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We are into the results season and these days, for equity investors, the results month is like being on a battlefield during an artillery barrage wearing fluoro orange. You never quite know when you are going to get blown up and this results season will take that risk to the extreme as companies report on the most unpredictable quarters in stock market history.
It’s not just COVID-19 that creates the risk. Results seasons have been getting progressively more dangerous for a number of reasons.
The first is continuous disclosure requirements which mean that a company can’t quietly feed a message into the market anymore. Instead, it has to dump it. When a company hasn’t said anything to the market for six months, their results can easily surprise.
Before continuous disclosure, companies would feed changing expectations into the market through select brokers. They would ‘seep’ their guidance in, not crash it in. It was called 'managing expectations' and this selective briefing method, far from being unfair, was seen as a company’s professional duty.
But it is no more. Now listed companies have no choice but to dump information in, either in a pre-results confession or on the day of the results. They aren’t managing expectations as well as they used to, making the odds of a surprise much higher than they used to be.
The other volatility-inducing factor during the results season is high-frequency trading (HFT). HFT identifies market activity, exaggerates it, and when it comes to the results season, if a stock was going to move 1% on the news, high-frequency trading means it moves 2%, or 5%, or 10%.
The algorithms run by HFTs are designed to detect other people’s orders moving in and out of the screen, even before they are executed. They also respond to executed trades and in so doing detect short-term price trends, in nanoseconds, and respond to them by placing their own orders in nanoseconds without any consideration for fundamentals.
The algorithms are also now electronically scanning the words of results announcements, no humans involved, and are picking up on adjectives and phrases like 'profit warning' and 'lowered guidance' or 'raised guidance'. And they instantaneously start placing orders in response.
That algorithm activity is then picked up by the vanilla activity-matching algorithms, and on the back of all that, a few years ago we saw big stocks WorleyParsons open down 21.8% on the day of its results, only to bounce 11.5% from the low before the end of the day. Company CEOs now get lessons on how not to 'do a WorleyParsons', how to phrase their announcements so as not to trigger the algorithms.
Notably, all this ridiculous HFT happens before any analysis is done by the brokers or the big institutional fund managers, otherwise some sanity might prevail. But it’s not possible for the big funds to do the research, revalue a company and make their decisions between 8:30am when the results are announced and 10am when they start trading the shares. The prices gap anyway.
And don’t expect this situation to change. ASIC’s study into HFT concluded that while it may be exaggerating short-term price movements, HFT was not disrupting the integrity of the market or materially raising the costs of execution enough to ban it. It is here to stay, and the ASX has no interest in limiting it, because they are making money from HFT customers paying for high-speed data feeds with terabytes of information provided by the exchange at a huge cost.
The bottom line is that results seasons are now high-risk periods for investors, and with a COVID quarter to report on, this results season is the riskiest on record.
Running the Marcus Today SMA, a $75 million fund, we have had to adapt to results risk and have done so using this mantra:'If in doubt, get out'. If we have concerns about one of our stocks having bad results, especially if it is a mid-cap stock, we often sell it before results. We prefer to avoid big risks and come back later, than go into the results announcement with our fingers crossed.
Some of the signs that set off the ‘results risk’ alarm bells are:
· trending down into results
· no recent guidance
· disappointment in previous results announcements
· operating against industry headwinds
· downgrading by brokers ahead of results
· a volatile stock
· a smaller or mid-cap stock
· liquidity issues (will move a lot on a surprise)
· a popular trading stock
· a ‘disaster’ stock (don’t bet on a resurrection).
Spotting stocks with low-risk results is the opposite. They are stocks that:
· are trending up into results
· have recently put out guidance (de-risked)
· have a share price that rose on their last results/guidance/trading update
· are swimming with the tide (good industry trends)
· have been upgraded by brokers ahead of results
· are a big, well-researched stock
· have a history of good results
· have consistent earnings growth
· have consistent dividend growth.
It is much better to miss a bounce on results and buy after the company has cleared the air than it is to step on a landmine. The market takes no prisoners these days, so caution rather than bravery will win the day. Far better you go to bed with no exposure than you go to bed worrying about some mid-cap results the next day.
