“Acheter les clarions, vendre les canon”
Buy the bugles, sell the cannons
It’s not a very difficult concept to grasp for our industry. We get paid for selling our winners when the fundamentals don’t seem to justify the price being offered by the market. However, it can be among the most difficult concept to internalize. Parting ways with a position that has treated us well is so contrary to common sense and what we instinctively want to do.
The quandary doesn’t present itself often. More often, the situation presents itself from a different perspective when it isn’t even in our portfolio. Rather, we are eyeing it, with a burning desire to buy into its steady surge. Even if the pace of its rally were cut in half, it still tries to entice us into buying.
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CMG
3-week 10% rally before 7/19/12. On the 19th, post-close earnings show an immediate 20% drop that evolved to 30% one week later.
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DELL
6-week 25% rally to new multi-year highs before 2/22/12. On the 22nd, pre-open earnings call resulted in an immediate 10% drop that became 35% after 5 months.
In reality, our job is to recognize value. The flip-side to that is recognizing when something is overvalued. None of this is possible if we are not always aware of catalysts that can make the market realize the value, or the lack thereof, of a security.
An earnings announcement is one such catalyst. It is a report card that describes whether the student’s behavior all quarter interfered with his learning or enhanced it. Behaving too optimistically ahead of earnings could be compared to the student acting too cocky on his way into the quarterly-exam room. But instead of bad grades, you lose money.
We can short, sell, or just not buy a stock that has gained double digits by rallying for at least one-two weeks before a prescheduled earnings announcement.
Trending relentlessly into an event like earnings, whose specifics are unknown, requires broad-based buying. A multi-session advance in price cannot be the product of “inside information.” Therefore, such a rally must be sponsored by outsiders. What is behind this widespread confidence, if not fact? Opinion. And when the broader market is overwhelmingly in agreement, then it is difficult for the facts to be more favorable than what the opinion already expects.
Even if earnings totally justify the recent price rise, they cannot justify much more. The earnings report is quarterly, so the next report card will be three months away. Other news stories and corporate announcements will fill the time in the interim, but the motivating factor behind the recent broad-based buying will have disappeared. Since price is the product of demand and supply, the shrinking demand will make prices fall.
Now, imagine what would happen if earnings “missed” and did not fulfill expectations. This would encourage selling, as much as the anticipation for good earnings attracted buying. Remember that equation for price? Increasing supply would drive price down, especially after so much demand had just been fulfilled by multiple weeks of rallying.
There is a price to pay for being early to a story. There is an unpredictable amount of time an early investor spends waiting for corporate announcements to prove the premise, and to attract other buyers that drive price higher. There is a bigger price to pay for staying too long, or for getting involved too late. When everyone is excited about a story, it can sometimes be the worst time to buy.