Market philosophy, strategies and tactics

If you manage money, your own or other people, you need to have a well thought out market philosophy, strategy and tactics on which to base your actions. Without clear understanding of those concepts, you will be lost in a jungle of biased opinions and you will never be consistently profitable.

Market philosophy is an understanding of how the stock market works and what moves prices. It is who you are and how you see the financial world. It could be derived from a comprehensive academic research or based on experience. There are three major approaches to the stock market – value, growth and price momentum. Which one is yours and why? Further, what is your time horizon? Are you an investor, swing trader or a day trader. Define yourself. There is no such thing as right or wrong market philosophy. You need to find the right philosophy for your level of patience and risk comfort.

People trade their beliefs. For example, I believe that stock price appreciation is a function of rising expectations for future earnings. Expectations are often altered when new information appears – information that is not already discounted in price. Such new information could be a new contract, change in regulations, substantial earnings and sales surprise, higher EPS guidance – a catalyst that has the power to start a new trend; an event that changes expectations. When expectations change, perceived valuation is altered and the market moves to solve the disbalance.

Strategy is all about proper allocation of capital and time. It deals with the essential subject of position sizing, risk management and leverage. It involves clear understanding of how much you can afford to risk (lose) on every investment/trading idea and with what level of volatility you are comfortable with.

Tactics are all about conditional thinking and becoming a specialist in trading one or few distinctive setups. If events A, B and C happen simultaneously, you buy. If they don’t, you stay on the sidelines. When I mention a setup, I don’t refer to a chart pattern. A setup could consist of only fundamental or only technical factors or a combination of both. A good setup is a sum of conditions that need to align in time and space, before you initiate a position.

Let me give you an example of three distinctive setups used by three successful hedge fund managers:

Todd Sullivan is a value investor. He  would only consider a new position if it meets his clear rules: wide margin of safety that will offer plenty of room for mistake and an upcoming catalyst that will help the market to recognize the value. Todd subtracts all liabilities from all liquid assets and requires at least 30% margin of safety. No matter how much he likes the story behind a business, if the stock doesn’t meet all his criteria, he will not buy it.

Howard Lindzon is a momentum investor. He only considers stocks that are at their all time highs, assuming that if a stock is at such level, the underlying company must be doing something right – it is in the right business at the right time. His setup is derived from comprehensive quantitative research made by Black Star Funds, which proved that trend following could be exceptionally profitable when proper risk management is applied. Howard believes that it is safe to invest in the stock market only when there is broad price appreciation and hundreds of stocks are hitting all time highs. He likes to buy stocks that are just emerging to new highs from a long sideways consolidation and he is looking for the catalysts that will continue to push the price higher in the future. He invests in trends that he understands.

Doug Estadt specializes in investing in biotech stocks and Chinese ADRs. He considers a new biotech position only if it meets his clear rules that have proven to be successful in his experience. He is looking for late stage drugs, at least at phase 3; management team that he trusts and  has a history of successful FDA approvals and new drug launching; drugs that treat a condition that no one is currently treating or it is not being treated successfully. He acknowledges the downside risk that biotech stocks bring and considers his investment as a call option – if it doesn’t work, the downside risk is limited; if it works, there is an incredible upside potential. Doug does his due diligence and put his money where his mouth is. He has managed to build a solid track record of successful biotech investments.

What is the common denominator between those three so different setups? – Consistency. Evey day these people wake up and look for the same conditions to align before they consider to initiate a new position or to add to an existing one.

When you have the same daily routine for a prolonged period of time, you become a specialist in what you are doing. Specialist is someone who is more productive that the average person in performing certain task. When you look for the same setup every day, gradually you will learn how to recognize quickly the combination of market conditions that will increase the probability of success. You will refine your entry and exit points and become better at risk management.

Random following of biased opinions will not get you too far in the investing business. Opinions do not make money consistently, setups do.

Positive Earnings Guidance

It is a public secret that companies try to manage analysts’ earnings expectations in order to consistently beat or at least meet them. Not shockingly the ratio of positive to negative earnings surprises often exceeds 5. Therefore an earnings beat by 1 to 3 cents is considered a non-event, because the news was already discounted in the stock price. Only a small percentage of companies will report a game changing earnings that will impress the market.

Some companies have the tradition to give the street a clue about future earnings. Such news is called earnings guidance or earnings pre-announcement. Companies that suspect that there is a slight chance of missing analysts’ expectations will lower guidance in order to convince the Street to lower its estimates to an easily beatable level during earnings season. Only a small number of companies report positive guidance. The ratio of positive to negative guidance in a typical quarter is around 1:3, often smaller. Therefore positive earnings guidance is an important event that alters the market’s expectations. When expectations change, perceived valuation changes and prices move.