After the results are out, that’s the time to jump on board, when the stock is de-risked for the next three to six months. Many uptrends will start the day of the results. And downtrends.
Undertake basic vigilance. Find out when results are due for the stocks you are holding or trading. If you find a stock you hold is down 10% one morning after announcing results you didn’t know were due, it is a bit negligent. There are plenty of results calendars around. Marcus Today has one.
Check the announcement history. Go back and look at the latest earnings announcement, an AGM maybe, a trading statement. Hopefully it was recent. If it was, the tone of these results is likely to be the same. Find out whether it was positive or not, if the share price went up or down, whether brokers upgraded the next day or not. It is unlikely a company that has seen an earnings announcement running into results (good or bad) will disappoint.
Avoid the bad ones. More than half the game these days is avoiding the disasters. Don’t bet on the unlikely, on resurrection, on a falling stock. Don’t swim against the tide. It’s not clever, it’s dumb. It’s a game of odds, not heroics.
Watch the share price trend. Another indicator of whether a stock is likely to surprise on the upside or downside is to look at the share price trend running into the results. The market is rarely wrong. Good stocks tend to do good things and bad stocks tend to do bad things, and the results announcements are unlikely to turn the current trend on a sixpence.
Look for dividend stripping. The traditional trade is to buy big income-paying stocks some 50 days or more before the dividend ex-date. Usually, this allows income-chasing investors to sell on the day it goes ex-dividend and still qualify for the franking under the 45-day rule. One broker published a chart last year showing that income stocks tend to outperform in the 50 to 70 days before the ex-dividend date suggesting you buy 50+ days out from the dividend and catch the statistically-typical run to the results and the dividend. I have another technique. Wait for the results from CBA or Telstra, and if they are good you can still buy the stock before the dividend in full possession of all the facts and catch the next 45 days rather than gamble on the pre-results trend. If the results are good, quite often, the stock will trend up after the announcement anyway.
Buy the bounces, sell the shock drops. An academic study once showed that a shock move up or down continues to in that same direction for the next nine days. In other words, if a stock has a good set of results and pops up 5%, don’t say 'I’ve missed it', buy it because it is likely to keep going in that direction for a while. Sharp moves tend to start trends, not end them, presumably because after a company announces good results, sentiment improves, not for a day but for a while. The research the next day will be upbeat. Brokers will raise target prices and recommendations over the next week and it takes a while for good news to be factored into the price. Your risk is lower than punting ahead of the results.
Check the numbers. Fundamentals are an obvious starting point for ranking stocks on potential risk. Broadly speaking, companies with consistent earnings and high regular return on equity are more likely to produce good, low-risk results. The bigger well-researched companies with higher yields and consistent (rather than high) ROE trends are the safest. The mid-cap and small-cap growth stocks and recovery stocks with no yield, high PEs, weak balance sheets, possibly loss-making concept stocks, are riskier.
Traders will try to make money out of this results season while investors will try to avoid the extraordinary risk. That’s what we are doing. We run our $75 million fund as we would our own money, and sometimes that means getting out of the market altogether.
We did it on 20 February 2020, we got back in on 24 March, we got out again on 12 June and as of today, the main fund is 100% in cash in this extraordinary market. We can’t see the reasons to be “All in” so we’re “All out”. Due to our current market view, we have no risk going into this results season. That seems the better play than being fully invested, hoping we’ve got it right.
We are always looking to make money for our investors but with an appropriate level of risk. With a COVID backdrop, and with the results season imminent, the market has rarely been so dangerous. In the next three weeks, the results season will reveal it all, clarify earnings, reduce the risk and provide certainty where there is mystery.
With cash we have power and are ready to use it.
I can see us buying individual stocks in the next three weeks, but only after they sound the ‘All clear’. We’re not going to ‘bet’ on one the most dangerous results seasons in history, we’re going to ‘invest’ afterwards. We’ll leave the results to people far smarter, braver, luckier or foolish than us.
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