The Importance of Liquid Secondary Markets

Higher liquidity leads to a decline in transaction costs (bid/ask spread + commissions) and therefore: a decrease in risk premium. If you are able  to sell your assets quickly at the current market price, the perceived risk is lower – not only for you as an investor, but also for your creditors. Liquid secondary markets cause a decline in risk premium, which by definition leads to an  increase in the value of the traded financial assets.

The existence of liquid secondary markets is essential condition for developed IPO markets. Secondary markets are the main exit strategy for IPO investors, therefore the higher the liquidity the higher the interest in IPOs.

IPOs are an effective tool for venture capitalists and entrepreneurs to transfer part of the risk to the public; to get paid for their work or simply to raise more capital for further expansion. In the same time investors (the public) receive the opportunity to participate in the growth of a promising business. There is no doubt that without enough interest in IPOs (which is a derivative of secondary markets’ liquidity), venture capital and entrepreneurs will be robbed from one of their main exit strategies; therefore VC funds are likely to raise much less money and less projects will be funded. The end result is less start ups, less entrepreneurs, less jobs, slower technological progress and ultimatelly lower living standard for everyone.

Hopefully the Congress will not take short-sighted decisions that are going to worsen the liquidity of US secondary capital markets. Am I opposing new regulations? No – the systemic risk in the economy needs to be addressed and intelligent changes in regulation are needed. The simple, but optimal approach to decrease systemic risk is to limit the size of leverage and prevent “too big to fail” companies to participate directly or indirectly in OTC deals. If you are “too big to fail”, you need to be accountable and transparent. If you don’t like it, become too small to matter for the survivability of the financial system.

The most powerful forces against poverty are technological progress and entrepreneurship, which scope and success are directly dependent on the liquidity of secondary capital markets. Don’t kill the liquidity.

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.