What’s a Fundamental Setup

Most investors know about technical setups, even if they dismiss them. But fewer investors know about fundamental setups.

I trade fundamental setups. While there are many tools on my investing tool-belt, fundamental setups are definitely the hammer.

But before we can get to fundamental setups we must discuss forecasting.

Forecasting gets a bad rap. However, done well forecasting clears that crystal ball which you’re always bitching is cloudy.

The reason forecasting is so maligned is due to singular forecasts. 32 Celsius and sunny next Tuesday, 12 month price targets, the list is endless. It’s not the forecasters fault, as they provide what the majority want, the highest probability outcome.

Forecasting done well recognises multiple outcomes with probabilities assigned to each. At it’s simplest a weighted range.

Here’s an example using Prana Biotechnology ($PBT, $PRAN).

Within 8 weeks Prana should announce results for 2 pivotal trails, one is a company making event the second is even bigger, a major pharma pipe-line ass-saving blockbuster.

The first trial will be reported any day now. Let’s say it has a 50 percent chance of good results, while the second $10 billion plus blockbuster trial has an 80 percent chance of success. Prana’s share price is up a whopping 500 percent in the last eight months on anticipation. Yes I’ve enjoyed the ride!

If the results of the first trial are so-so or worse, the share price could easily halve.

In the unlikely (10 percent) event the results are bad then you’d loose three quarters of your investment. In case 3/4 doesn’t sound too bad, invert it. While a 50 percent loss only takes a double to make you whole again a 75 percent loss take a home-run — a 400 percent gain — to make you whole.   

If the results are good then the share price should quickly double. Good results would also provide a substantive floor under the share price in case the blockbuster results are disappointing, while simultaneously increasing probability of success for the blockbuster to 90 percent.

If the second trial results are excellent then Prana should be a ten bagger, a 1000 percent gainer, over the next couple of years.

Should you buy?

Prana Biotechnology $PRAN $PBT

The current risk reward profile based on the above simplified forecast is a risk of 55 percent of capital to make a double, that is roughly 2:1 reward to risk — 10% chance of a 75 percent loss, 40% odds of losing 50 percent and a 50% likelihood of doubling your money with an accompanying higher likelihood of further large returns. We could quantify those potential future returns, but we’ll keep this simple.

A 2:1 reward to risk is not great when dealing with speculative opportunities so I would not be a buyer now.

The fundamental setup I’d now look to buy is a failure at the first hurdle, so long as it is a stumble and not a glue factory fall. The share price will get hammered, yet the probability of success in second trial should only fall slightly.

Let’s say the share price falls the forecast 50 percent and at the same time the probability of good results from the second trial fall to 70%.

The risk reward then becomes a 10% chance losing 75%, 20% chance of losing 50%, 30% chance of 200 percent and 40% chance of 500%. That’s a risk of 58% for a possible 370% gain or over 6:1 reward to risk profile. That’s a much better fundamental setup than the current opportunity provides.

Alternatively a buy on thirds approach makes a lot of sense in this type of situation. That is, buy a third now, a third more after the HD results and then a final third only if the AD results are good. Your gains will be less, but importantly your risk will also be considerably less.

A third approach is to explore options as a means to play Prana.

Other fundamental setup examples

Here’s an example of a fundamental setup for pSividia last year.

A Peter Lynch favourite setup was the out of favour stalwart. A good example of the stalwart setup was QBE in 2012. I recommended QBE to TMF Share Advisor because there was very high probability of a getting a quick 30-40% gain out of QBE. That’s the type of return to expect from a stalwart setup, staying longer simply ensures your returns will quickly approach market averages.

One of my favourite setups is the fallen market darling. A great example here is CROX — remember Crocs? I recommended CROX as a turnaround play back in 2009. Another is when Netflix was taken out to the woodshed in late 2011 and 2012. If you forecast these events as having a probability of occurring then you’re prepared to buy if and when they do.

In summary, forecasting is good, nay essential, in fundamental investing. Forecasting clears my crystal ball helping me think more clearly about the future and thus assists me in finding the type of fundamental setups I like to invest in.

Disclosure: Long Prana – but have been a seller recently.

Be Sociable, Share!


Leave a Reply

Your email address will not be published.