Two common methods of sorting and selecting stocks are fundamental and technical analyses. It’s a personal choice how and when you use each, but they both have their strengths.

Fundamental analysis aims to identify stocks with strong growth potential and a reasonable price. It does this by looking at the company’s business, the conditions in its industry, or the overall economy. Investors have used fundamental analysis for long-term investments, using metrics such as earnings per share (EPS), the price-to-earnings ratio (P/E), P/E growth, and dividend yield.

Technical analysis, however, ignores the fundamentals of a company and looks instead for statistical patterns in stock charts which could predict future price and volume movements. Stock prices are already a reflection of all publicly available information, so it’s not necessary to read through a company’s income statement, balance sheet or other financial data. Technical analysis has traditionally been used for short-term trades because it focuses on volume and price movements.

Does it always have to be either/or?

What type of analysis is best for you?

Fundamental and technical analysis both reveal valuable information. Focusing on one type of analysis could lead you to miss out on important clues regarding a stock’s prospects. Considering that the duration of a trade or investment may vary, you should consider using both types of analysis.

Why not combine their strengths? A trader could, for example, use fundamentals in order to choose the stock candidate, while technicals would be used to determine a specific price at which to enter or exit.

Growth Investor’s Strategy

Growth Investors concentrate on the prospects of an individual company. In general, corporations are built to grow. They also want to make a profit and eventually give some of this profit back to their shareholders. Few new companies are profitable immediately. Growth investors might still consider a company that reports a strong revenue increase in the early stages, even if they don’t make a profit. Investors may accumulate stock when they decide that a young firm has a compelling competitive edge or an innovative product. This tends to drive the price up. Stock prices are likely to increase as more investors join the party. When buying shares in relatively new companies, these investors tend to focus on metrics such as a company’s projected and historical revenue growth rates.

Value Investor’s Strategy

Value investors focus their attention on whether or not the current stock prices make sense, given the health and performance of a company. They typically look for companies that are priced lower than what their revenue, earnings per share, or other metrics would suggest. These investors tend to focus on companies that are industry leaders and have generally passed their peak years of revenue growth as they pay steady dividends. Value stocks usually have lower P/E and higher dividends. However, they can be traded at prices that are below or very close to their book value. Value investing can be described as buying great companies for a reasonable price. It is not just about buying cheap stocks.

Screening to determine growth or value

Schwab clients may use a stock-screening tool under Research to help narrow down a large collection of stocks into a manageable selection of growth or value candidates.

Consider focusing your screening on stocks that are rated A or B by Schwab Equity Ratings (r), as these are “buy” candidates compared to other securities (C-F). This step narrows down the possible stock list from 2,800 to only 814.

Growth Screening

Schwab Equity Ratings takes into account many fundamental factors, so investors looking for growth stocks can look at stocks that have shown strong revenue growth and are expected to continue doing so in the future. Selecting these criteria reduces the 814 candidates in the following example, which screens for a minimum of 25% revenue growth during the past three years.

Value Screening

When searching for value stocks, you can also use other metrics. A simple method would be to look at those that:

• Dividend yields above average (but not excessive)
• Low P/E Ratio
• The price that is lower than the book value of a company

Selecting these three criteria reduces the list from 814 to 25 in the example below.

Be cautious when searching for stocks with high dividend yields. They may be too good to be true. A cheap stock price does not necessarily mean that the company is undervalued. Low stock prices can be a result of outdated products, poor management, expired patents or pending lawsuits.

It’s now time to use some technical screening tools.

Selecting stocks using technical indicators

Stock selection with technical analysis usually involves three steps: screening stocks, scanning charts, and setting up trades. Stock screening is a way to narrow down a list of candidates by using technical criteria. Then, you could try to reduce that list to three or four by examining the charts to find possible entry points or points at which it might make sense to purchase. You’ll then perform a detailed chart analysis to select the one that you might consider trading.

