When it comes to technical analysis, or ‘charting’ as it’s otherwise known, investors mostly fall into one of two camps: those who embrace technical analysis and those who are staunchly against it.
I’m a big fan of technical analysis, as I’ve seen the benefits from being able to properly analyse charts.
That said, I don’t consider myself to be a technical ‘trader’. That is someone who buys and sells stocks using only patterns on a chart as a guide, having no regard for the company’s operations, its history or business potential, or the industry it operates in.
I prefer to use charts as more of a backup tool.
When analysing a potential investment, my first line of analysis involves identifying companies that meet each of my eight criteria. Let’s call them fundamental criteria.
I won’t give them all away today — they are detailed for members of the Australian Investors Club. But they cover things like having a history of rising earnings, a quality management team, the ability to respond to threats and challenges, low levels of debt, and the stock not being too expensive.
Only after I have identified a company that ticks all eight boxes will I move on to analyse its share price chart. I use a series of technical indicators that point to the share price rising over the medium to longer term.
This gives me confidence that I’m recommending a stock that, all else being equal, is more likely to rise.
Of course, there’s no absolute right way to invest. And there are many investors who don’t see chart patterns as being important. Some have the view that if a quality company is selling for a cheap price, then it’s a buy. It doesn’t matter what its charts are saying.
However, this strategy can see you hold on to a stock while it falls all the way to its bottom, before the market (hopefully) recognises its value and its share price then moves higher.
It’s worth having a more open attitude. Even ‘value investors’ ― that is someone who looks for companies with beaten down share prices they can buy for a bargain — can add technical analysis to their toolkit. It can help you identify when it is a good time to buy, or to sell, an investment.
Take a look at the following chart of property developer Stockland Group [ASX:SGP]. In hindsight, would you rather have bought at point A or at point B…or does it even matter?
Source: Yahoo! Finance
You might think that it doesn’t matter. If it’s a quality company with promising long term prospects, it’s a good investment either way. At either time you would have paid $3.50 per share, for a 28% gain today.
But, if in mid-2011, you were able to predict that the price was likely to fall, you could have had your money invested in something else and avoided riding Stockland to the bottom.
I’d prefer to have bought Stockland in October 2012, when its share price was rising.
Of course, I’m ignoring the gains from dividends in this example. But other than that, waiting for a share price to hit its bottom then rise back to that level is idle time. You could have your money working better for you in a rising investment.
In this example, there were technical indicators available that suggested Stockland’s share price was likely to fall in mid 2011 and to continue rising in late 2012.
Anyone can add some simple technical analysis tools to their arsenal.
But it is important that you keep emotion out of your analysis. You can often find evidence, in the form of charts signals, that confirms your already held beliefs, or hopes.
There are thousands of different signals you can choose from. This gives you options but can be overwhelming and some will give conflicting signs. And it leads to the problem of selecting those that confirm your existing biases.
Let’s say I analyse a company using my eight criteria and everything looks great on that front, so I move on to take a look at its charts.
Some of the indicators might suggest it’s in a long term downtrend, but then other indicators fail to confirm this trend and suggest the stock is beginning to turnaround.
Given that I had earlier concluded that it was a good investment — having not yet looked at the charts — I might be tempted to believe the signals that confirm it’s the right time to buy.
It would be tempting to ignore the signals that don’t support my earlier view that it’s a buy.
The best way to deal with this is to be consistent in the tools that you use. They don’t have to be overly complicated. You don’t need to filter through the hundreds of technical indicators and signals available for every stock.
What’s important is that you keep your emotions out of it. In fact, possibly the most important thing to do in technical analysis is to decide which indicators you will use and stick to them.
In the coming weeks, I’ll demonstrate some simple tools to help get you started.
Investment Director, Australian Investors Club