Fundamental Differences

Here we go again. As I said in my recent four-part interview series, it's always the fundamental followers who take time out of their busy schedule of analyzing 10-K's, participating in earnings calls and figuring out the current "PEG," who feel obligated to take a swipe at technicians.

Why do they do this? I don't know. Maybe it's easier to throw rocks than to try to understand something. Or maybe this is what they do for kicks. Or maybe, just maybe, they had a bad year and love to play the zero-sum game. That is: Make everyone else look bad, so they can look better!

Regardless, this tit-for-tat has become an annual event (however, I'm consistently the tatter, never the titter!), so here we go again, with a column by Bill Mann over at The Motley Fool.

Here is Bill's column, with my comments interjected. In the end, use technical analysis or don't use technical analysis, but please, make an informed opinion.

I guess it should not be surprising that many people have short memories. A "What have you done for me lately?" patina colors almost every sector of public opinion: Athletes get hit with it, politicians get it, companies get it. If you're not producing now, you're nothing.

This year the Rule Breaker portfolio, among all of our real-money portfolios, has been shredded by negative sentiment from practitioners and media alike, stemming from its horrid 2000 performance of -50%. Suddenly the proponents of "buy quality at any price" are looking for someone or something to blame, and David Gardner -- with his bubbly, eminently positive view of the stock market -- makes for as good a target as any.

What I find interesting about the witch hunt is two things: First, David stated at the beginning of 2000 that he was comfortable with the prospect that his portfolio (the Rule Breaker is his money) could lose a significant portion of its value over the year; and secondly, that we are seeing from many correspondents that one of the lessons learned from the carnage in 2000 is that investors "ignore the charts at their own peril," or something similar.

GBS: One note, here. Notice how Bill immediately puts skeptics on the defensive by labeling their barbs a "witch hunt." Ever know a witch hunt to be a positive thing? Didn't think so. Especially when the target is a "bubbly, eminently positive" guy!

Technical analysis received a pretty big publicity boost in 2000, given the long, tortuous decline in several sectors popular with individual investors. I think that some of this attribution is faulty: Over the last nine months, those with some money on the sideline inherently did better than most of those who were fully invested. Yep, long-term buy-and-hold sure took it on the chin.

The Rule Breaker has never been advertised as anything but a high-risk portfolio, nothing less than a venture-capital portfolio. Ask any VC and he will tell you that, give or take a few percentage points, he expects more than 90% of his investments to lose money, and that he will actually earn the majority of his returns on 1% of those investments made. This is why "price doesn't matter" for Rule Breakers, because so few are expected to succeed, and those that do will do so brilliantly. It is an aggressive, high-risk way to invest, one to which I would only allocate a small percentage of my capital.

GBS: Fools can weigh in, here. I'm not sure I ever caught the "we're a venture-capital portfolio" designation. But I plead ignorance here.

Using such methodology, of course price is less valid than a firm grasp of how the company expects to make money. I have seen no one yet who has devised a good model for valuing Amazon.com (AMZN Quote - Cramer on AMZN - Stock Picks), except for those who can make a pretty good case that it is zero (and, of course, Paul Commins' YGBFKM methodology). David can speak for himself, but I would like to say that of all of the messages of Fooldom, this one may be the one that has been most poorly communicated and thus misrepresented.

Technical analysis is a simple science: It states that stocks that are in motion tend to stay in motion, that a stock that rose today is more likely to rise tomorrow.

GBS: Well, if you've read one of my columns, you know it's a little more complicated than that, but we'll give Bill the benefit of the doubt.

It is a powerful tonic for those who are terrified by the notion that short-term stock market movements are without rationality.

GBS: Again, notice how the use of the word "tonic" and "terrified" make the person using technicals look like a complete ninny...

Technical analysis allows investors to say, "Ignore the reasons, they are meaningless. Focus on the patterns." The pure technician ignores such basic concepts as stock value, price, or other fundamentals on the belief that the institutional investors leave telltale signs when they are moving into or out of a stock, and that the "smart money" telegraphs its actions by virtue of its sheer size.

GBS: Agree with all, except the ignoring of price. I'm sure Bill meant something else, though.

This is a powerfully attractive theory, and I do not doubt that there are those who can practice it with some success. But these people are not the "average" technical analysts. They are, in fact, few and far between.

GBS: And that would be based on what study, exactly?

Where are the role models?

GBS: A quick read through The New Market Wizards: Conversations with America's Top Traders, reveals many. Buzzy Schwartz, Marty Weinstein, Ed Seykota, Linda Bradford Raschke. Also Paul Tudor Jones hasn't done badly. Yes, some are gone, some have retired, some washed out. But I could make that claim about many, former great fundamentalists also.

One of the chief criticisms of technical analysis is that it has many practitioners, but no true success stories. The Warren Buffett, Ben Graham or Philip Fisher of technical analysis does not exist.

GBS: See above.

Howard Ruff made blunder after blunder. Joseph Granville was extremely influential in the late 1970s, when he had successive years of uncanny calls. In 1982, Granville famously pooh-poohed some of his earlier errors by stating that he had failed to read the charts correctly, and that his system was so foolproof that he would never "make a serious mistake on the stock market in his life."

Soon after, Granville's charts told him that the stock market was going to crash in 1982, and that not only should they sell, they should short. He made the call as the Dow hit 800, but within a year it had risen to more than 1200. This was the beginning of the longest rally in history, and millions of dollars disappeared with Granville's disastrous call. In his wake have come others, such as Elaine Garzarelli -- she of the famous 1987 "The market's gonna crash" call (a good one) and that it would keep falling (less good).

GBS: Hmmm, wonder how many fundamentalists were saying to buy the "crash" of this past April? Sure, Granville got it wrong, but I'm willing to bet the number of fundamentalists who got smoked due to poor market calls over the past 30 years outnumbers technicians 10-fold. Is the bar for technicians such that they have to be right each and every time, while the Julian Robertsons of the worlds are allowed to get a free pass?

And, as long as bricks are being lobbed, it seems to me the negative 50% return posted by the Rule Breaker portfolio works out to be about the same as Granville's 800 to 1200 mistake.

The fact is that there are no truly successful long-term practitioners of technical analysis. Just as every "proof" that exists in investing relies heavily on data mining and thus will never conclusively be proven one way or the other, there is no way that I could claim that technical analysis does not work.

But where are the stars? Where's the massively successful guru whose methods for utilizing technical analysis have worked for decades? Perhaps Warren Buffett is a "six-sigma" individual whose performance is unlikely to be duplicated, but his methods are teachable to a point: "Buy quality at an attractive price. If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes."

GBS: A few thoughts here. One, I've come up with names above. But, apart from that, I'd flip it around. Fundamentalists probably outnumber technicians 1,000 to 1. Maybe 10,000 to 1. Given that, shouldn't there be at least 1,000 more Buffetts? But, where are they?

In addition, The Oracle used to be a buy-and-hold man. I'd argue that he has morphed into more of an insurance conglomerate over the past few years. In fact, his holdings like Coca-Cola (KO Quote - Cramer on KO - Stock Picks) and Gillette (G Quote - Cramer on G - Stock Picks) have been pathetic lately.

And finally, I'd argue that one of the keys to Buffett's success is not his method, but rather his patience at living through huge, huge draw downs. Forget the methodology; it's unlikely many people have his tolerance for pain! So, I'm not sure Buffett is so much a testimonial to fundamentalism as he is to ice-water veins.

This discussion will continue with a second story tomorrow. Check back in the morning for more analysis on technical analysis.