Fundamental analysis is a powerful tool for stock investors; however, it is easy to over-complicate. Like any analytical method, fundamental analysis is not a perfect predictor for stock performance and is definitely not a replacement for sound investing concepts like diversification and money management.

Potential obstacles are numerous for the fundamental analyst. Some investors feel unprepared to tackle financial statements without a formal background in finance. The list of popular valuation ratios and fundamental metrics is nearly endless. It can be difficult to try to understand a "bad" fundamental metric versus a "good" one. There are, however, a few basic concepts that can be used to simplify this kind of analysis.

Avoid "Indicator Piling"

A long list of fundamental ratios and statistics is not likely to increase the odds of picking a good stock. In fact, selecting stocks based on a long list of requirements is more likely to lead to over-concentration in just a few stocks or industry groups, which can be dangerous. Over-concentration can increase your risk.

To keep it simple, I suggest using a single benchmark fundamental ratio that encompasses as much as possible about a firm's sales performance, cost structure and capital management. ROE, or Return on Equity, is a good example of the kind of the kind of ratio I would look for because it summarizes information from both the income statement and the balance sheet.

ROE is essentially the ratio between a company's net income (income statement) compared to its shareholder equity (or net assets from the balance sheet.) Another way to look at ROE is that it is the return on the money invested in the company. ROE is a classic way to measure how effectively a company is using its assets and leverage to create profits. And, of course, consistent profits generate probably the most visible impact on a stock's performance.

Fundamental Scores are Relative

A good ROE score in one industry is not necessarily a good score in another industry. Companies in different industries have to handle cash flow, assets and investments differently. When looking for a "good" ROE score, it makes sense to compare a firm to the average in its industry rather than across the market as a whole.

There is a long list of good searching tools available on the Internet to find stocks with an ROE ratio that is better than their industry average, including the Stock Screener tool in your Scottrade account. The Stock Screener tool can be found under the Quotes & Research tab in your account under "Stocks" in the left navigation menu. Picking a few stocks with better-than-average ROE scores from several industries is a good way to integrate fundamental analysis into a diversified portfolio.

Stay Diversified

Fundamental information relative to individual stocks is very "symmetrical." This means that investors generally have equal access to information. The given fundamentals for a stock are widely known by other traders. This means that a fundamental analyst doesn't necessarily have an information edge over other traders.

Because of this, good fundamentals are more likely a predictor for lower volatility than huge profit potential in the short term. Lower volatility, however, is a good thing for most traders. It smoothes your equity curve growth and can improve returns over the long term.

Essentially, the strategy I am advocating is to use a key fundamental metric to build a portfolio of 10-12 stocks from several different industry groups. Building a pool of several stocks based on their fundamental performance is often referred to as fundamental indexing. Essentially, you create your own index fund that corresponds to a major market index like the S&P 500, for example.

The concept of fundamental indexing is new but gaining in popularity. There are a few ETFs (exchange-traded funds) based on fundamental metrics like ROE that show very promising results by outperforming the broad market indexes over the last few years. Investing in an ETF that matches your investment goals and target benchmark index is one way to take advantage of the fundamental indexing strategy without having to select each individual stock on your own.

You can see an example of this in the chart below that compares the performance of the S&P 500 versus a fundamentally indexed ETF over 2009. The fundamental ETF has outperformed the broad market index 28% to 13% since the beginning of this year.