This guide will either be really easy and almost trivial for you to read, or its content will be quite difficult to believe – depending on the angle from which you have been first exposed to the stock market.
The road we traveled on shapes our understanding of stocks
Whoever introduced you to stocks, or whatever way stumbled over them, will have imprinted a number of assumptions, even what you personally might consider axioms, on “investing” in stocks. One of the big assumptions that come from the people who have a more ‘classical’ introduction to the stock market is the almost religious reverence of “fundamentals” (e.g. valuation, balance sheet analysis, operational metrics, financial ratios). We will dispel here the notion that fundamentals matter, since they are barely more than numerology.
Earlier, I wrote there were two factors that corroborate each other to help us spot what and when institutional market participants are buying. Price- and volume analysis tells us where there is a trend. But there is also a basic understanding necessary of the “why” of institutional interest, to tell us whether such buying demand by large money interests is likely genuine, and thus has a high probability of continuing to persist in the near future to keep moving the stock for a while.
Because, how do we know that a price trend will last? How do we know that buyers won’t lose their appetite soon and will start selling soon en masse, or worst case that a stock run isn’t just something like a very short-term pump & dump scheme? How do we know a trend is not just caused by a few large speculators who are likely to run at the first sign of problems, or are aiming for a temporary play and are inclined to take their profits off the table and sell their shares very soon, leaving the stock price unsupported by continued large buying, thereby evaporating any chance of a continued trend? Remember that sustaining a trend requires ongoing buying by a large pool of institutional money.
We don’t want to risk our hard-earned money on hot air. If we risk it at all, it should be because there is a clear case of possible and outsized reward.
What you don’t want:
What you want:
There are a few basic checklist items to lower the risk of that happening, like minimum stock price, liquidity/average volume, etc, which we’ll discuss when the time comes…
…but, the main corroboration that tells us whether the future of a fresh and currently establishing trend is likely to be fruitful is of course that we demand that we can see compelling reasons that institutional buyers should consider a stock worth their time in the first place.
The stock market works in future time
Of course, we can never truly “know” what will happen (that’s why we’ll be applying stringent risk management). But we can shift the odds highly in our favor, in doing some minimal digging into a stock’s company. Because here, the “why” for institutional buying interest is found. For the purposes of a stock speculator, only a very lightweight type of what’s commonly called “fundamental analysis” is ever required, and is very different from what you expect it to be.
Here, the question arises, how does the large pool of institutional money make buy decisions? As we discussed, institutional funds manage at the least hundreds of millions to hundreds of billions of dollars. As they are not as nimble as we small speculators, and with their massive size have to enter positions over weeks, months or even years, they need to look at stock commitments as rather long-term bets.
For long-term bets, their idea is to own stock of a company that they expect to have large buying demand in the future, which will rise prices and make them a profit. Not all, but definitely the majority of really large institutional investors managing billions of dollars have always and will always use complicated valuation models to guess what a stock should be worth in their opinion at some point in the future. Again, this is not something you should do – but it’s something they have to do.
Long-term bets on stocks that are believed to have higher valuations down the line will, i.e. a stock that is expected to be more valuable in the future, will always be based on the expectation of higher future value. To them, by definition, equity in a future company that is organically and rapidly growing and profitable company is more valuable than equity in a future company that is not doing so.
Necessary here is market positioning that will lead to high expectations for future growth and profitability. Companies that currently produce strong profitability growth (i.e. earnings, margin and sales growth) are not per se valuable – they are only valuable if this growth is expected to at least continue and ideally accelerate in the future.
Institutions calculate what a company stock should be worth in the future based on its expected profitability in the future, and should its current price be below that expectation, start buying en masse. They do this with the aim of selling for a profit once the valuation target or higher has been reached.
At any point in a stock trend, buying will happen in anticipation of growth with about 6-12 or more months ahead.
In a healthy market, money flows to future expectations of high and accelerating growth like a heat-seeking missile – often long before any fundamental numbers are on the table, or long before it turns out they might actually never appear.
