CFA Institute

Origin of Fundamental Analysis

Author(s): Malvin C. Spooner
Source: Financial Analysts Journal, Vol. 40, No. 4 (Jul. - Aug., 1984), pp. 79-80
Published by: CFA Institute
Stable URL: http://www.jstor.org/stable/4478764
Accessed: 27-02-2018 09:15 UTC

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 by Malvin C. Spooner
Origin of Fulndamental Ainalysis
FUNDAMENTAL ANALYSIS IS a method
of systematically modelling facts-eco-
nomic and industry statistics, financial ra-
tios, et al.-in order to derive in a logically
coherent manner an explanation, hence an un-
derstanding, of observed phenomena. We em-
ploy this understanding to pass judgment and
ultimately influence behavior. This is procedur-
ally congruent to the method articulated by
Darwin with respect to the natural sciences;
both his method and explanations provide the
theoretical foundations for modern scientific,
economic and social thought and, yes, even
fundamental analysis.
Environment: Economy
The natural scientist observes the habitat in
order to better understand the species. As geog-
raphy or climate varies, more varieties of wild-
life with differing survival characteristics myste-
riously provided by Mother Nature are
observed. The environment helps explain ob-
served deviations in characteristics within a
given species.
The fundamental analyst would like to ex-
plain substantially different phenomena, but his
motives and methods for studying the economy
are much the same as the naturalist's contem-
plating his environment. Macroeconomic con-
straints, analogous to climate and geography in
the natural scientist's scheme of things, neces-
sarily determine the structures of industries.
With few economic barriers to trade, and a
technological sea-faring edge, Britain once ruled
the seas. Businesses that flourished in world
trade at that time were structured to compete
successfully in an open economy. The coming
of protectionism and trade barriers gave rise to
isolated economies in which differing corporate
species competed one against the other domes-
Malvin Spooner is Senior Investment Analyst, Portfolio
Manager at Bolton, Tremblay Inc., Toronto.
The author thanks R. Tattersall, R. Morrison and C.
Monaco.
FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1984 O 79
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tically. Their very existence was contingent
upon a change in world political economy, and
the few that survived were the ones best fitted
to the climate of the closed economy. But just as
the kangaroo, the product of an isolated geogra-
phy, could not exist outside Australia, busi-
nesses so isolated assume distinct shapes fitted
to their macroeconomic environment and are
often indigenous to that environment.
Species: Industries
Diversification of structure in nature provides
for the survival of a greater number of species,
given limited mutual space and means of nour-
ishment. "Survival of the fittest" governs and is
as crucial in business as it is in the natural order.
In fact, it provides the framework for microeco-
nomic theory, competition and capitalism. A
host of industries exploit various limited re-
sources in diverse ways, subject to constraints
imposed by the economy. Infinitely dynamic
and complex relations (comparative advantage,
duties, exchange rates, markets, economies of
scale, technological innovation, supply and de-
mand and so on and so on) act upon competing
industries, which either develop structures con-
ducive to prosperity or soon perish.
A process analogous to natural selection in
the animal kingdom is also at work in the world
of business. Unlike the natural scientist, howev-
er, the fundamental analyst not only seeks to
explain the survival of the fittest industries, but
also to use his restricted understanding to dis-
cern which of the many corporate species are fit
and which are suited to weather unforeseeable
dramatic environmental changes. He endeavors
to discover which will be fit.
Organisms: Firms
Within a species, the characteristics specific to
individual organisms will often vary to the
degree necessary to enable survival, depending
upon the degree of competition for sustenance.
Where competition is most intense, organisms
adapt or become extinct. Those that do adapt
are obviously the fittest, and they in turn spread
as competition among themselves intensifies.
By spreading, they create a chain reaction that
causes other competing organisms to adapt or
perish, ad infinitum.
Clearly, firms thrive and become extinct in a
parallel fashion. They compete, they intercross
(mergers and acquisitions) and, when fit,
spread, compete and coexist with other firms
that have managed to adapt to circumstances.
There are, however, numerous standards of
fitness; no one type is necessarily best. Just as
the naturalist acknowledges that organisms
with backbones are not necessarily superior, in
view of the many complex factors involved, the
fundamental analyst must recognize that a rela-
tively modest debt to equity ratio or a wide
gross margin or current ratio will not always
best suit a company for a particular environ-
ment. Facts must be evaluated in context.
Making Progress
Fundamental analysis may be seen as an at-
tempt to apply to security analysis a method
and philosophy that has done much to broaden
the horizons of human understanding in the
sciences. It goes beyond the mere explanation of
phenomena, however, because it is employed
to influence behavior.
Of course, even prior to Darwin, man deliber-
ately used selective breeding to create desirable
characteristics in domestic animals. Indirectly,
man ensured the survival of certain beasts and
made others extinct. Man displaced long-horn
cattle with short-horn. His understanding of
these processes has improved since, and most
will agree that the gains have, on average,
outweighed the costs by at least a narrow mar-
gin.
Fundamental analysts are applied business
scientists. They observe, model and draw con-
clusions with the object of making progress. By
determining that one firm is structurally fit to
survive in a growth industry and suited to the
dynamics of the economy, and then buying
shares or debt issued by that company, they
contribute in a self-fulfilling way to its fitness.
Fundamental analysts also coexist in competi-
FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1984 C 80
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tion with one another. It is to be hoped that
their conclusions, in concert, instigate behavior
that results in the most efficient allocation of
financial resources, just as Mother Nature mys-
teriously allocates her resources.
Before we analysts let our heads grow too
large (although the nature of our work is often
humbling enough), it may be prudent to consid-
er the following excerpt from Charles Darwin's
Origin of Species. If one were to replace a word
here and there, it is surprisingly appropriate:
"It is good thus to try in imagination to give to
any one species an advantage over another.
Probably in no single instance should we
know what to do. This ought to convince us
of our ignorance on the mutual relations of all
organic beings; a conviction as necessary as it
is difficult to acquire. All that we can do, is to
keep steadily in mind that each organic being
is striving to increase in geometric ratio; that
each at some period of its life, during some
season of the year, during each generation or
at intervals, has to struggle for life and suffer
great destruction. When we reflect on this
struggle we may console ourselves with the
full belief that the war of nature is incessant,
that no fear is felt, that death is prompt, and
that the vigorous, the healthy, and the happy
survive.'"
BALTIMORE GAS AND
ELECTRIC COMPANY
Dividends have been declared for the
quarter ending June 30, 1984 at the follow-
ing rates per share:
Common Stock-75 cents.
Preferred and Preference Stock-at the
specified rates.
All are payable July 2, 1984 to holders of
record at the close of business on June 11,
1984.
B. C. TRUESCHLER
Chairman of the Board