable earnings power of the past is more secure than one built on extrapolated trends of growth. Such projections can be chancy, they repeatedly warn, even for prime growth companies. Then, too, for every real growth stock, dozens will fade in the stretch, if not at the gate.
The second problem with growth investing is that, even with accurate analysis, the question remains of what the proper P/E should be. It didn't take a genius in the 1920s to realize that the automobile would be a growth industry for decades. If anything, investors underestimated the industry's expansion. But that didn't help the analyst pick the three or four survivors from the hundreds of promising companies. Packard, Nash, Stutz-Bearcat, Duesenberg, Studebaker, and dozens of others were formidable competitors in their day. Internet companies now present a similar jungle of possibilities. Scores of companies contend for this rapidly growing market, many with state-of-the-art technology. Which will survive? What price shall we pay for their prospects?
The third problem is: a rapidly growing company can trade at a P/E ratio of 40 or 50, then drop to 25 or even 15 as investors change their minds about its value. This happened to biotech stocks in 1993 and 1994. It also happened to Ascend Communications and 3Com in July of 1996. These stocks fell 45% or 50%, as perceptions went negative. In little more than a heartbeat, they turned positive again and the stocks regained most of their losses within six weeks.* Evaluation, then, is just as difficult as forecasting.
* But not for long. Ascend dropped over 70% again by late 1997 on disappointing prospects.
An even more troublesome question: Why have the conservative proponents of the Graham and Dodd model not outperformed, or even kept up with, the market as a whole? First, standard analysis increasingly emphasizes near-term outlooks while downplaying other key fundamentals, thus abandoning one of Graham's key principles. Forecasting is the most important factor in contemporary securities analysis. As we shall see in chapter 5, research analysts forecast poorly. Chapter 5 also demonstrates that even a moderate miss can devastate a stock's price.
Second, although certain issues may be substantially undervalued, there is no guarantee that the market will recognize it. The stocks may linger in the dumps for years.
Warren Buffett gave a third reason. He said he consistently applied fundamentals that "others cavalierly disregarded." But were they disregarded? Or were their adherents forced by weaknesses in the methods to abandon them, most often involuntarily? Part II will examine this question in some detail. Meanwhile, let's look at methods born of mixed fundamental and technical lineage: market timing, tactical asset allocation, and momentum.
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