Investment Analysis

What Is Investment Analysis?

Investment analysis is a broad term for many different methods of evaluating investments, industry sectors, and economic trends. It can include charting past returns to predict future performance, selecting the type of investment that best suits an investor's needs, or evaluating individual securities such as stocks and bonds to determine their risks, yield potential, or price movements.

Investment analysis is key to a sound portfolio management strategy.

Understanding Investment Analysis

The aim of investment analysis is to determine how an investment is likely to perform and how suitable it is for a particular investor. Key factors in investment analysis include the appropriate entry price, the expected time horizon for holding an investment, and the role the investment will play in the portfolio as a whole.

In conducting an investment analysis of a mutual fund, for example, an investor looks at how the fund performed over time compared to its benchmark and to its main competitors. Peer fund comparison includes investigating the differences in performance, expense ratios, management stability, sector weighting, investment style, and asset allocation.

In investing, one size does not fit all. Just as there are many different types of investors with unique goals, time horizons, and incomes, there are investment opportunities that match those individual parameters.

Strategic Thinking

Investment analysis can also involve evaluating an overall investment strategy in terms of the thought process that went into making it, the person's needs and financial situation at the time, how the portfolio performed, and whether it's time for a correction or adjustment.

Investors who are not comfortable doing investment analysis on their own can seek advice from an investment advisor or another financial professional.

Types of Investment Analysis

While there are countless ways to analyze securities, sectors, and markets, investment analysis can be divided into several basic approaches.

Top-Down vs. Bottom-Up

When making investment decisions, investors can use a bottom-up investment analysis approach or a top-down approach.

Bottom-up investment analysis entails analyzing individual stocks for their merits, such as their valuation, management competence, pricing power, and other unique characteristics.

Bottom-up investment analysis does not focus on economic cycles or market cycles. Instead, it aims to find the best companies and stocks regardless of the overarching trends. In essence, bottom-up investing takes a microeconomic approach to investing rather than a macroeconomic or global approach.

The global approach is a hallmark of top-down investment analysis. It starts with an analysis of the economic, market, and industry trends before zeroing in on the investments that will benefit from those trends.

Top-Down and Bottom-Up Examples

In a top-down approach, an investor might evaluate various sectors and conclude that financials will likely perform better than industrials. As a result, the investor decides the investment portfolio will be overweight financials and underweight industrials. Then it's time to find the best stocks in the financial sector.

Proponents of bottom-up analysis include Warren Buffett and his mentor, Benjamin Graham.

In contrast, the bottom-up investor may have found that an industrial company made for a compelling investment and allocated a significant amount of capital to it even though the outlook for the broader industry was relatively negative. The investor has concluded that the stock will outperform its industry.

Fundamental vs. Technical Analysis

Other investment analysis methods include fundamental analysis and technical analysis.

The fundamental analyst stresses the financial health of companies as well as the broader economic outlook. Practitioners of fundamental analysis seek stocks they believe the market has mispriced. That is, they are trading at a price lower than is warranted by their intrinsic value.

Often using bottom-up analysis, these investors will evaluate a company's financial soundness, future business prospects, and dividend potential to determine whether it will make a satisfactory investment. Proponents of this style include Warren Buffett and his mentor, Benjamin Graham. 

Technical Analysis

The technical analyst evaluates patterns of stock prices and statistical parameters, using computer-calculated charts and graphs. Unlike fundamental analysts, who attempt to evaluate a security's intrinsic value, technical analysts focus on patterns of price movements, trading signals, and various other analytical charting tools to evaluate a security's strength or weakness.

Day traders make frequent use of technical analysis in devising their strategies and timing their buying and selling activity.

Real-World Example of Investment Analysis

Research analysts frequently release investment analysis reports on individual securities, asset classes, and market sectors, with a recommendation to buy, sell or hold them.

For example, on Feb. 11, 2021, Charles Schwab issued Sector Insights: A View on 11 Equity sectors. The report gives a three-to-six month outlook on the 11 main stock sectors that represent the broader economy.

Among the highlights, Schwab analysts looked at the communication services sector, which includes telecommunication service providers, media, entertainment, and interactive media. In the note, the analysts said that while the pandemic-related stay-at-home behaviors have been good for some companies in the sector, with streaming demand rising, the demand for traditional TV and cable had dropped, which has hurt ad revenues.

The analysts then assigned an overall neutral assessment rating of "market perform." This neutral rating means the communication services sector should provide returns in line with that of the S&P 500.

Schwab also looked at the financial sector, which includes banks, savings and loans, insurers, investment banking, brokerages, mortgage finance companies, and mortgage real estate investment trusts. Schwab noted that the sector should benefit from the likelihood of continued fiscal stimulus coming out of Washington, a Federal Reserve that is likely to maintain stimulus for years, the positive impact of the vaccine rollout, and the likelihood of a continued rise in long-term interest rates.

Schwab rated the financials sector "outperform," meaning that the sector and its underlying issues are likely to see returns that surpass the S&P 500.