For all the badgering that the Chicago School has taken in the months following the market collapse, the efficient market theorists got one thing right: markets react fast to new information. There’s a lovely scene in “Fun with Dick and Jane” that illustrates this perfectly:
The markets really do react this quickly! I remember an exercise in business school where we watched a CNBC reporter revealing new information about a company while, next to her, a stock chart tracked the company’s stock price in real time. She was the first anchor with positive information, and by the end of her five-minute report, the stock had climbed more than 10%.
The following bits of information have the potential to move individual stocks substantially:
earnings surprises
mergers and acquisitions
joint ventures / distribution deals
new product announcements
spinoffs / divestitures
restructuring
share repurchase plans
To see the impact that these changes can have on the markets, just look at the biggest percentage changers over the past 13 weeks on Google finance. Read the stories associated with each change and note the change in stock price the moment the information was released.
One thing all these bits of information have in common is that they are usually in the works for months (or even years) before the markets get wise. There are a number of ways to discover this information before the market gets it, all with their own problems:
Network: If meeting people is your forte, or if you just happen to have gone to law school with the lead counsel for an acquisition candidate, call him up and ask how the deal is going. There’s just one tiny problem with this approach: it’s illegal.
Eavesdrop: It’s still illegal if you happen to get information on a transaction this way and trade on it, but if you happen to be drinking at a bar next to an accountant bragging about how a recent restructuring is going to deliver surprise earnings, you’re in the clear. You’re also safe if you notice that the factory next door to your apartment is suddenly moving a lot more merchandise into trucks. Cash out your retirement and buy some options! Of course, such situations are rare and hard to plan for. The other problem is that this kind of serendipitous information is easy to misinterpret. That accountant might be a fireman telling a yarn just to pick up chicks (not), and that factory could be liquidating.
Research: If you dig really deep into the public record, deeper than most investors are willing to go, you might discover something that gives you an edge. This seems to be the method employed by most successful investors who aren’t currently in jail.
Of all the methods above, the last is probably the best approach, in theory. In The Big Short, Michael Lewis tells the story of the handful of private investors and hedge fund managers who made a fortune off the recent market collapse by being the only people in the world willing to read complete 1,000 page documents detailing the composition of various Collateralized Debt Obligations. While the information they were trading on was public, it was too draconian for most investors to understand. Thus, the market remained inefficient long enough for them to make a killing.
Another investor who has been very successful at spotting inefficiencies through research is Joel Greenblatt. Greenblatt made a sizable chunk of money by researching poorly valued companies that had recently divested one of its divisions. A spinoff is the accounting equivalent of cleaning out the refrigerator: by throwing out the rotten product lines, management has more capacity to focus on more profitable ventures. A spinoff may also signal a shakeup in management, and for an underperforming company, that’s usually a good thing.
These exceptions aside, it’s usually very hard to make money off new information. Efficient market economists believe that the stock price reflects the sum of all available information. As soon as the positive news becomes available, the theory goes, the price will immediately go as high as it’s going to go on that information.
But I’d take that theory a bit further and say that the price will immediately go higher than it really should. That’s because the people who tend to trade on positive information are usually optimists. When that big merger goes through, investors are thinking about synergy and rosebuds when, in reality, 80% of all M&A transactions fall far short of expectations.
So what’s an investor to do? One approach would be to place a put after a positive announcement, but options are usually priced based on volatility, so a surprise is likely to push both puts and calls past an attainable strike price.
The Contrarian approach is to turn the information trading technique on its head. Instead of looking for positive news, Contrarians look for negative news. Since most people trading on negative news are likely to be pessimists, they’re also likely to over-react to the information and drive a stock price into bargain territory. Things don’t always work out that way, but the odds improve if you invest in companies that have a strong moat (e.g. a good brand).
In my ever-evolving investment philosophy, I’m going to add the 13 week percentage change metric. But I won’t be looking for the gainers. I’ll be fishing for bargains.
Domestic Trends
:: Google paints a stark vision of the US economy.
