I love stocks because they give you direct objective feedback about your work and process. It’s a journey that doesn’t end because market conditions change. I made my first direct stock investment in 1984 and have made many mistakes since then.
There are thousands of good books about finance but very few on stocks. (That’s a good list to publish here next.) Even so, you’ll need to do your work and make your own mistakes.
But this week, I was reminded of a very useful *category* of mistakes you can avoid without having to “learn” from them.
Uncontrollable Events
Few things are controllable, but there’s a spectrum. I’m talking about the farther end of very opaque, hard-to-know, uncontrollable events.
Two things this week that reminded me about this. The first was the failure of some cannabis legislation (SAFE) to make it through the US legislative process before the end of this government term. Cannabis is not a big investment focus for me, but I have done work on it, and one of the stocks I have owned is Glass House $GLASF. It rallied from $2 to $4, and I sold my stake. It came back to the $2 level, and I wanted to re-enter but held off pending the outcome of SAFE negotiations. After the news came out, the entire cannabis stock universe took a nosedive.
The second was the Bank of Japan's (BOJ) overnight tightening move. All the macro signals suggested being long of the Japan market EWJ 0.00%↑. That move sent the stock market there into sharp decline. This may be short-term and not “a big deal,” but if you were enticed by all the rhetoric this week, you’re down sharply.
Avoid Clinical Trials like the Plague
I’ve been tempted a few times into owning stocks before clinical trial results were announced. There used to be firms like SAC that got illegal inside information on trial results so that you might get a window into the outcome. That’s over now, and they often come as a surprise to everyone involved.
To make matters worse, they tend to be binary outcomes, as in “worked” or “didn’t work.” And these companies are typically pre-revenue and losing lots of money. An unfavorable outcome can spell the end of the company.
If I did speculate on a trial result again, I would couple it with many put options, which is a good strategy. (more below)
Avoid Earnings Reports
Playing earnings reports is a losing game. Sometimes you’ll be right; other times, you’ll be wrong. Even if you knew the numbers ahead of time, the guidance often matters more than the report. It’s also typical for senior management teams to be blindsided by their results! I’ve seen it happen many times, including at IBM when I worked there.
Some aspects of company revenues are hard to predict, even after the quarter is over. Channel revenues often come in with a lag, as do international revenues. Sometimes some small unwatched part of the business falls off unexpectedly.
I use annual models in evaluating long-term investments, so quarterly results have almost no impact on my fair value estimate. A company doing $100M in quarterly revenues can “miss” by $10M and see its market value cut in half. Unless something has changed with the fundamental thesis, my fair value estimate would be unchanged. That creates opportunities to vary position size based on the distance between the current price and my estimate.
The only place I regularly violate this rule is in the IPO market. Even then, it’s only when many factors line up, including a clear “edge” for us regarding information, low valuation, and a lack of information due to the stock not having analyst coverage. For example, we did this with InMode INMD 0.00%↑ when they came public because investors didn't realize the company had $1.75/share in earnings power yet sat at $14 post-pricing. The earnings report was just an information catalyst for investors to see the earnings power and bid up the price.
The final point about earnings reports is to consider the share action going into the report and use that to inform your decision and timing. (see below)
Sometimes people are so scared of what the ER might be that the stock sells off sharply going into the report. Depending on your analysis of fair value, it might be that a weak ER is now priced in, and it’s possible to begin to buy before the report. The opposite is true as well with short sales.
Mitigation Strategies
Wait for Post Event: The first few percentage points are not the most important if you’re right over the medium and long term. I typically am buying stocks that I think are worth a multiple of their current value. Missing the first few percentage points off a “pivotal” trial or ER is not a concern.
Consider pre-Event Stock Action: Sometimes people are so scared of what the ER might be that the stock sells off sharply going into the report. Depending on your analysis of fair value, it might be that a weak ER is now priced in, and it’s possible to begin to buy before the report. The opposite is true as well with short sales.
Use Options: Almost every time I get involved with anything speculative, I have put options along with my long position. This has saved me many times this year and, a few times, allowed me to book a profit on both sides of the trade. Rumble RUM 0.00%↑ is a good example that we published on over at SPACvest.
Although our fundamental view was that the shares were probably only worth $5/share, the enthusiasm around the shares and our trading community was eagerly buying. So I was both long the shares which went from $8 to $12, and long Puts struck at $8, which were in the money less than two months later.
[Reference Link: SPACvest: Get Ready to Rumble!]
Finally, you can also use options for speculation instead of owning shares. This is especially useful in cases where a single product or product cycle will drive the investment story. It will depend on the pricing of the call options. Biotechnology call options are almost always too expensive. Still, other companies sometimes have very cheap long-term call options that can offer high returns for a fixed investment (which you will lose entirely.) If it feels more like a bet, use a betting method like call options versus the stock.