Nicolas Darvas was best known as a technical trader. His famous “Darvas Box System” was a simple trend-following method.
But, as with most things in life, there’s much more to the story when you dig below the surface. In this case, there’s much more to the Darvas System than purely trend-following technical analysis.
Darvas referred to himself as a “techno-fundamentalist.” While he discovered (the hard way!) that there was zero value in fundamental analysis alone, he found that he could vastly improve his trading results by ADDING a fundamental perspective to his technical method.
Here’s how he came to that conclusion.
In 1955, Nicolas Darvas nearly went bankrupt on an investment he based solely on stellar fundamentals. This “can’t miss” stock had everything fundamental investors dream of: a low P/E multiple, a high dividend yield, strong balance sheet ratings, etc. Yet, Darvas quickly discovered that even though this fundamentally-superb stock looked like a sure thing on paper, its stock price didn’t seem to agree with the experts’ fundamental analysis.
Darvas sold this “perfect” stock less than one month after buying it. Its price had simply fallen too far and too fast. Darvas was leveraged with this investment and he sold in order to avoid financial ruin.
After this debacle, Darvas questioned the conventional Wall Street wisdom about fundamental analysis. Darvas wrote, “What, I asked myself, was the value of examining company reports, studying the industry outlook, the ratings, the price-earnings ratio?”
These questions led Darvas to the formation of his technical “Darvas Box System.” But, this trend-following method alone was not enough.
Darvas found that while technical analysis worked well, his results could be vastly improved by combining his technical system with certain fundamental requirements.
In analyzing top-performing stocks, Darvas recognized a clear correlation between earnings growth expectations and the speed of stock price gains.
“I found the majority of these [top-performing stocks] were companies whose earning trends pointed sharply upward,” Darvas wrote. “The conclusion was obvious: capital was flowing into these stocks, even in a bad market. This capital was following earnings improvement as a dog follows a scent.”
The correlation could not be ignored.
Darvas summed up his findings by stating: “I saw that it is true that stocks are the slaves of earning power. Consequently, I decided that while there may be many reasons behind any stock movement, I would look only for one: improving earning power or anticipation of it. To do that, I would marry my technical approach to the fundamental one. I would select stocks on their technical action in the market, but I would only buy them when I could give improving earning power as my fundamental reason for doing so.”
These are powerful words from Nicolas Darvas.
He found that fundamental ratings alone were worthless. But, he also found that relying on technical analysis alone was too broad. There were just too many stocks trading erratically to rely SOLELY on technical analysis.
Darvas’ big “aha” moment came when he realized that technical trend following worked, but it worked exceptionally better when combined with fundamental prospects.
And what were the fundamental prospects Darvas relied on? He wanted to see big earnings and big earnings expectations. He wanted to see stellar earnings reported in the most recent quarter and even better earnings expectations for the upcoming quarter(s).
Vast studies have proven that trend-following technical analysis does work in the stock market. But what Darvas realized is that even better results were attained when earnings power was combined with his technical “Darvas Box System.”
When Darvas made this powerful connection, he applied it to his trades and turned $37,000 into $325,000 over the next year. He then turned that amount into $2.25 million over the following year.
When discoveries like Darvas’ produce results like that, it pays well to learn from such discoveries.