Earnings Surprise + High Short Interest = Big Profits

Financial markets tend to underreact to genuine surprises and overreact to know threats. When a company reports better than expected earnings and sales number, it receives a positive reaction to their numbers and it has a high short interest, it can deliver hefty returns in a short period of time. CONN and RH are two recent examples. The new earnings season has just begun. It will likely provide several similar opportunities.

Innovation and Structural Edge – the Keys to Market Survival and Growth

 

Some say that discipline is the key to market success. While necessary, discipline is not enough. Otherwise, all quant systems would be always profitable. This is hardly the case. Market edges get erased all the time.

The statistical definition of a market edge is having an approach with positive expectancy.

If you have a 50% success rate and your average winner is two times bigger than your average loser, then you have an approach with positive expectancy.

Josh Brown says that any market edge is ephemeral. It cannot be sustained for long and only a few institutions have managed to adapt successfully to the constantly changing markets. Finding new edges on a regular basis might be very unrealistic when you manage billions of dollars.

Some market methods provide a structural market edge. A structural edge is an edge that doesn’t disappear forever, but it has a cyclical success rate. It goes through periods of making money, followed by periods of making no money. Structural edge is based on market forces that have always been a fundamental part of what moves prices: momentum, value, fear of missing out, fear of losing, range expansion and range contraction, the tendency of the market to underreact to genuine surprises and overreact to known threats.

Some say that the definition of insanity is doing the same thing over and over again and expecting different results. If you do the same thing over and over again in the market, you are guaranteed to get very different results. The same approach that makes a lot of money in a raging bull market is often a losing proposition during range-bound, choppy markets.

Trading or investing are not that different from any other business. You have to sustain a competitive advantage in order to continue to grow.

Markets change all the time. Great investors and traders innovate and adapt to constantly changing market conditions. The change might take the form of taking a break and moving to the sidelines or coming up with a new edge.

The main point of my latest book is exactly that: different setups work in different markets: Top 10 Trading Setups – How to find them, when to trade them, how to make money with them.

About Fat Tails and Market Timing

Morgan Housel has an interesting post comparing investing in startups with investing in established publicly traded large-cap companies. To summarize his points:

Both types of investing rely on a small percentage of positive outliers that will account for most of the profits. VC investing is considered riskier because of the velocity of the wealth creation and destruction involved. A VC fund can lose everything or make a 10X return on capital in a few years:

A VC portfolio can go from a standing start to a point where two-thirds of your companies have whiffed and one or two knock it out of the park in three or four years.

In public equities that same distribution can take 10 or 20 years to play out.

That’s the risk difference between the two asset classes. It’s not how the individual companies perform. It’s the amount of time it takes for those companies to log their performance. VC is just like investing in public equities, but at 5x speed.

If VC generates higher returns than large-cap public equities, it’s not because investors have to endure more risk. They just have to endure about the same amount of risk crammed into a much shorter period. Which is hard. There’s a cost to it. You pay for it, not with money but with worry and doubt.

I want to make three points that add to his analysis:

  1. It is not that private startups grow wealth a lot faster than publicly traded large caps. The first are apples, the second are oranges. It’s a lot harder to achieve a 100% annual sales growth when you are already a 100-billion dollar company. Startups are by definition smaller companies and can grow a lot faster. Yes, some startups go up 100X in a few years and publicly traded companies might need 20 years to achieve similar returns, but the former enrich only a small number of people and the latter provide that opportunity to millions of investors.

2. Investing in startups does not necessarily involve more volatility and stress for any of the sides involved. VCs don’t need to report quarterly earnings. They have the luxury of a long-term capital. Yes, they send the occasional annual letters to their general partners, but no one expects from them wonders in a short period of time. Their investors know they might need to wait seven to ten years before they see a substantial return or any money back.

Compare VC partners’ situation to publicly-traded large caps. The latter give detailed reports on a quarterly basis and are covered by hundreds of analysts on a daily basis. Meeting Wall Street’s short-term expectations is a priority for most. Public companies’ investors have the luxury of liquidity, which is a double-edged sword if you don’t know what you are doing.

3. Timing matters a lot, in both private and public investing.

One of the most important questions that angel and VC investors ask startups is “Why now?”. Is the world ready for your product or service? There were hundreds of internet video startups in the late 90s and early 2000s, but most of them failed, because the tech infrastructure was not ready to support them. Youtube was founded in February 2005 and it was bought just a year and a half later by Google for $1.65 billion. It was an all-stock deal, so Youtube’s founders had the opportunity to make even more money. Google went up 250% in the next ten years.

You can achieve angel investing returns in public markets after big corrections. The bigger the correction, the bigger the opportunities afterward. If you look at the best-performing stocks of the past 10 years, you will notice that not a single one of them has delivered a 100X return. Netflix went up 44X, Priceline went up 30X, Amazon went up 20X. Only 29 stocks went up more than 10X between 2007 and 2017. Public markets were close to all-time highs in 2007. If you measure performance since the financial crisis lows in March 2009, you will find hundreds of stocks that went up 20x, 30X, 50X in the next five to eight years. There are some that even went up more than 100x.

