Investment Analysis

What is Investment Analysis?

Investment analysis is a broad term used to describe the process of evaluating financial markets and investment opportunities. It can focus on traditional asset classes such as equities or bonds, alternatives such as real assets or commodities, or pooled investments such as mutual or hedge funds. Investment analysis involves assessing the expected returns and potential risks of an investment by using quantitative and qualitative approaches, with the aim of establishing whether it is likely to achieve the investor’s financial objectives. Analysts would typically use different methods such as examining financial statements, industry trends, and economic indicators (which form part of what is known as fundamental analysis) or may explore price movements and market signals as part of a technical analysis. Investment analysis is fundamental in supporting other processes such as investment selection, portfolio construction, portfolio management and ongoing monitoring.

How Investment Analysis Works?

Investment analysis works as a structured process that requires following particular steps. Below is an example of what this would typically look like:

1.      Investment Objectives and Constraints

This is the first step where investors must realistically define their investment horizon, financial goals and risk tolerance, liquidity requirements, as well as any constraints such as ethical constraints (which may lead, for example, to the exclusion of certain sectors such as oil and gas or tobacco from the investment universe).

2.      The Investment Universe

The second step is to clarify the different parts of the market that are to be explored and potentially invested in. To begin with, this could include researching different asset classes and defining the weighting they would represent in the portfolio. For example, the typical balanced portfolio would have 60% invested in equities and 40% in bonds (hence called the 60/40 portfolio). Then, the investor must define the desired market exposure. For example, the percentage invested in developed and/or emerging market stocks, or the proportion invested in investment grade and/or high yield (or otherwise known as “junk”) bonds. This step is very important as it would drive the research efforts of investors, which is typically a complex and time-consuming exercise.

3.      Scrutinising the Universe

Also known as investment screening, this is the stage that requires gathering and analysing various pieces of data. Professional investors use data platforms such as Bloomberg Terminal (best for economic/macro and company data), Morningstar Direct (best for researching funds) or Preqin (associated with alternatives such as private credit).

As an example, for the equities part of the portfolio, an investor could start with exploring the companies that are featured in the MSCI World Index (which captures large and mid-cap companies across most developed market countries) by filtering them for different criteria. This could include:

• Valuations – looking for those that are trading below their fair value. Typical ratios include Price to Earnings, Price to Book and Price to Sales
• Quality – businesses that display consistency in their operations and delivery of shareholder value. Metrics to assess quality include Return on Equity, Return on Assets and Return on Capital Employed
• Growth – these may be smaller firms that are set to significantly increase their share price due to disrupting a particular market. Innovation is usually key in this market segment, be it technological advancement (in the Technology sector) or scientific discovery (in sectors such as Healthcare)

Investors would also go over the companies’ historical performance and assess their risk (e.g., assessing volatility or credit quality, depending on the type of asset) to support their evaluation. However, since past performance is not predictive for future returns, this step typically focuses on how companies had performed across different market environments.

4.      Making Comparisons

The final stage before making investment decisions is to assess relevant alternatives of the securities that passed the filtering process. If we use the above example, the MSCI World Index consists of around 1500 companies, of which maybe around 10-15% would make the cut. Here, investors may also consider multiple qualitative factors, for example the quality of the leadership/management of a company and/or its competitive position in the market.

Types of Investment Analysis

The types of investment analysis range widely and are often tailored to feature the investor’s specific requirements. However, there are a few basic types that we explore below.

Fundamental

This approach aims to establish the intrinsic (or fair) value of an asset by analysing financial, economic and qualitative factors. It finds its most popular application in researching equities but it can also be useful in assessing a range of other asset classes such as bonds and foreign exchange. At its core, fundamental analysis includes going through financial statements, industry reports, and economic indicators with the goal of determining whether an asset is under or overvalued and to forecast its future prospects. Institutional investors such as asset managers would primarily focus on this method.

Technical

Technical analysis focuses on past market data (mainly price and volume statistics) with the aim of predicting future price movements. It is mostly employed in trading, where the environment is dynamic and investment decisions are made for the short-term. Its philosophy is based around identifying market patterns that will serve as indicators to predict future price movements.

The typical assets that receive attention from technical analysts include stocks, commodities and foreign exchange (currencies), and will be monitored for trend lines, prices, moving averages, support/resistance levels and momentum indicators.

In the below chart, we show how the two approaches can be combined in investment decision-making.

 Bottom-Up and Top-Down

The bottom-up and top-down are two contrasting approaches. Bottom-up analysis focuses on individual companies, regardless of the broader economic or industry conditions. Investors using this method would examine the fundamentals of a business, such as earnings and revenue growth, valuation ratios, etc. The philosophy of this approach is that strong companies can outperform even in weak economic environment. It is commonly used by long-term stock pickers seeking undervalued or companies with high future growth prospects.

On the other hand, the top-down method begins with analysing macroeconomic factors like a country’s GDP growth, interest rates and inflation, as well as global trends. Investors then narrow down to promising sectors and industries and, finally, select companies within those segments. The rationale for this approach is that economic conditions and sector cycles strongly influence individual stock performance. It is popular among asset allocators and macro-driven investors.

The two can be (and are often) combined. While the bottom-up emphasizes micro-level strength, the top-down approach focuses on the big picture. The table below provides a simplified comparison of the two approaches.

Example of Investment Analysis

J.P. Morgan Asset and Wealth Management regularly publishes a newsletter called “Eye on the Market”, where the Chairman of Market and Investment Strategy shares his views on the market. The edition in the free download section covers Nvidia, which is an American leader in chip making and one of the largest companies worldwide.

Conclusion

To sum up, investment analysis is a critical part of the overall investment process. Defining its objectives is critical and it determines how the approach is structured, what features the process would seek and what the most attractive opportunities are as an outcome of the analysis. A robust structure of the process is likely to contribute to better returns if executed diligently.

Additional Resources

Portfolio Management Certification

Inflation and Bonds