Technical Analysis: It's Not What You Think

Includes: AAPL, AIG
by: Brian Nelson


You've been deceived. Technical analysis, as Valuentum sees it, is not what you think it is.

The right state of mind in thinking about value investing and technical analysis will help you become a better investor.

More and more investment firms are using fundamental/value analysis and technical/momentum analysis in a combined setting.

Let's talk about how the conceptual underpinnings of technical and value-based methodologies are similar and offer up two firms -- AIG (NYSE:AIG) and Apple (NASDAQ:AAPL) -- that fit the Valuentum® style, a combination of rigorous valuation analysis overlayed with a number of momentum indicators.

I've spent quite a bit of time trying to figure out who was first to say 'technical analysis is like reading tea leaves.' After being unsuccessful, I've given up looking and have since moved on to more important items. But whoever first uttered those words -- and those that repeat it -- may have done (and are doing) a great disservice to the common investor. A stock chart is extremely valuable in a variety of different ways: 1) to assess the historical volatility of the equity 2) to evaluate the performance of the equity through the course of the economic cycle 3) to uncover correlations of the equity with other assets and 4) to assess the materiality of historical events that may repeat in the future - these are just four items, and all four of these examples are fundamentally-linked (i.e. not cup-and-handle speak). A stock chart is so valuable that many buysiders I know first-hand do not even know how other investors can purchase a stock without looking at one first.

There's a substantial amount of misinformation in the investment publishing business - and it continues to spread like wildfire. Unfortunately, I don't have the reach (yet) to work to change these views, nor do I think it will happen overnight. There are herds of individuals from organizations that just repeat the catch-phrase on technical analysis -- without even thinking about it. Many fundamentally-based writers may misrepresent the concept of technical analysis to support their view that it is taboo, an opinion that they themselves cannot support. Like your uncle's parrot, they just repeat it and repeat it and repeat it. How can this still be happening? It may be true that writers that readily dismiss technical analysis may have no experience using it, applying it, or even observing it. These individuals may not understand how buy and sell decisions impact a firm's share price - or how stock prices move. But if these things don't matter to them, should readers be taking their opinion on a topic they know nothing about?

There's also the common utterance about there not being investors that have done incredibly well over long periods of time applying technical and momentum processes. The reality is that there are examples everywhere of successful investors applying technical and momentum analysis to achieve strong performance -- one such example is famed and highly-successful investor Richard Driehaus of Driehaus Capital Management. Another example is Cliff Asness of AQR. Mr. Asness and his colleagues Tobias Moskowitz of the University of Chicago and Andrea Frazzini and Ronen Israel, both also of AQR, recently wrote an excellent paper dispelling the myths of momentum investing (1), many of which we hear all too frequently.

I can't speak for all technicians (nor do I want to) -- as there may be a distinct difference between how traditional technicians apply the discipline and how technical analysis is applied at Valuentum. I view technical analysis (solely) as a window into future buying or selling behavior by market participants on the basis of a firm's stock price performance, much like value analysis is used as a window into future buying and selling behavior by market participants on the basis of a firm's intrinsic valuation. The firm's future stock price is unpredictable to a degree, and the firm's future fundamental cash-flow stream is unpredictable to a degree. Both are mechanisms used to assess future stock price performance, and in this light, they are equally important market drivers -- no more, no less.

To an unbiased onlooker, for example, there might not be much more to chart-reading other than the fact that investors use charts to assess the future price of stocks, and by their own actions, drive stocks higher or lower (via buying or selling) to their target prices. Equivalently, this unbiased onlooker may also conclude that there might not be much more to fundamental and value analysis other than the fact that investors use it to assess the future price of stocks, and by their own actions, drive stocks higher or lower (via buying or selling) to their fair value estimates. There is a 'self-fulfilling' dynamic to both disciplines - they work because other investors apply them and make them work.

Just ask Sam Stewart, president of Wasatch Funds about the value of using fundamental/value analysis and technical/momentum analysis in a combined setting. Wasatch isn't the first firm that has taken advantage of the benefits of cross-methodological fundamental and technical work, and it won't be the last. With all of this said, let's take a look at two stocks that fit the Valuentum style of investing, a unique and distinct method that looks for both strong value and strong momentum characteristics within a single equity (outside the portfolio context).


AIG is the highest-rated insurer on the Valuentum Buying Index at this time, with the company registering a 9 (equivalent to a "we'd consider buying" rating). AIG is now far-removed from its troubled past, and our fair value estimate of the insurer is nearly $70 per share. Shares are trading at roughly $55 each at the time of this writing, and we're expecting pricing upside. The stock also achieved a multi-year high recently. It has both good value and good momentum characteristics.

AIG's board seems to agree with our view, and it recently authorized the repurchase of an additional $2 billion of shares June 5, funded in part by the completion of its sale of ILFC. Since the end of the first quarter of 2014, AIG has repurchased more than $400 million of shares, and we're very much in favor of any share buybacks completed below our fair value estimate of the firm. For members seeking exposure to the insurance industry, AIG is our favorite idea to consider. The company's book value per share stood at $71.77 at the end of the first quarter, advancing 6% on a year-over-year basis (price/book = 0.77).


We plan to release an updated 16-page report on Apple the week after the split (which was effective today), or the week of June 16. On a split-adjusted basis, members should expect our valuation of the iPhone maker to come in at just over $100-$105 each. The recent strong stock-price performance of Apple has propelled returns in both the Best Ideas portfolio and Dividend Growth portfolio higher. We don't think we could be happier with the iPhone-maker's improving fundamentals or more excited about the new products and applications in its pipeline. Apple will be buying back a significant amount of stock through the end of 2015 (~$130 billion), and while this will reduce balance-sheet cash dividend coverage, we think Apple is a Dividend-Aristocrat to be on the basis of its tremendous cash-flow generation. We're reiterating our above-market fair value estimate on shares, which continue to exhibit strong momentum. Apple has both strong value and strong momentum characteristics, the combination of which we attribute in part to the company's recent relative price outperformance.

(1) Fact, Fiction and Momentum Investing, May 9, 2014 (click here to download)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: AAPL is included in Valuentum's newsletter portfolios.

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