Expectations vs. manifestation of growth
Let’s look briefly at why insisting on fundamental numbers, even the ones often touted by popular “investment” strategies, will often result in you missing large parts of a move, if not the whole one.
Some of the time, an advancing stock will only slightly precede the appearance of growth in a company (earnings, revenue, margins, company size, you name it), as shown below in sketch A. The stock will be discounting the expectations of future growth, but only ahead a few months at a time – thus, although one will not be able to capitalize on the full meaty part of the up-trend, a speculator can still squeeze out some sizable profits.
However, a lot of the time, company growth will not be tangible (i.e. existing/reported numbers on the table) by the time the stock price starts rising. Look at sketch B below. Large institutional investors and their superior research capabilities will project this growth far ahead of the time (many months to years) and start buying the stock up to put themselves in front of the future demand that is expected to bring the stock up. Their counterparts, the parties that are selling and marking up the stock, will be generating trading activity and media buzz also far ahead of the time the growth manifests in reality. As a result, a lot of the time, stock prices will lift many months or years ahead of actual reports of the manifesting company growth, and thus a speculator might join a trend very late in the game if he insists on numbers such as growing earnings to be reported before getting into a stock.
Another possibility is that the growth will never manifest. Examine sketch C below.
All of these cases happen many times over in every and any stock market cycle. Looking at the above, you will realize that a lot of the time, thought not always of course, you may miss quite a portion of the trend by insisting that fundamental metrics & numbers live up to popular opinions.
Since the dot-com bubble, earnings and earnings growth has been the number one buzzword for those that look at fundamental numbers when deciding to put their money in stocks. While earnings growth is often associated with growth expectation, it again is a lagging metric – it shows what has already happened. Institutional money though flows into what is likely about to happen in the future.
Most fundamentals are disconnected from the underlying company, and few are a proxy for potential demand
Once you start seeing through the big clockwork that is the stock market, you will see that fundamentals are in no way reflective of the underlying company, and do not reflect value as often espoused by people who think themselves “investors” but in reality are speculators.
As I elaborated elsewhere, the stock market is not an “investment” vehicle, because it does not fulfill the requirements of an investment. There cannot be “investors” in a company stock after the IPO or other offerings. When buying stock, no money goes to finance operation of growth of the business in question. We bid, with each other, on glorified slips of paper, hoping that in the ‘greater fool theory’ someone in the future will buy it from us for higher price. Fundamentals are akin to numerology, because this bidding in the stock market is not based on what happened in the past or present (i.e. fundamentals), it happens on what is expected to happen in the future.
A large wealth of institutional capital may use earnings expectations-based models to try to forecast how high this bidding might bring the price of a stock, and thus start buying it up for that possible future. Even they try to forecast the future, not bet on the past – i.e. they speculate on what they think will happen.
If enough institutions do so in parallel, a strong trend ensues, and continues to persist for a while, even if that forecast never comes true. If too few do, the price does not rise substantially, even if the “fundamentals” of the company are outstanding, or any forecasts later actually materialize.
It is crucial to understand the nature of the secondary market, i.e. the ‘stock market’ – no one “invests”, no one can invest. When I call institutional “investors” or “investment” banks so, it’s because they also put their money into other vehicles that actually count as investments.
The well-kept secret is that everyone and anyone in the stock market speculates – institutions, Pros, amateurs, long-term buy & hold “investors”, value “investors”, fundamental “investors”, day- or swing-traders, mom & pop, smartphone retail traders, whatever you want to call them, they all do the same thing. They buy a stock predicated on their expectation that they’ll be able to sell it at a higher price in the near or far future. That’s the definition of speculation … whether they like it or not.
This should be a wake-up call for you to both drop classical fundamental analysis from your operations, and to fully understand why risk management is so crucial – as any speculation, or bet, can go backwards.
The only factor that matters for a strong stock trend is expectation of growth, not when nor whether it actually manifests later or already has. Stock is bought because the smart institutional money is expecting future demand of the stock, and thus is trying to “front-run” future demand by other institutional money and individual stock buyers that will bring the stock up.
