Reblog: Price Discounts Everything – Even Results

There are lots of people who trade stocks based on news and financial results. And they get severely confused and even disappointed when stock price roars despite a bad result/bad news or worse, it falls despite a wonderful result/good news. Today’s article depicts how trading based on news and results is a hopeless, dangerous and a loser’s game.

In India, companies are required to report their quarterly earnings to its shareholders. So, in every three months’ time, we are faced with a plethora of companies coming out with their quarterly results. So, most traders buy if results are good and if results are disappointing, they sell. On the face of it, it appears completely logical but let me tell you, it is far from being logical.

Let me show you a recent real life scenario which defied the logic of buying on good results:

Mahanagar Gas Limited (MGL), announced it’s Q1 2017-18 results on 9th August 2017. The result was terrific yet the stock fell like there’s no tomorrow.

Here are the key highlights of the result:

As can be seen that results were by no means ‘bad’.

Now, let’s see how the stock price behaved:

As you can see, the stock took a beating of nearly 7% on “good results”. And had someone bought in futures, he would be cursing himself because lot size of one contract of MGL is 600 shares. So with every one rupee decline in the stock price, a futures buyer would have suffered Rs 600/- loss per lot. To put it into perspective, had someone bought in 1 lot of MGL futures contract at the 9th August close price of Rs 1035.50/-, the moment stock price opened on 10th August, he would have suffered a loss of Rs 12,000/- per lot and had he kept it till closing of the day, the loss would have increased to Rs 41,820/- per lot.

So, what happened actually?

To understand this peculiarity, let us first understand discounting. You must have all heard the phrase, Price Discounts Everything”. Some of you would have understood it but some of you would still have trouble understanding this concept. If that is the case, I wrote this post for you.

I have always observed and experienced that, “Price Precedes Fundamentals” or in other words “Technical precedes fundamental”. I know this sounds strange but I’m sure that once you’d think hard enough, you’d agree.

Now let me explain the concept. As you’d agree that every happening in the world on all the fronts, economical, social, political, financial and so on is instantly available to everybody and there is no delay in action based upon the information. With the advent of internet and global broadcasting systems, information flows faster than the speed of light so everything that can be known about a company and its business, becomes immediately known to everybody. So, if you have a news about the result or any happening about the company, you are at no advantage over other market participants as everyone would have the same news as you. In fact, big institutional investors and so called “big money holders” get the information before general public so they take action even before a general investor gets the news. So, before you realize, the information gets into the price.

This means that anything which is in public domain and known to everybody, like annual reports, economical reports, news about the company, political issues, global factors affecting the company, earnings data and so on, is already reflected in the price. So, if every “known fundamental” is already in the price, there is no point to act after the news gets published.

But another thing to note is that when everything, that is known, is already in the price then why is price moving? This is a key question. And the answer is, that price is moving due to “unknown fundamentals”. And by the time the unknown fundamentals become known in the form of some news or report, its too late to act because the price move is already over. The reason is that, in the world and markets, there are always some people and groups who know the information before it becomes the news and it is these people who move the price much before the fundamentals become known to general public. Most of you must have seen the price moving sharply in a direction without any evident cause. And by the time the cause becomes evident, the price move is already over.

Now, you’d say that how can these big institutions know the result before the company reports it. Of course, they don’t. Becoming party to results or other public information before it is publicly reported is a punishable crime. But remember, they have far more knowledge and resources than an average retail investor (YOU). Their research and analysis is so vast that a retail investor can’t even imagine the depth of it. Let me give you a peep into the workings of a big fund house. Imagine having 20 separate teams of financial experts with each team having 10 team members. So, all in all, a grand team of 200 research analysts. Further, each team is dedicated to a specific sector. So, 20 teams focusing on 20 different sectors exclusively. So, one team’s job would be to just analyse textile sector and companies in it while the other team’s job would be to know everything that is happening in automobile sector and companies in it and so on. And further, within a team, analysts are divided as buy side analysts and sell side analysts. These sector specific teams work day in and day out dissecting every news, financial happening, government policies and everything that is affecting their dedicated sector and it’s companies. Further, they work closely with management of the companies that they are following. Plus, they put all their efforts in analyzing decades of past financial data of the companies that they are following and extrapolate that data too far into the future. So, if a fund-house is following Tata Motors, it would already have drawn profit and loss account, balance-sheet and its cash flow for future quarters and future years based on its in-depth analysis of the past data and future plans of the company. And, it will take positions before the actual result, as they already have a full blown estimate as to what the result would be like. So, in a manner of saying, they ‘know’ the results before it comes out and before you lay your eyes on it.

