Earnings Game Part II - "Greetings, Professor Falken. Would you like to play a game of chess?"

In my last blog post I highlighted how volatile and irrational “earnings season” often feels when stocks of even the staidest companies can exhibit elevated levels of volatility around even the most minor levels of variability relative to Wall Street’s “expectations.” This more extreme price action can easily have the effect of making market participants question their long-term investment rationale due to trading patterns influenced by short-term data and noise. Worse (in my opinion), in more recent years the trading noise has increased due to changes in market structure and dynamics. Daily trading is increasingly dominated by computer algorithms, a focus on trading faster, more specialized exchange-traded funds (ETFs) that indiscriminately buy and sell whole swaths of companies with little regard to individual company fundamentals, and options (leveraged vehicles) with weekly expirations—all of which exacerbate short-term volatility. A client recently remarked to me, “OK, David—I get it, earnings season creates extra volatility and noise—so how do you manage it?” A good question indeed!


Many folks who lived through the 1980s remember the 1983 movie WarGames in which a young computer whiz named David (not me!) hacks into a government supercomputer looking for new video games to play. In so doing, David unwittingly activates the computer’s artificial intelligence interface known as Joshua. As David thinks he is turning on the game “Global Thermonuclear War,” he quickly finds out that Joshua is not playing with David, but rather is engaging in a real-world nuclear launch scenario and has assumed control over the country’s nuclear arsenal. With the “game” now activated, Joshua begins to crack the country’s nuclear launch codes with the intention of seeing how various nuclear launch scenarios will play out. As Joshua cannot be overridden or shut down, panic ensues and fear of an imminent, global nuclear holocaust takes center stage as the defense department helplessly watches. In a desperate act of brilliance and in an attempt to distract Joshua, David instructs the “intelligent” computer to play a game of Tic-Tac-Toe with itself—a game Joshua has never played, but which David knows cannot be won. As a series of Tic-Tac-Toe stalemates goes on, Joshua still manages to crack the nuclear launch codes and begins to display every possible launch scenario with each resulting in total global destruction. At the same time, Joshua plays thousands of Tic-Tac-Toe games before finally “learning” that the game is unwinnable no matter who moves first. At its climax, just as Joshua is about to launch the first nuke, the room goes dark as everyone believes the country is at war. Moments later Joshua comes back online and remarks, “A strange game. The only winning move is not to play” (both to Tic-Tac-Toe and nuclear war). And just like that the nuclear launch is cancelled, the fear of global disaster dissipates and the DEFCON (Defense Condition) level is raised from DEFCON 1 (imminent nuclear war) back to DEFCON 5 (normal readiness).


So how does that relate to managing through earnings volatility? My point in writing this is not to say that important information can’t be gleaned from quarterly business updates, nor is it to say that there is never a good reason to sell an investment. However, there is so much noise and volatility around the short-term data that it often feels like an investment disaster is imminent even when there is much ado about nothing. It’s a strange game and I’ve found that the best course of action is often simply not to play the quarterly earnings game.


The question then becomes how can a manager arm an investment portfolio to be less inclined to trade when stock and market volatility increase? The answers may seem simple and intuitive because they generally are. First, I believe it is critical to know exactly what you own (and why) and to maintain focus on the longer-term big picture. In a market in which investment portfolios are increasingly packed with large holdings of ETFs and investment products that are designed to make things simpler, the opposite is often true. Do the holders of these various financial products actually know what their underlying holdings are? If not, how do they distinguish between signals and noise? When these opaque investments exhibit periods of heightened volatility, do the holders know (or care) what is causing the asset prices to move or do they simply respond to the movement itself? By knowing exactly what you own and why you own it, riding through periods of heightened volatility, while still uncomfortable, can be much more tolerable. While it may be appropriate to allocate a piece of a portfolio to these assets, if that is all that is owned, things become more opaque and less manageable (in my opinion). Maintaining focus on the longer-term big picture is a powerful reminder not to get overly worked up over a few days or weeks of “tough” market conditions and knowing more about each investment can make it easier to identify opportunities when they come around (and keeping some “dry powder” at all times ensures the one can take advantage of these opportunities when they present themselves).


Next, I strive to build portfolios with position sizes that allow me to sleep at night and with diversification across sectors, asset classes and investment styles, knowing that no single style or asset class will outperform in every environment. The heightened levels of discomfort that more easily come with larger, more concentrated position sizes can create much more powerful urges to “get out” of positions when the pain is too great—often at inopportune times. By maintaining more manageable position sizes it is much easier to remain calm when stocks have outsized moves in either direction.


Markets ebb and flow and businesses will invariably have some quarters that are better than others within the context their long-term trajectory. Reading too much into a single quarter to attempt to predict the future is dangerous. While a business management team has insights into their customer base and a degree of “visibility” given what they know today, they don’t have a crystal ball that can tell them how the next 3 months or year will play out so they are regularly subject to “cutting guidance” or “raising guidance” along the way. Sometimes completely normal variability in their business can create minor changes at the margin that work short-term traders into a frenzy. In my experience, being “generally right” on the overall trajectory of a business is far more important than being “perfectly right” about short-term data points. Further, it can easily result in missing the forest for the trees and missing out on the bigger, long-term moves (which is also less tax efficient and increases trading costs). To be sure, sometimes a business is truly being impacted by meaningful changes in their industry meriting a thorough reassessment of the investment thesis. However, (in my humble opinion), these big picture fundamental changes usually take more than a single quarter of data to become clear and making a reactive buy/sell decision during periods of extreme volatility can do more harm than good.


Lastly, it is important to maintain an independent point of view and not read too much into what the talking heads and financial press are saying or to get caught up in “group think”. There is no shortage of opinions masquerading as experts on why various assets are doing one thing or another on any given day, only to be replaced by a completely different opinion the next day or two when markets reverse. Some days feel like DEFCON 1 and the next day it feels like DEFCON 5 again. That’s just the nature of markets.


Benjamin Graham once explained that, "In the short run, the market is like a voting machine--tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine--assessing the substance of a company." Another wise man once said, “the only people who get hurt on roller-coasters are the ones who jump off.” :)






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