The Folly of Earnings Analysis?
Posted on March 11, 2010
As this earnings season wraps up, one important lesson I’ve been reminded of is that it is sheer folly to analyze earnings reports and attempt to predict the Market’s reaction to the numbers.
As always, the stock prices of companies whose earnings I thought were dismal this quarter, have moved up significantly since their reports. At the same time, the stock prices of those companies whose earnings I thought were excellent have gone nowhere and in some cases have dropped dramatically. Needless to say, I sold the stocks of the companies with the “bad” earnings reports and bought the companies with the “good” earnings reports. Luckily, for a handful of investments, like INAP, I didn’t even bother to carefully read the earnings reports or listen to the conference calls, and lo and behold the stocks have appreciated nicely.
So why does analysis fail to work in the stock market? This is a difficult question, but I suspect that some form of the “fallacy of composition” is the main culprit. Basically, the Market is made up of many individuals, so that what maybe rational for one person, is not necessarily rational for the Market as a whole. In general, I believe that individuals are rational when acting alone, but as a group, rational individuals must eventually act irrationally. There really is no way to prevent this. The outcome is simply that the Market is everywhere and always irrational.
So what to do? This of course is a tougher question.
However, I now think that a good method of moving away from individual rationality into the irrational mind of a group is to always challenge your initial reactions. So, if your first reaction is to sell, try to figure out if there are good reasons to buy. Are things that bad? And if you’re first reaction is to buy, try to figure out if there are good reasons to sell. Are things that good? This type of inverted thinking should help one move out of an individual perspective and into the Market’s “group” thinking.
It’s also vital to understand the emotional mechanics underlying your investment decision. Is it based on some sort of panic or fear? Is the decision about an individual investment being based on the performance of your entire portfolio?
Overall, since you are always fighting group irrationality when investing in the Market it should be clear that pretty much whatever you decide to do will be wrong, especially if you approach investments from a rational perspective.
The one rule that seems to have worked for me over the years, and would have worked incredibly well last year, is that if the balance sheet is strong and the business has potential in the next 3 to 5 years, you should never sell at a loss. The way to make money in the stock market is to Buy Losers and Sell Winners. It never ceases to amaze me how quickly things can turn for no apparent reason.
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