We often hear that the fundamental analysis is an outmoded concept; Fundamental analysis is not valid now and it does not function in Nepalese stock market.
Sharesansar got many remarks on "fundamentals analysis is not effective in Nepal Stock Market" so we decided to publish a story on “why it works?” in all the stock market from fast-moving market to the sluggish market.
First, let us understand, what does a fundamental analyst do?
A fundamental analyst observes the financial health of the business by interpreting various financial indicators from the administration of the company to the balance sheet to assure the company sustainability in the country. A fundamental analyst believes that the business should be sustained in the same standard at least for the period of investment.
As of April 2013, 334 companies were listed in NEPSE and as of now, there are less than 200 listed companies in NEPSE. Taking into account the newly added company we can say that more than 134 firms have been delisted in the last five years. Many investors still have the stock ownership certificate of those company but its worth stands at zero.
The market always flows in a trend, for some period there will be an uptrend and for other, there will be a downtrend. During the bull market, even the prices of the undesired stock go high despite the poor fundamentals. A fundamental analyst believes that if the company could sustain up to the bull market then investors can make a profit with the sky-rocketing prices.
The chart below displays the movement of National Hydropower (NHPC) from 2014 to 2018.
During the bull of 2016, the NHPC stock price had increased by over 100% in the period of just 5 months. NHPC stock was not attractive among the investors but still, it manages to gain more than 100 % in the bull market.
Now consider this situation, if I had bought NHPC Stock at Rs 200 before the beginning of the bull market then even in the bull of 2016, I wouldn’t have made any profit.
No one knows the depth of the bearish trend and the bearish market could take the stock price to the lowest. So if the investors lose a majority of the investment capital in the bearish market then even in the bull market they will not be able to recover losses.
Observing the durability of the business is one part of the fundamental analysis and another important part is to buy the stock at the lowest risk price.
Now we will discuss, what is the lowest risk price and how to choose a stock with the lowest risk?
The important thing we observed in the stock market is that the stock market price rarely goes below its book value (net worth). So the investment in the stock with least difference between the market price and book value will carry a comparatively low risk.
But the book value of the company could change in various circumstances. It could increase or decrease and if the book value of a company decrease, the risk associated with investment increases. So it is important to choose a company with higher possibilities of net worth increment.
How to choose a company with the higher possibility of net worth increment?
First, let us understand the meaning of Net worth.
Net worth is the sum of the paid-up capital and reserve & surplus of the company. Paid-up capital usually remains constant or increases which means net worth will decrease only if the reserve & surplus of the company decreases. Now, as the reserve & surplus includes the net profit of the business, the company with higher profitability prospect can maintain and increase the Net worth of the company. The earnings of the company are explained by the different indicators like Net profit, EPS, P/E ratio, EBITDA etc. A profitable company can increase the net worth and the increased net worth implies that the stock price may not go very low during the bearish market.
Just glancing at a profit and Price to book value ratio will not be enough because “how the firm is earning?” is an important factor and for that, we have to interpret the available information of the company in details. Apart from financials numbers, we need to review the company’s management. The fundamental analysis is conclusive in all around the world and it works in every stock market.
The Nepalese stock market is influenced by the bonus and right distribution, so in Nepalese stock market just comparing the price of the same company in two different periods will not be effective. Company A could have been traded at Rs 5000 at once and after 3-4 years the price could drop to Rs 2000 and even with the 60% decrement in stock price an investor can make a profit as the number of shares that were initially owned will increase by the bonus and right share distribution.
The core concepts of Fundamental Analysis are:
To check the durability of the company
To purchase stock with a low P/B ratio, with the belief that the stock price shall not go lower than its net worth value.
To choose the company with a decent earning so that it could maintain its net worth.