Earnings Season Myopia

Published on 10/17/23 | Saurav Sen | 1,123 Words

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The BuyChart of the Day: JPM – before and after…

We had sent out a chart on JPM’s risk a few days ago. We measure risk via our Safety Rating – the nuts and bolts of which we had published. But Safety is just one half of our overall Rationality Rating. When we sent that last Friday, JPM’s new quarterly numbers had not yet percolated through our systems. Now they have. Here’s the comparison of their overall Rationality Ratings – before and after the numbers flowed through our systems:

We should reiterate that we like investing in companies whose stocks have a Rationality Score of 9 or above. JPM is close. But here’s the main point:

For most stocks we cover (maybe 95% of our universe of nearly 4,000 stocks) our Rationality Ratings won’t change much after one (or even two quarters of earnings). That’s because our ratings are long-term. That doesn’t mean the stock will remain steady. In fact, stocks can react violently to one single earnings report. But we see that as an opportunity to buy more if our subjective thesis about the company remains intact.

Nothing highlights the manic-depressive nature of the market like Earnings Season.

Underrated Stock Insight: Beware of Earnings Season Myopia

The terms “Investor” and “Trader” are often used interchangeably on Main Street. On Wall Street they mean different things. I’m going to use stocks to illustrate the difference.

Trading is normally associated with making regular (sometimes incessant) trades based on the company or macro news of the day (like quarterly earnings). Investors take the news in their stride as data points. They give the company time for the strategy to play out over a couple of years. In fact, investors expect quarterly numbers to either overshoot or undershoot thereby causing (sometimes violent) stock price swings.

Let’s put it this way: Traders view stocks as commodities – a series of numbers that can be traded based on predicting the demand for that commodity. Investors view a stock as a means to buy a business that will propel their portfolio returns towards their long-term target. If the business does well, the demand for the security will invariably follow.

So, what is the line where a trader becomes an investor? It's blurry. But I think quarterly earnings reports give us a clue. If you trade frequently based on earnings reports, you’re decidedly a trader, in my opinion. If earnings reports are just valuable pieces of information – not to be traded upon (usually) – then you’re an investor.

I’ve found that the trader in me wakes up in the early days of every earnings season. It takes me a lot of willpower sit there quietly and not act on quarterly numbers. It gets even harder to sit still if a stock tanks when the company’s revenue or profit numbers didn’t live up to Wall Street expectations. In that agony, I must remind myself that we all tend to extrapolate our current misery into eternity, when we’re in the moment. We do this in many situations in life, but in stocks it nudges us to sell when everyone else is selling. Earnings Season Myopia (ESM) is a massive returns-incinerator.

So, the obvious follow-up question is, “should I be a trader or investor?” The answer depends on your personality. Personally, I prefer investing over the long-haul. Recently, I had a debate with a trader-type guy who called long-term investing a cop-out. I had never heard that before. But then I realized that it’s because he associated competence with swift activity. I associate competence with doing less and patient compounding. Again, neither approach is wrong. But…

In my opinion, as you shift from a trader mindset to an investor mindset, you’ll sleep much better at night. I do, and there are 2 main reasons for it:

  1. I don’t have to bet on votes in the stock market.
  2. My risk variable shifts from volatility of the stock price (as dictated by votes) to ‘thesis risk”, which is the risk of permanent loss because the growth strategy of the company didn’t play out as planned.

I find Thesis Risk much more palatable than Votes Risk or Volatility. Thesis Risk is more controllable. Every quarterly report is an opportunity to assess that Thesis Risk. We measure it via our Safety Rating. And for more than 95% of our investing universe (nearly 4,000 stocks), the Safety Rating doesn’t change much with an earnings report.

And the first point about betting on votes, I find it too stressful because that’s a non-stop game that needs to be played every day based on guessing what the next guy is thinking about the stock. In the long run, most players of such a game have either burnt out or lost heavily.

I’ll leave you with 2 nuggets of wisdom on this topic from two legends of the game:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” – Benjamin Graham (Warren Buffett’s Guru)

“Of course, the best part of [Benjamin Graham's approach] was his concept of "Mr. Market". Instead of thinking the market was efficient, Graham treated it as a manic-depressive who comes by every day. And some days "Mr. Market" says, "I'll sell you some of my interest for way less than you think is worth." And other days, he comes by and says "I'll buy your interest at a price that's way higher than what you think it's worth." And you get the option of deciding whether you want to buy more, sell part of what you already have, or do nothing at all. To Graham, it was a blessing to be in a business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct. And it's been very useful to Buffett, for instance, over his whole adult lifetime.” – Charlie Munger

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