Theory

The stock investment process looks considerably different depending on the investor’s belief about market efficiency. The discussion in the academic literature about whether the stock market is efficient or not is endless long and the conclusions differ.2 Based on the belief in the degree of market efficiency, two major investment theories emerged that still separate the financial community. On the one hand is fundamental analysis based on the idea of non-efficient markets and on the other hand modern portfolio theory (MPT) with a strong faith in market efficiency.

Fundamental Analysis

Fundamental analysis is an investment approach that uses existing economic information, such as historical financial statements or different fundamental information about a company, to make investment decisions. The principles of fundamental analysis were first outlined in the book ‘Security Analysis’ of Graham and Dodd (Graham and Dodd, 1934). Two approaches to fundamental analysis are widely used today: the ‘Top down’ and the ‘Bottom up’ approach. The idea behind the ‘Top down’ approach is to use all information available, including macroeconomic data, to make an investment decision. In general, fundamental analysts look first at the current macroeconomic conditions, because for them the decision to invest depends mainly on what stage of the business cycle the economy is heading and which industry is expected to perform well in the forecasted economic environment. Then analysts try to find the best companies in these industries. The stock selection process is based on the idea that the stock of the selected company must outperform its peers in the industry and the industry must outperform other industries. The top-down approach is widely accepted and followed on Wall-Street and well documented in investment textbooks. Investment strategies based on that approach include sector rotation (changes in the sector allocation based on changes in the economic environment) and style investing (the differentiation between value and growth stocks).

In contrast to the top-down approach, the ‘Bottom-up’ approach to fundamental analysis does not attempt to forecast the economic environment. It consists mainly of estimating the value of a stock and comparing it to its current market price. If a stock is significantly undervalued, it is considered a buying candidate independent of future market or macroeconomic conditions. The proponents of this approach try to find good companies that are selling at a low price in relation to their fundamentals. Mainly because academics feel uncomfortable ignoring some important available information, the bottom-up approach is less of a focus in textbooks and empirical research and therefore also known as the practical approach to investing.

Although we know of no academic study comparing the empirical validity of the top-down and bottom-up approach to fundamental analysis, it seems that the bottom-up approach produced the most profit for its followers (Buffet, 1984). Forecasting the economy has been proven to be a very difficult task that rarely produces satisfactory investment returns. The most common mistake in the top-down approach is however that investors focus on companies rather than on stocks. Investors must recognize that a good company is not necessarily a good investment. The stock selection process should always be based on a comparison between the intrinsic value of a stock and its current market price. Investors must thus determine whether a stock is under- or overvalued based on the fundamentals of the business. Only when value exceeds price by a high enough margin of safety should a stock be bought.?

Modern Portfolio Theory

Modern portfolio theory (MPT) is based on the idea of efficient markets. The underlying

philosophy of this investment theory is that all investors in the marketplace are intelligent, profit-oriented and are trying to find mispriced stocks. The large number of informed participants will ultimately drive a stock price to its intrinsic value and hence create an efficient market. In such an environment mis priced stocks would be detected immediately, the under- or overvaluation would disappear and no profit could be gained from using any form of investment analysis. In other words, the MPT states that all stocks are priced fairly and nobody can persistently outperform the market. Consequently, followers of this method of investing will try to reduce risk by diversification and costs by minimizing transaction fees and taxes. The 6 optimal investment strategy is the creation of an efficient portfolio based on covariance’s of all the stocks in the global marketplace. In praxis however, this strategy usually means investing in index funds.

As far as we know, modern