Wednesday, 1 August 2012

Stock selection, fundamental analysis and Austrian Economics

In a recent article in the Quarterly Journal of Austrian Economics titled "Fundamental Analysis as a Traditional Austrian Approach to Common Stock Selection", Richard C. Grimm discusses "...fundamental analysis and its potential as a traditional Austrian approach to common stock selection" and explains that "Fundamental analysis was selected as the subject of this preliminary work due to its presence in Austrian literature and the favourable treatment it typically receives from Austrian authors". He explains,
"An Austrian approach would emphasise the role of purposeful human action and the effects and potential effects of such actions on common stock performance. It would encompass basic characteristics that differentiate human beings from other species and forms of matter, such as the possession of free will and consciousness. It would make provisions for the exercise of human mental processes involved in understanding and anticipating key developments. The approach would allow the investor to exercise his mental capacity to the fullest extent with enough flexibility to incorporate every detail deemed necessary to properly evaluate an investment opportunity and anticipate future conditions".  
"A traditional Austrian view acknowledges the common stock selection process as an entrepreneurial/speculative activity. Within this context, success depends on the investor’s ability to excel at identifying opportunities for profit in dynamic and uncertain environments. Action follows conviction—the investor will only engage in a position when convinced that his view of future performance is correct.3 There are also implications for the role of risk and uncertainty. Many Austrian economists dismiss the mainstream economist’s view that it is solely the "quantifiable risk characteristics" of common stocks that determine future returns. A comparison of key authors of Austrian persuasion, who have written extensively on the entrepreneur, indicates that the entrepreneur’s perception of risk is often "shouldered aside" or "eliminated."
"All speculative activities are characterised by uncertainty. An Austrian view proclaims that future risks and uncertainty cannot be objectively measured due to the arrival of unforeseen events, unanticipated reactions, influence of cognitive biases, and misinterpretations of data that culminate from the actions of human actors. Therefore, risks and uncertainties are subjectively assessed at best during the stock selection process. In addition, it is important to realise that risk and uncertainty can be managed through actions apart from common stock analysis. These actions may include: (1) spreading risk through diversification (2) placing limits on the amount of funds invested in a single position and (3) providing order entry instructions to brokers that curtail losses before predetermined limits are breached. Similar methods are commonly employed by successful serial entrepreneurs as ways of dealing with the risk involved in starting new ventures". 
"...speculative activities are often complex and encompasses a great deal of uncertainty. The analysis of such endeavours requires the application of a framework that is descriptive of how we formulate our choices; this represents a hallmark feature of a traditional Austrian view. The thymological framework was derived from an Austrian view and is applicable to the evaluation of all speculative activities, including methods for common stock selection. This framework is applied to a study of fundamental analysis in order to determine its alignment with a traditional Austrian view".
He concludes,
"As a means for common stock selection, it [fundamental analysis/valuation] provides a suitable approach for attaining an investor’s end in view and is suitable for those who desire an approach that is amenable to traditional Austrian views. It is a method in which success or failure depends on the skill and ability of the investor as opposed to an artifact of outside forces. In addition, it is likely that those who use fundamental analysis as a means for common stock selection play an instrumental role in allocating capital to its best use in a free market".
"...the investor who masters the basic tenets of Austrian economics, and utilises fundamental security analysis as a means for stock selection, is likely to gain an edge over those using inferior methods, and thus enhance the likelihood of success".
Based on his article, Austrian Economics and fundamental stock analysis used in tandem can prove a very powerful combination indeed.

I recommend you read the full article.