We are in a period of profound change, driven by dynamic new technologies and a powerful pandemic economic recovery.

At times like this, it is natural for investors to seek out investments that can benefit from these dramatic changes. But in investment booms like now, the search for healthy investments is clouded by a haze of promotion and speculation. How then do you tell the difference between the substance of the investment and the hype?

While it’s not always easy to do, a general framework called fundamental investing can help overcome the hype. Essentially, it’s about basing investment decisions on a few basic factors that have proven to be helpful in achieving strong long-term investment results. This distinguishes it from speculative forms of investing which may involve the continuation of a short-term trend.

“Real investing is understanding the fundamentals,” says John Stephenson, a leading figure in the investment industry and currently thematic research analyst at BMO Capital Markets.

Fundamentals can foster healthy skepticism of speculative trends as heavily publicized as cryptocurrencies, memes stocks, non-fungible tokens, and Special Purpose Acquisition Companies (SPACs), to name a few. only a few. But fundamentals can also help distinguish legitimate investment opportunities that may arise from many of today’s most promising emerging technologies.

Fundamental versus speculation

Fundamental investors often think they are investing in real companies rather than just investing in stocks. They usually invest for the long term and don’t just try to follow popular short term trends. They strive to have a deep understanding of the companies and management teams behind the investments. This includes carefully considering the impact of technological and economic changes on the company’s prospects and weighing up the upside potential against the risks of realizing that potential.

A key part of the fundamental approach is to perform a careful financial assessment. Fundamental investors understand that investing in good companies can turn into bad investments if you overpay.

Stock analysts who follow a fundamental approach typically perform detailed financial analysis to value individual stocks. Typically, this includes projecting the future cash flows of the business and then discounting those cash flows using the rate of return required to determine present value. This provides the basis for estimating the “intrinsic value” of what the stock should be worth. If you can buy the stock for less than its intrinsic value, it should be a good deal. If the share price is higher than its intrinsic value, it appears overvalued.

Most average investors aren’t in a position to go into this level of detail, but they can get a rough idea of ​​whether or not a valuation is appropriate. For example, they can compare the current market valuation of a stock to other stocks with similar business characteristics or to the market as a whole. To make these comparisons, they use valuation metrics like the price-to-earnings ratio (PE) (share price divided by earnings per share).

Speculation contrasts sharply with fundamental investing. Its main flaw is that it does not have a relatively strong measure of intrinsic value to use in making sound investment decisions. Speculation is much more dependent on investor sentiment, which is fickle and subject to sharp swings between optimism and pessimism.

Since investment booms tend to be accompanied and fueled by hype, speculation often builds on itself and pays off for a while. Stories abound of people making heaps of money in hot investments, which attracts new investors with Fear of Missing Out (FOMO). But investment booms can quickly and unpredictably turn into massive sales and at times can turn into outright panics. All stock investors are likely to suffer to some extent from a generalized downturn in stock markets, but speculative investments tend to be particularly volatile and susceptible to larger market declines.

Hyping the trend

Here’s how a fundamental perspective can be applied to two of the most publicized speculative trends, cryptocurrencies and memes stocks.

There are now over 13,000 cryptocurrency offerings, ranging from fancy dog-themed coins like Dogecoin and Shiba Inu to established market leaders like bitcoin. Unlike real currencies, cryptocurrencies are too bulky to be useful for day-to-day transactions. Crypto enthusiasts see them as “stores of value” similar to gold, but they lack the price stability one would normally expect in this role.

The price of a bitcoin was around $ 60,000 at the start of last week, but sometimes this year that price was under $ 40,000 (in January and July) and at other times over $ 75,000. $ (in spring and fall). Unlike stocks, there is no stake in an underlying company that generates profit and cash flow, so fundamental investors cannot find a solid basis to value or derive from it. silver.

Meanwhile, in the stock markets, speculation is rampant in specific areas. A new phenomenon is Memes Shares, a motley group whose prices have been pushed to stratospheric valuations by the organized promotion of amateur investors on social media. They tend to see themselves as a populist movement fighting against hedge funds and Wall Street and are not very influenced by fundamentals.

One of the more well-known memes stocks is AMC Entertainment Holdings Inc., a large movie theater chain under intense pressure from home streaming services. The company lost money in 2019 even before the pandemic. With the additional impact of restrictions and pandemic closures, its stock price hit a low of $ 1.91 (US) last January.

But soon after, he got caught up in the same stock craze. In a matter of months, the stock price has risen 38 times, reaching a high of $ 72.62 in June. Since then, the stock has still enjoyed significant support on social media, but the stock price has nonetheless fallen by more than half. It was trading around $ 30 at the start of last week.

Meanwhile, the company is still losing money and facing stiff competition from home movie viewing on streaming services, with no clear indication of a reversal in these trends. Given that the stock price hit a pre-pandemic low of $ 6.26 in February 2020, it is difficult to justify a stock price close to recent levels, even after the pandemic has subsided.

Examining growth

Fundamental investing can be particularly useful for sorting out growth or thematic stocks and distinguishing which ones represent credible opportunities from those which have been overstated.

Of course, picking the fundamental winners from growth stocks is harder than it looks. Growth stocks are often accompanied by compelling stories of exciting new technology that will generate explosive growth and big profits, but this heady vision too often fails to materialize. Yet despite the challenges, at least doing some careful fundamental analysis should increase your chances of making the right choices.

As an example of the application of a fundamental process to growth stocks, a particular theme that Stephenson and his colleagues analyzed is the impact of autonomous vehicles and electric vehicles on long-haul trucking in North America. This research requires a thorough understanding of how these technologies develop as well as the economics of trucking and how it competes with rail freight. “While we believe this will ultimately be a game-changer for this particular industry, we expect it to be eight or nine years from now. “

You might be wondering if it’s worth trying to foresee an opportunity so far into the future, but it’s a deliberate part of the process. “A real thematic investment is trying to grab the next thing before anyone else looks,” Stephenson says. “There will likely be a point where the market catches up, then it gets overstated and valuations stretch. This is the time when you should be looking to leave, ”he adds. “It’s very difficult to make money with something that gets the hype. “

One of the hottest stocks in the pandemic, Tesla Inc. is an example of a heavily publicized growth investing. The price of Tesla stock reached a pre-pandemic peak of around $ 180 (US) in February 2020, peaked at $ 1,243 in November 2021, and has since fallen back to around $ 900 at the start of the week. last.

This represents an exorbitant market value. The futures price-to-earnings (PE) ratio was around 146 early last week, compared to 22 for the US S&P 500 stock index. Tesla’s valuation was also well above that of the other five largest US tech stocks. , which had futures PE ratios ranging from 24 to 66. (PE sources: Nasdaq, Zacks Investment Research, and Birinyi Associates.) When Tesla stock peaked in price. this fall, the Financial Times noted that its market value exceeded that of the other nine most valuable global automakers combined.

For fundamental investors, this raises a red flag. For Tesla to justify such a high fundamentals-based valuation requires a dramatic scenario of massive dominance of the global auto industry, and possibly dominance of related emerging industries like battery storage and autonomous vehicle services as well. It’s not impossible, but it’s definitely a huge stretch.

“One of the problems is that the audience falls in love with something and they jump on it,” Stephenson explains. He notes that Tesla has a charismatic and visionary founder in Elon Musk, while the company has grown into an early leader in the manufacture of electric cars.

But he says you have to look beyond the superficial justifications and dig deep into the fundamentals. “A lot of times it’s just, ‘I like electric vehicles. I think everyone is going to have an EV. I’ll buy the chef. But why? And why buy it here at this price, compared to a year ago at a much lower price? “