Another facet of how future profitability matters to a stock
Here is another example to lend some context to the above – there is another breed of institutional investors who exploit the inclination of other “investors” to speculate using such profitability-valuation models for their own gains. They own a stock of a still young and unknown growth stock from its IPO on or before (you could call them institutional “insiders”, for example a syndicate of IPO underwriters, and/or private placement bidders). Due to their connections to the company, they have reasonable information to expect high-earnings or high-revenue growth in the future. They accumulate more of the stock in the open market after the IPO for months, years and sometimes a decade or so, knowing that there are a lot of other “outsider” institutional investors and a vast army of gullible amateur speculators that will use valuation models to speculate in their stock at a future juncture when growth expectations become apparent more strongly. Sometimes this time never comes, but when it does, it is inherently profitable.
When the right time comes, they will proceed to mark the stock up. That means they will stimulate an up-trend using a circle of other investment bankers, brokers, pool operators, analysts, and financial media to stir up excitement, generate publicity, exposure, buy ratings/upgrades and thus buying demand/interest. Fundamental data (e.g. reports of earnings/sales, earnings/sales surprises, and forwards guidance) come in very helpful, as they are literally carrots that can be dangled in front of the dumb money to generate buying interest of those that do not know that the reported numbers had been discounted and acted upon long ago.
Let’s take earnings as an example. Positive surprises in earnings reports (i.e. the numbers reported outpace the consensus expectations by the investment community, ideally by far) lead to:
- outdated expectations that need to be adjusted for, outdated projections of future valuations that need to be discounted for, and valuations that need to be revised upwards – all prompting more institutional buying,
- actionable novel information that existing institutional owners can dangle like a carrot in front of the investment community and use to generate a trading and media buzz around the stock to stoke more buying demand and mark prices further up (see section below).
The smart money (the “insider” institutions) will sell into rallies to not drive price up to quickly, and buy into temporary declines to support the stock. Over time, the resulting strong trend will more and more create a buzzing market at higher prices, ripe with trading activity and liquidity into which they can then unload/sell their massive stock positions and take profits.
Who is buying from them? The “dumb” money that does not understand the forward-looking nature of speculation in the market. They buy too late into the excitement. They think that past and present numbers of growth is what makes the stock valuable – but no, that is what made it valuable a long time ago. Once the lack of continued institutional buying support fails to keep the stock up anymore, they are left holding a stinking bag.
Bottom line – everything hinges on expectations of future growth
In the end, it doesn’t really matter who does what, because all this action is eventually intertwined with each other and becomes a self-fulfilling prophecy of those that are in the right place at the right time, those in the right place at the wrong time, and everybody else.
The cemetery of Wall Street is filled with those that “believed” in the fundamentals of a company. There are countless examples of stocks which companies had flawless, pristine classical “fundamentals” that trended consistently down or flat sideways for decades, while there are always great examples of stocks that run up hundreds of thousands of percent on expectations only, sometimes but also often not yet supported by organic earnings and/or sales growth numbers reported over the last few financial quarters, and sometimes showing negative reported numbers.
Existing fundamental numbers, whether that is some convoluted book ratio or earnings growth, and whether existing earnings are large, consistent, or stable, doesn’t matter per se. Only the expectation of high future growth, matters. It creates expectations of high value in the future, and will lead to institutional interest and buying demand to speculate on future price rise, and reasons to mark a stock up in a trend that will make its holders profitable.
There are slight variations to this theme, for example “cyclical” companies which become more or less profitable with monetary cycles, e.g. inflation-linked increases in profitability for some resource stocks, or companies that experience growth due to a sudden radical change in its operation. We will discuss this later, but the same basic expectation of growth remains.
In the end, the ‘growth’ in growth stocks does not stand for fundamentals that show existing growth (growing earnings, sales, etc) – it stands for growing expectations of future growth.
We will learn later what simple characteristics of a company will improve our chance of betting on a true winning horse.
The smart professional (whether institutional or private) will buy shares on the speculation that a stock will be valued higher in the future by others, whose buying will drive the price up, and thus want to own it in size now to be able to sell it to them then for a large profit.