We’re all across the share market folklore. Did you know that the S&P 500 has returned 11% in odd years since 1951 vs. 6% in even years? Are you aware of the adage to ‘sell in May and go away’? Should you bank on the Santa Claus rally? Are you searching for a bullish and bearish engulfing double candlestick pattern?

If that all sounds like nonsense to you, there is another way. There is an investing approach based on the fundamentals of the underlying business. Fundamental analysis is the approach that we favour at Morningstar, and it has a bit of pedigree as it was invented by Ben Graham. It has a celebratory endorsement by none other than Warren Buffett, but most importantly, it is common sense. The premise is simple- since buying a share means taking an ownership stake in a business, it makes a lot of sense to understand that business. Since you are paying for that ownership stake, you should at least try and figure out the approximate value of that business.

My exploration of this topic is front of mind because I’m presenting on fundamental analysis at the ASX Investor Day in Brisbane this weekend, and in Sydney and Melbourne in the upcoming weeks. It is also front of mind because so much of what we hear these days is a mix of fundamental analysis and what can only be described speculative nonsense. You will hear proclamations of the market being cheap and the advantage of investing now because it is a US mid-term election year. We hear that a particular month is traditionally good for shares as part of an analysis of how interest rates impact valuation levels. As we flail about desperately trying to find a sign if it is a good time to buy or sell, we lose sight of what matters over the long-term.

One of the most famous quotes in investing was coined by Warren Buffett when he said, “In the short-term the market is voting machine and in the long-term it is a weighing machine.” He is talking about the fact that day to day share price movements are driven by supply and demand. If there are more buyers than sellers one day, a share price will go up. If there are more sellers than buyers, it will go down. And if you are a short-term speculator, you care a lot about the voting. You are concerned with momentum and clues on short-term moves based on price and volume. There is nothing wrong with speculating on short-term market movements, just like there is nothing wrong with gambling. Both of those things are fine as long as you accept that the vast majority of people will have a poor outcome while only a few will win big. As long as you accept that your goals will remain out of reach.

Fundamental analysis is about the long-term. It is tied to the notion that over the long-term, the driver of investment returns is the performance of the company and the price that you paid for taking an ownership stake in that company. Within those high-level guardrails there are many flavours of fundamental analysis. Investment professionals may opt to build discounted cash flow models where they estimate cash flows into the future, then discount them by the weighted average cost of capital (WACC) to arrive at an estimated value. This process is time consuming, and I know of few non-professional investors that undertake the effort - myself included. Yet other efforts at determining if a share is attractively priced also benefit from a fundamental understanding of the business. A relative valuation measure like the price to earnings ratio (P/E) is meaningless without prospective and context. If the company has a sustainable competitive advantage, or moat, it means that the resulting higher margins and returns on invested capital will accrue to the owners over time - and one of those owners is you. It makes sense that you would pay more for that company.

The biggest advantage that we have as individual investors is the ability to invest for the long-term. The best way to find those companies that deliver for shareholders across the decades is by studying the business and the competitive environment in the industry that it operates. At its core, capitalism is competition, and competition is bad for business. It means lowering prices and investing in better products and services to win market share. All of that is money that doesn’t flow into your pocket as the owner of that business. Think about the types of attributes that allow a business to hold competitors at bay without eroding margins and lowering returns on internally invested capital. It is those companies that will perform in odd years and even years. Midterm election years and non-midterm election years. They will rally with Santa Claus and refuse to go away in May. Those are the companies that are the secret to achieving your goals. Warren Buffett has called on investors to be students of business. So, study up.