Does Past Success Change Future Returns?

One of the top money managers and deep thinkers of our time, Howard Marks says the ultimate market truths are:

  1. Public psychology determines price action in short-term perspective.

Psychological and technical factors can swamp fundamentals. In the long run, value creation and destruction are driven by fundamentals such as economic trends, companies’ earnings, demand for products and the skillfulness of managements. But in the short run, markets are highly responsive to investor psychology and the technical factors that influence the supply and demand for assets. In fact, I think confidence matters more than anything else in the short run. Anything can happen in this regard, with results that are both unpredictable and irrational.

2. Most things will turn out to be cyclical and eventually mean-revert.

In investing, as in life, there are very few sure things. Values can evaporate, estimates can be wrong, circumstances can change and “sure things” can fail. However, there are two concepts we can hold to with confidence: • Rule number one: most things will prove to be cyclical. • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

Marks also believes that past performance impacts future performance in a big way:

If everyone likes it, it’s probably because it has been doing well. Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.

In the quote above, Howard Marks talks about assets. Does the same principle applies to trading and investing systems? In business, when a company has very high-profit margins, it attracts competition, which eventually significantly reduces those margins.

What happens if too many people start to apply the same market strategy? Usually, that same strategy stops to work for awhile. Faced with poor returns, many will move on and try something new. Then, all of a sudden that same strategy miraculously starts to work well again. This is a basic market principle – anything that works well for the long-term, has to go through short-term periods of not working (losing money).

If everyone becomes a value investor, deep value opportunities will become more scarce. They will likely come once every five or ten years near the bottom of big bear markets. Traditional, long only value investing is hard during prolonged bull markets when a lot of money chases very few good opportunities. Warren Buffett realized relatively early in his career that value investing is not scalable. Then, he switched to buying great businesses at reasonable prices. A true value investor is basically forced to look for short opportunities during much of his career while he is waiting for the next bear market to create incredible long opportunities.

What happens if everyone becomes a momentum investor? Does momentum investing stops working or price trends last even longer and deliver even higher returns? Or maybe, trends become shorter in duration, but a lot more intense and as a result, we see moves that used to take a year to happen in one or two months?

When happens if most people become passive indexers? Correlations are likely to rise further, which means that great businesses will become very attractive deals during market corrections and crappy companies will overshoot to the upside during bull markets and eventually turn into great short opportunities.

In the financial world, you have two basic choices:

  1. Stick to one market approach and go through periods of big drawdowns.
  2. Have several approaches and apply the one that best fits the current market.

I am not saying that one of those approaches is right and the other is wrong. One requires less time and efforts. Thr other significantly reduces drawdowns and potentially can deliver higher returns. One is a science and the other is an art. Art is usually a lot harder.

My strategy is to be flexible and adapt to the ever-changing markets.

What Can We Learn about Trading from Warren Buffett and Jeff Bezos

At the beginning of his career, Warren Buffett was a value investor. At some point, he realized value investing cannot scale after certain capital size is reached. Then, he started to buy great businesses at a reasonable price.

I like businesses I can understand. It is not an easy business for competitors to enter. I look for a competitive advantage – cost, brand; share of mind is priceless and better than market share. How much could anyone hurt them if they had a billion or 10 billion dollars. If they can’t make a dent, I am in.

I want to know what a business will look like 10 years from now. If I can’t see them where they will be 10 years from now, I don’t buy them. We are buying a piece of a business. You will do well if the business does well if you didn’t pay too high of a price.

The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.

Jeff Bezos manages Amazon the way Buffett invests nowadays. He asks the question what is not likely to change ten years from now and builds his operations on those principles.

I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time. … [I]n our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, ‘Jeff I love Amazon; I just wish the prices were a little higher,’ [or] ‘I love Amazon; I just wish you’d deliver a little more slowly.’ Impossible. And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it.

Both Buffett and Bezos look for long-term sustainable competitive advantages that are very likely to pass the test of time.

Is your trading system developed on principles that are not likely to change ten years from now?

Is your approach based on an understanding that the market is constantly changing and different markets need to be approached with different setups? This requires having a portfolio of different setups and knowing when to use them.

Do you have methods that will find big future winners on a regular basis? The names of future winners will be different than the ones today, but they will have something in common.

Do you have a clearly defined plan to Take advantage of the inevitable market corrections, sector rotations, institutions’ buy and sell decisions, price trends, momentum, volume and price range expansions?

Do you realize that correlations and volatility spike during market corrections and no amount of plain vanilla asset diversification will save your portfolio from a deep drawdown? Are you prepared to stomach 20%, 30%, 50% drawdowns or do you have a way to make them a lot smaller?

Check out my book: Top 10 Trading Setups – How to find them, When to trade them, How to Make Money with them