Fundamental Analysis Trading Strategy — Insights and Backtest Example

You must have heard about fundamental analysis whether you trade stocks, futures, or forex. Many market pros, such as portfolio managers, hedge fund investors, and investment bank professionals, use fundamental analysis. But what the fundamental analysis strategy actually entails?

A fundamental analysis strategy is a way of evaluating the intrinsic value of an asset and its growth potential. The asset can be a stock, commodity, market index, or currency. The goal of fundamental analysis is to ascertain the asset’s fair market value and how it might move in the future so as to know the direction to trade.

To backtest a fundamental analysis trading strategy is not easy, but we present you with an example at the bottom of the article.

In this post, we take a look at fundamental analysis.

What is fundamental analysis?

Fundamental analysis is a way of evaluating the intrinsic value of an asset and its growth potential. The asset can be a stock, commodity, market index, or currency. The analysis is based on macro factors (general economy and external events and influences), as well as micro factors, such as financial statements and industry trends.

Fundamental analysis is one of two main ways of analyzing the markets — the other method is technical analysis, which is based on the analysis of price movements on the charts. The key assumptions behind fundamental analysis are as follows:

  • The current price of an asset, a stock for example, often does not fully reflect the value of the issuing company when the publicly available financial data is assessed.
  • The value calculated from the company’s fundamental data, the intrinsic value, is more likely to be closer to the true value of the stock.
  • The stock will, in the long run, move to reflect its fundamental value.

Both the macroeconomic data and company-specific information analysts need for fundamental analysis are public. So, anyone (institutional analysts and retail traders alike) can gain access to the information and use it.

Some of the company-specific fundamental analysis indicators can include revenues, earnings, book value, return on equity, profit margins, future growth forecasts, and price-to-earnings ratios. Analysts also consider qualitative factors, such as a company’s business model, corporate governance structure, the experience of the management, and the competitive landscape.

Fundamental analysis example

Fundamental analysis can be used to evaluate all kinds of assets, such as stocks, bonds, commodities, forex, and even cryptocurrencies. The tools traders use for fundamental analysis vary depending on which asset is being traded. For example, forex traders use the figures released by central banks that allow insight into the state of a country’s economy, while stock traders focus on a company’s earnings report. In this post, we focus on stock trading.

There are various ways of performing fundamental analysis in stock trading, but the approaches are categorized into two:

  1. The top-down analysis model: This method starts by taking a broader view of the economy and the entire market before narrowing down into a sector, industry, and finally a specific company. At the macroeconomic level, a trader studies indicators like the GDP growth rates, unemployment rates, Consumer Price Index (CPI), and interest rates. At the sector and industry level, they look at industry trends and competitors. Coming down to the individual stock, they look at the company’s earnings reports: revenue, earnings per share (EPS), projected growth, or profit margins.
  2. The bottom-up analysis model: This method starts with a specific stock before spreading out to consider all the external factors that can impact the price of that stock, including industry trends, market sentiment, and the state of the economy.

Whichever approach is used, once the trader has determined a numerical value for the asset (the so-called intrinsic value), they can compare it to the current market price to assess whether the asset is overvalued or undervalued.

For example, let’s say a stock is trading at $50, and after extensive research on the company, the trader determines that it ought to be worth $70, and upon that, it has potential for future growth. The trade would buy the stock with the hope that the price eventually trades up, at least, to its actual worth of $70 but can go higher as the company continues to grow.

Note that while some fund