Now, you may ask, “Fine, they have big teams to analyse companies and sectors and they take positions well before the event (result in this case) but why does the stock price fall on good results?”

Let me explain !!!

Let’s continue the example of MGL itself to understand this. So, I explained earlier that how the price of MGL took a 6.7% dive on good results. But, what is the logic behind the fall? See, the institutional investors interested in MGL would already have anticipated a good result. They would already have calculated all the numbers through their deep analysis. They’d also know that since result would be good, everyone (retail traders) would rush to buy so there would be great demand for the stock one day before the result (most retail traders would want to buy the stock one day before so that they can enjoy the gap up opening next day post good result). So, if everyone would rush to buy based on good results, who will sell to these institutional investors? And if there would be no one to sell, how would the institutional investors buy and as such they generally buy huge quantities. So what they do is that they make positions much before the result as they already have a good idea of the result. Now, they’d buy when no one would notice and then gradually, they’d take the price to a peak before the result and just before the result when the retail traders rush to buy the stock, these institutional investors dump the stock causing a big fall. See, it’s simple demand-supply economics. They collect over a period of weeks as they already ‘know’ the result and then they dump when the actual event happens.

Now, let me show you MGL chart again and you would see the whole theory being applied in real life:

So, now you can clearly see that how the price was kept in a range for a long time so that big hands could accumulate the stock much before the result as they had already anticipated a wonderful result. And you can also see that the rise which retail traders thought of as random was not actually random. It was due to good anticipated results. And when the actual good results came, the price took a nosedive due to dumping (profit booking) of the big hands. And the proof of this theory becomes evident when the price again rose to the same level as it was on the result day, just within 4 sessions of making a drastic low. To a fundamental investor (retail), it would be a confusing move, because he would have anticipated prices to rise on a good result. But to a technical trader, the whole picture would have been clear as glass (I am one of them). So, fundamentally, there is no explanation for a rise before the result, the fall after the result and the recovery from thereon. You see, nothing changed fundamentally in the company when the price took a beating from a high of 1089.25/- to a low of 922.90/- in just 2 days. And, nothing changed fundamentally in last four days when price recovered from a low of 922.90/- to 1035.45/- (today’s close).

You may feel that under such complex circumstances, a retail investor or trader does not stand a chance. No, it is not that way. Just that, he needs to align his thoughts with reality. To become a successful trader or investor, you have to understand what Howard Marks (a legendary value investor) call, “Multi-Level Thinking”. To explain this concept, let us take an example of MGL result itself. First level thinking would include anticipating that company will post good results so share price will rise (this is how most retailers think). Second level thinking would include thinking that how people would be thinking about the results and what actions they would take. Third level thinking would include thinking that what people would be thinking of other people’s thinking. You’re getting my point? So, great investors and traders indulge in second level and third level thinking while retailers confine themselves to first level thinking. But, how to apply this in real life?

That is where technical analysis come into play. Since it is focused on analyzing price action, it catches the price movements before the cause of movement becomes evident. While a fundamentalist always wants to find out the causes of price movements, a technician never thinks about the cause and always focuses only on the effects. As I earlier explained that most of the times, there are no evident causes of price movement. There was no evident cause for price to rise before results, there was no evident cause for price to fall on results and there was no evident cause for price to recover post the fall. So, it is better to detach yourself from the causes and put all your energy in looking at effects.

Now, let’s see, how could you figure out the whole game before it was even played. Since the institutional investors figured out the results beforehand and started making positions, the same could be easily seen in the charts. You would ask but price was being kept in a range, so how would one have anticipated the upcoming rise? See this: