The efficient market hypothesis (EMH) may state that the price of a security reflects all known information at any given time, but in the real world, security prices tend to be much more correlated to the psychology of the masses. Long-term investors exploit these psychological variations through value investing, but shorter-term traders and investors can profit more quickly from simple misunderstandings.
TUTORIAL: 20 Investments To Know
Identifying the Opportunities
There are many different types of misunderstandings that can occur in the marketplace, ranging from misjudged earnings figures to ill-informed press coverage. However, they all share one thing in common: They result from a short-term failure to look behind the scenes. Ultimately, the small drops from these investors can trigger larger sales from technical traders and create great opportunities to buy.
A few common opportunities include:
- Earnings misses are often the result of deteriorating fundamentals, but they can occasionally be attributed to one-time events. For example, a lawsuit settlement or non-cash derivative liability could hit a company's net income and create scary figures on the surface.
- Bad press coverage can be either misinformed or biased and lead to an undeserved drop in the price of a security. For example, a short seller may put out a bearish story about a company in order to make a short-term profit without presenting a solid case.
- Technical drops may lead to lower security prices without fundamental justification. For example, a well-performing company may fail to rebound from an important moving average and drop lower without fundamental justification.
- Unexplained drops can be caused by a number of different things that do not relate to fundamentals. For example, a hedge fund may be forced to liquidate its positions and cause significant selling pressure on a thinly-traded stock.
Researching the Cause of the Fall
Market-beating returns reward the due diligent investor – there's no way around it. This means that it is often necessary to sort through regulatory filings and conference calls in order to create an investment thesis and explanation for the drop. However, the time spent doing this can be significantly limited by knowing where to look for the information.
Reading Financial Statements
Weak revenue or net income figures can shock the market, even if they can be explained by reading into them. If you see a stock drop sharply due to earnings, take a look at the Management Discussion & Analysis section of its 10-Q or 10-K filing. Specifically, the Results of Operations will detail in plain English the reason for the decline in each line item on the income statement. (For more, see Speed Read SEC Filings For Hot Stock Picks.)
Listening to Conference Calls
Conference calls represent management's opportunity to explain their company's situation to investors. Often, this means detailing why revenue or net income has fallen, even if it isn't immediately apparent in the financial statements. Investors are best off listening to these calls directly, but they can also access transcripts on various websites. (For related reading, see Conference Call Basics.)
Debunking Short Sellers
Short sellers are increasingly acting like investigative journalists. While much of their research is well-informed, investors should be sure to check references and validate any conclusions. Meanwhile, many short-sellers targeting a common industry may cause a temporary discount among even reputable companies in the sector – a great opportunity for savvy investors to get involved.
Thanks in large part to the advent of exchange-traded funds (ETFs), the market tends to group all stocks in a particular industry into a single trade. For example, a drop in oil prices may lead to a decline across all oil stocks – even those that are hedged against oil prices. Investors can purchase these stocks after any drops and sell them when they return to more appropriate valuations and make great risk-adjusted returns.
Watch the Major Holders
Hedge funds and other large shareholders can have a major impact on stocks – especially those that are thinly traded. Upon any unexplained drops in stock price, investors can look at Form 4 filings and/or compare Schedule 13D and 13G filings from period to period to determine changes in holdings. Combined, these filings can provide key details of insiders or significant holders selling.
Planning and Executing the Trade
While "buy low, sell high" may be the prevailing mantra in finance, buying stock in a company that is falling can be a difficult and scary venture. So, what's the best way to determine the right time to buy and sell these often distressed securities?
TUTORIAL: Technical Analysis
Ultimately, technical analysis has proven to be an invaluable tool for determining entry points. Instead of catching the proverbial falling knife, investors should instead look for small changes in technical indicators signaling a change in momentum. After all, even if investors are acting irrationally, there is no reason for them to stop doing so at any given time!
The best technical indicators include:
- Moving Average Convergence/Divergence (MACD) is a time-tested technical indicator that is designed to signal a change in trend. Investors should look for a bullish crossover above the median, while also looking for upward slopes in shorter-term moving averages. (For more, see Spotting Trend Reversals With MACD.)
- Parabolic SAR is another popular technical indicator designed to determine the direction of a stock's momentum and when it has a higher-than-normal probability of switching directions. Investors should look for a dot to appear below the stock price on a chart to signal a turnaround. (For more on this indicator, see Introduction To The Parabolic SAR.)
- Relative Strength Index (RSI) is a third useful indicator used to determine the beginning and end of key trends by calculating the difference between closing prices. Investors should look for a reading below 30 to indicate that the stock is oversold as well as an upward slope before buying.
While technical analysis is certainly no guarantee of success, combining it with a fundamental thesis helps determine statistically probable turning points for which to buy. Selling, on the other hand, is often best done when the stock recovers from its original decline or trades in-line with its comps.
The Bottom Line
There are many different cases when a stock may drop due to a misunderstanding, ranging from earnings misses to non-fundamental selling by a large shareholder. By learning to identify these key trends, investors can make exceptional risk-adjusted returns. Meanwhile, using technical analysis can help identify optimal entry points without "catching a falling knife," creating a better risk profile. (For related reading, also take a look at Blending Technical And Fundamental Analysis.)