Why would a company guide higher and risk to miss earnings’ estimates when it reports? It is very simple. It doesn’t risk anything. It is absolutely confident that despite higher guidance it will beat again, often by a good margin. In addition to potential positive price reaction, an impressive earnings outlook gets more press and results in higher liquidity, which is extremely important for a small company.

When it comes to a small and relatively unknown company, most analysts don’t have a clue how to calculate its earnings and sales estimates. Often such companies are followed by less than five analysts, who gladly and blindly follow the guidance of the company’s management. The massive belief is that the management knows the most about the future perspectives of its company and its guidance should be “the best number we can get”. The point is that the management has the incentives to keep analysts’s estimates to a level that is easily beatable. As a consequence, analysts place their estimates in the middle of the announced earnings guidance range. For example if the EPS guidance for next quarter is $0.40 to $0.50, the consensus estimate will often be $0.45 or lower. In the cases, where the estimates are in the lower half of the guided range, analysts often have a buy or overweight rating for the stock. In such occasion, analysts have the incentives to be extremely conservative, so their customers won’t get caught in a stock that misses earnings’ estimates. Certainly not all analysts are lemmings. There are some quite sophisticated and highly intelligent, who do their own research and calculate their own estimates. Unfortunately the best analysts either follow the biggest and most popular stocks or after a few short years of exceptional work get promoted and go to work for the Buy side.

Remember, prices rise only when expectations rise. Expectations rise when there is a new catalyst on the horizon. The best performing stocks in any given year are the ones that manage to surprise the most in terms of size and frequency.

I have much more to say about positive earnings pre-announcements and how they should be used, but I’ll leave that for another time.

Dr. Steenbarger follows his own advice

If I as a coach am not pushing myself to grow and develop, then my efforts to help others evolve are fraudulent. I cannot offer others more than I can achieve myself. To take myself to the next level as a psychologist, I need to pursue challenges that will bring the best out in me.

Remember this: Your growth always lies on the other side of your discomfort. Whether it’s in the weight room or in career decisions, you’ll never develop yourself by staying in your comfort zone. People don’t become old when they reach a certain birthday; they become old when they decide to live life without crossing that line of discomfort.

A Guide to Earnings Season

Each earnings season brings three waves of information from companies. The first is guidance, the second is actual earnings, and the last is an outlook. Each wave of information becomes more important than the last.

About two weeks before the end of each quarter companies begin to announce whether they will meet the expectations of analysts. This ‘confession period’, as Wall Street calls it, can help set the tone of the season.

Companies strive to beat analysts’ expectations, which means that they prefer to guide lower in order to lower expectations to a level, where they are easily beatable. On average, companies that guide earnings estimates down outnumber those that raise them three to one, according to Thomson Reuters. This is why a positive earnings guidance is rare and  powerful sign of managerial confidence in the near future earnings and sales growth. There are three reasons for a company to guide higher:
1) it is a small company than wants to attract analysts’ attention, which will result in higher liquidity for its stock.
2) it would like to time a secondary offering with strong guidance
3) it is confident that despite rising street’s expectations, it can still beat them. This is very often the case.

When earnings’ season comes investors’ focus quickly changes from the guidance companies give to their actual results. The pace of earnings announcements looks like a bell curve. Less than ten percent of the companies in the S&P 500 announce in each of the first two weeks of a quarter. Then two-thirds of the companies report results in the span of three weeks. The pace then slows through the end of the quarter. (The majority of retailers report a month after the main earnings season as they close their annual books in January instead of December.)

In this flurry of results, a lot of attention will be placed on the surprise factor. This measures the extent by which a company beats analyst expectations (which very often have already been lowered numerous times by company guidance). The majority of the companies beat. This is why a surprise of one cent or two is considered no news. Sometimes a 100% earnings surprise is also no news at all if it was already discounted in the stock price. Companies that are early in their earnings expectations’ cycle have a better chance of outperforming. Their basis for comparison is still low and analysts are usually very cautious in raising estimates of companies that were neglected for quarters. This is why the so called cockroach effect exists and one strong earnings surprise often leads to a sequence of earnings surprises. For a company that had 4-5 consecutive quarters of substantial surprises is much harder to beat as analysts’ expectations eventually catch up and all potential good news is discounted by the market.

The stock market is a forward looking mechanism that constantly tries to discount changes in investors’ expectations. For this reason, company forecasts trump past successes. Even stocks with strong results can plummet if they deliver tepid outlooks with their results.

In the financial world, everyone tries to be one step ahead of everyone else. Any clue for better earnings and sales might impact expectations. Change in expectations leads to change in perceived valuation, which impacts prices. For basic material stocks such event is a change in prices of the underlying commodities futures, for retailers – changes in year/year comps or new stores opening, for semiconductors – new contract, for consumer goods producers – new distributor, for biotech companies – FDA approval or an announcement of positive preliminary results, for others – it could be change in regulation.