Economic Analysis
:: Project Syndicate provides newspapers with analysis from the world’s top economists
Economic Calendar
:: The key events moving the market, highlighted by Briefing.com
Real Clear Markets
:: Daily briefing on the markets
Undervalued stocks
:: Stock screen based on “Warren Buffett and the Interpretation of Financial Statements”
Value Cruncher
:: A web tool that simplifies discounted cash flow analysis of public companies
Wikinvest
:: Simple research and portfolio consolidation.
Data trading for value investors
For all the badgering that the Chicago School has taken in the months following the market collapse, the efficient market theorists got one thing right: markets react fast to new information. There’s a lovely scene in “Fun with Dick and Jane” that illustrates this perfectly:
The markets really do react this quickly! I remember an exercise in business school where we watched a CNBC reporter revealing new information about a company while, next to her, a stock chart tracked the company’s stock price in real time. She was the first anchor with positive information, and by the end of her five-minute report, the stock had climbed more than 10%.
The following bits of information have the potential to move individual stocks substantially:
To see the impact that these changes can have on the markets, just look at the biggest percentage changers over the past 13 weeks on Google finance. Read the stories associated with each change and note the change in stock price the moment the information was released.
One thing all these bits of information have in common is that they are usually in the works for months (or even years) before the markets get wise. There are a number of ways to discover this information before the market gets it, all with their own problems:
Network: If meeting people is your forte, or if you just happen to have gone to law school with the lead counsel for an acquisition candidate, call him up and ask how the deal is going. There’s just one tiny problem with this approach: it’s illegal.
Eavesdrop: It’s still illegal if you happen to get information on a transaction this way and trade on it, but if you happen to be drinking at a bar next to an accountant bragging about how a recent restructuring is going to deliver surprise earnings, you’re in the clear. You’re also safe if you notice that the factory next door to your apartment is suddenly moving a lot more merchandise into trucks. Cash out your retirement and buy some options! Of course, such situations are rare and hard to plan for. The other problem is that this kind of serendipitous information is easy to misinterpret. That accountant might be a fireman telling a yarn just to pick up chicks (not), and that factory could be liquidating.
Research: If you dig really deep into the public record, deeper than most investors are willing to go, you might discover something that gives you an edge. This seems to be the method employed by most successful investors who aren’t currently in jail.
Of all the methods above, the last is probably the best approach, in theory. In The Big Short, Michael Lewis tells the story of the handful of private investors and hedge fund managers who made a fortune off the recent market collapse by being the only people in the world willing to read complete 1,000 page documents detailing the composition of various Collateralized Debt Obligations. While the information they were trading on was public, it was too draconian for most investors to understand. Thus, the market remained inefficient long enough for them to make a killing.
Another investor who has been very successful at spotting inefficiencies through research is Joel Greenblatt. Greenblatt made a sizable chunk of money by researching poorly valued companies that had recently divested one of its divisions. A spinoff is the accounting equivalent of cleaning out the refrigerator: by throwing out the rotten product lines, management has more capacity to focus on more profitable ventures. A spinoff may also signal a shakeup in management, and for an underperforming company, that’s usually a good thing.
These exceptions aside, it’s usually very hard to make money off new information. Efficient market economists believe that the stock price reflects the sum of all available information. As soon as the positive news becomes available, the theory goes, the price will immediately go as high as it’s going to go on that information.
But I’d take that theory a bit further and say that the price will immediately go higher than it really should. That’s because the people who tend to trade on positive information are usually optimists. When that big merger goes through, investors are thinking about synergy and rosebuds when, in reality, 80% of all M&A transactions fall far short of expectations.
So what’s an investor to do? One approach would be to place a put after a positive announcement, but options are usually priced based on volatility, so a surprise is likely to push both puts and calls past an attainable strike price.
The Contrarian approach is to turn the information trading technique on its head. Instead of looking for positive news, Contrarians look for negative news. Since most people trading on negative news are likely to be pessimists, they’re also likely to over-react to the information and drive a stock price into bargain territory. Things don’t always work out that way, but the odds improve if you invest in companies that have a strong moat (e.g. a good brand).
In my ever-evolving investment philosophy, I’m going to add the 13 week percentage change metric. But I won’t be looking for the gainers. I’ll be fishing for bargains.