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Fundamental, Quantitative or Technical: Investors Need a Style

David Edwards

This column is called Portfolio Manager's Toolbox because my goal is to expand the average investor's repertoire of analytical methods. There's no single tool for building a piece of furniture, and there's no single method for being a successful investor. The best portfolio managers favor a particular style of investing -- whether fundamental , quantitative or technical -- but supplement their primary strategy with tools from the other styles. What kind of investor are you?

Fundamental investors are attracted to a company primarily because of:

• An attractive and unique product or service.

• A talented management team, strong marketing or promising research and development.

• A monopoly position.

• A defensible strategic niche.

• Environmental factors, such as a "paradigm shift" (for example, computer use shifting from mainframe to desktop computers).

Fundamental investors are "tire-kickers." They devour trade magazines, attend trade shows and like face-to-face meetings with company managers. Some have been known to count cars in the company parking lot after 5 p.m. to estimate whether or not engineers are working overtime to complete a project. Fundamental investors often use a top-down approach , first trying to understand economic trends, then looking for companies that will benefit from those trends.

Quantitative investors are attracted to a company primarily because of:

• Low relative and absolute valuations (for example, price-to-earnings , price-to-sales and price-to-book growth ratios that are lower than those of its industry sector and the S&P 500 index).

• High return on equity and return on assets .

• Positive cash flow and cash in the bank.

• High and/or expanding operating margins.

• Historical earnings growth rates higher than those of its industry sector and the S&P 500, and good reasons to expect future earnings to grow faster.

Quantitative investors are "numbers people." They devour quarterly and annual reports. These investors devise computer screens to select companies for further analysis. They develop models to tease out a company's "intrinsic value ." Quantitative investors often have accounting or computer programming backgrounds.

Technical investors are attracted to a company primarily because of:

• A good-looking chart.

• Positive trading volume or money flow characteristics (i.e., investors paying up to get into the stock).

• High relative strength (the rate at which a stock rises or falls relative to other stocks).

Technical investors are trying to anticipate which stocks will be attractive to other investors. Certain indicators are more useful in trending markets (for example, moving averages, such as the 50-day or 200-day moving averages); other indicators are better in trading (trendless) markets (for example, relative strength). Price indicators, in combination with volume indicators, can be particularly useful. Technical investors also follow sentiment indicators such as put /call ratios, and market statistics such as advance/decline lines and new-high/new-low trends.

There are many studies that attempt to prove or disprove the utility of technical indicators. In my practical experience, fundamental factors rule the long term, but technical factors rule the short term.

Why do these distinctions matter? Too many investors take a scattershot approach to stock selection, buying a company because of a tip or because it's their broker's "stock of the week," or because of a knee-jerk reaction to a news item -- not because of any deep understanding of the company and what value it will add to their portfolio. They don't know why some stocks do well and others badly.

How can you improve your investing? Keep a steno pad next to your computer and record what factors you considered when you bought a stock. When a position goes against you, or does really well, try to figure out why and make notes. Over time, you'll find that one of these styles is the primary driver of your decision-making process.

For your weekend research, read some biographies (Peter Lynch's One Up on Wall Street) and histories (Jack Schwager's Market Wizards). In reading about the most successful investors with outstanding track records over a decade or more, you'll see that a certain style dominates. For example, Peter Lynch is primarily a fundamental investor -- he once claimed he got investment ideas from what his wife brought back from the mall -- who follows up with exhaustive quantitative research.

My own firm's research is driven primarily by quantitative screens that reduce the universe of 13,000 stocks down to 250. From these 250, we look for fundamental reasons why a company should continue to screen favorably. In actually assembling a portfolio for a new client, we choose 40 stocks among the survivors that have the best technical characteristics.

After the pullback of the past four weeks, Intel (INTC Quote - Cramer on INTC - Stock Picks) has reappeared on our screens. (The upside of Intel's recent pullback is that its relative valuations are sharply improved.) The fundamentals on Intel are quite compelling -- revenue shortfall or not, no competitor can knock Intel out of its dominant position -- but the technicals on Intel are negative. Money is still flowing out of the stock. We have a small position in Intel now, and when the technicals turn positive, we'll probably buy more.