Screening stocks

Consider the following when setting up a screen:

• Market capitalization and price. This is a great place to begin because you can eliminate many stocks immediately. You can exclude stocks over $100 if that’s what you don’t want.
• Sectors & industries. Many investors compartmentalize the stock exchange into broad sectors, such as technology, energy, finance, etc. You can also break the stock market down into specific industry groups like semiconductors, computer hardware, or software within the technology sector. If you are looking to buy stocks with the hope that their price will increase, you should look for industries that have a strong track record. Conversely, if your goal is to sell short, you would borrow and sell a stock that you believe is likely to drop, then purchase it at a lower price later. Short selling is considered an advanced strategy because it involves a potentially unlimited amount of risk if the stock price rises. It also requires a margin.
• Momentum. Traders who use technical analysis are looking for stocks that have a strong uptrend and for stocks with a weak downtrend. Moving averages are an indicator that smooths out the day-to-day price fluctuations to reveal a stock’s overall direction over time. This helps identify the main price trend. These levels can act as resistance and support. Support refers to an area of the chart in which downward trends appear to be halted as selling pressure is overcome by buying pressure. Resist can be a price zone where upward trends begin to fade as selling pressure overtakes buying pressure.
• A moving average can be calculated by taking the average of a stock’s closing price over a specified period. Most traders start with 20 days. However, you can choose to use other periods, such as 50 days or 200 days, depending on your trading style.
• A momentum trader who is going long may ask: Is a stock currently trading above its moving average of 20 days? Is its 20-day average above its 50-day average? If a trader is looking to short an equity, he might look for one that has a moving average of 20 days below the 50-day average. You can narrow your list by searching for stocks that are traded at least 200,000 times per day.

Scanning charts

It’s now time to find the best entry points. There are two common strategies for entering the market: either look for breakouts in the direction the trend is moving, such as stocks with a rapid upward price movement, or look for pullbacks, which are short-term movements in the opposite direction of the trend.

A breakout entry point for longs could be the second or first new high after the stock had traded sideways or consolidated over a period. In the case of shorts, a breakout (or, more accurately, a breakdown) could be defined as the first or second low following a period in which there has been a consolidation. You may wish to wait a few days for the stock to correct in the opposite direction of the trend when using the pullback strategy. Then, you might consider selling shorts to take advantage of the short-term strength or buying longs when the stock is weak.

Set up the trade

For this discussion, we’ll assume that you prefer pullback entry and have reduced your options to two candidates for buys: stock A and B. It might make sense to use a few indicators when choosing between them: volume, price patterns, moving averages and the stochastic indicator.

We’re searching for pullbacks, so our first step is to determine if a change in price is temporary and not a complete reversal. If the stock has pulled away from a level of support, like a moving average or an old low, then the chances of a reversal will be lower. This is not a guarantee. Also, we want to know when a pullback will end. If a stock is able to surpass the previous day’s peak, this could indicate that the trend has resumed.

Here are our charts. Both stocks A and B (the yellow lines) have held their 20-day moving medians. So far, so good.

Stock A

Stock B

 

We’ll use the stochastic indicator. This is a momentum index that compares the current price of a stock to its highs or lows for a certain period. The values can range from zero to one hundred, and a reading of 80 or more indicates that the stock is “overbought”, possibly with an overextended upward trend. Under 20 readings indicate the stock may be “oversold” and possibly overextended to the downside. The stochastic oscillator is composed of two lines on a chart: %K (fast, red line in the chart above) and %D (slow, blue line). The value of the former represents the value during the current trading session. The latter is the three-day moving mean of the former.

Look for a price change when a stock trades in a certain range and the oscillator values reach overbought/oversold levels. Be aware that if the stock has been strongly trending for some time, its values may remain in overbought and oversold areas. It can be useful to compare the %K vs %D line in either case. The convergence or divergence of the lines could indicate a change in momentum.

Applying this to a hypothetical trade, let’s look at the last day of trading for each stock. Stock A, on either an intraday basis or a closing basis, was unable to trade above its previous day’s highest price. It also traded in a small range and closed close to where it opened. All signs of lack of confidence by buyers.

The %D line shows that stock A has not been oversold, which is good. The two lines are not crossed. As you can see, they remain below each other. If %K crossed %D, it would indicate a bit more strength on the upside.

Volume was low, which is a good thing. Heavy volume can indicate danger when a stock moves against the trend.

The last trading session on B stock tells a completely different story. Stock B not only closed above its previous day’s closing high but also traded above it during the day. It also had a day of wide ranges with a closing near the top. All of these are signs that the buyers have taken control of the main trend, and the pullback has ended. This is especially true because a higher-than-average volume accompanied the price action. The stochastic oscillator also shows that neither %K nor %D is oversold. This indicates strength. A bullish sign is also %K crossing %D. Stock B is the better candidate.

Simplify stock selection

You don’t need to be a stock expert to choose stocks, but you must be flexible. Be willing not to trade but look for markets in motion. You can also consider going short. Last but certainly not least, you must be disciplined. Do not let inevitable bad trades become a catastrophe. You can trade again if you limit your losses.