As investors it is key to understand what the market is thinking given that it will translate into price movements. When there is a lot of optimism, prices tend to rise and vice versa. How can we take this a step further and take advantage of market sentiment?
The first thing to do is to see the numbers and have an idea of where are we standing. In our view (and as some of the great investors say) for this it is better to be vaguely right than precisely wrong. Two good strategies to understand where we stand are:
1. Use common sense: Sometimes the market will assign valuations that can only be justified with growth rates that are too high, making these scenarios the base case. A good way to practice is finding the implicit growth in earnings that the market is paying for. This can be done with P/S, P/B or P/E mutiples and/or to see the implicit growth rate in free cash flow (what some call reverse DCF). Market price will always reflect future expectations and it is our duty to understand what level of optimism or pessimism is currently priced in.
2. Gauge sentiment through newspaper headlines, management commentary and the price recent trend. Generally, when one stock has had a spectacular run recently, this draws in new investors that think the trend will continue indefinitely. Also, let’s remember that some of management’s compensation is linked to the stock price performance.
With a general sense of where we stand, we can start thinking in terms of probabilities and base rates, which are the historical data points of how many things has something occurred in the past. For example, how likely is it that a company with a market cap of US$100B continues growing its earnings per share at a 30% rate in perpetuity? (let’s remember that a multiple is a way to assign a perpetuity). Making this type of questions we can have an idea of how in favor or against us are probabilities.
Another example is what recently happened in Argentina. Before the primary elections (PASO), Argentina had a very strong recovery both at the currency and broad equity index levels. The base scenario was that the alliance formed by Fernández-Fernández would win by at the most 7 points, which would give Macri some time to cut the lead by October, aided by improved economic data. People were thinking that the improvement in economics, mostly the Argentine Peso, would reflect in less inflation and an increase in consumer confidence, which would bring support from voters.
This previously cycle thought as virtuous transformed into a vicious one, the ARS has depreciated strongly, which will trigger inflation. In spite of statements made by the government that some prices will be frozen and that minimum wages will increase, the impact is still there, only this time the government (and therefore taxpayers) will be the ones who pay for it, either through milder economic growth or more public debt.
Some investors bet against Argentina right before the election. What were they looking at? Did they have a crystal ball? The answer is no. Simply, they understood that the market was pricing in all the good news before the election. This makes that in the best of conditions (base case) the upside is very limited while if there is even the slightest deviation from this scenario (which happened) the downside is very steep. As a reference, the Merval (Argentine broad index) lost 37% the day after the election results were announced.
Knowing where we stand with regards the value of assets and the level of optimism/pessimism that are priced in is not easy, but it is a taks that we can (and should) refine. After achieving this we will skew the odds in our favor, and by the law of large numbers, after playing several times, this advantage should translate into sustainable profits over the long-run.
Adastra Finance 