How to handle a reporting season blow-up and cut a losing stock like a pro

When people first arrive at markets, particularly stock markets, they typically think that what they buy will be the most important decision to make.

Often any analysis doesn’t get past the question “What company should I buy?” and that is typically a derivative of “Which company will go up the most and the fastest?”

As time passes, people begin to ask, “What price should I pay?”

After a lot more time, if they stay in the market, people start to wise up and realise that it’s not the buying decision that is the most important decision to make at all.

Any dummy can buy stocks. It’s those that have a discipline for managing and discarding risk, and maintaining winners, that typically outperform over the long term.

With a potentially challenging reporting season upon us, likely filled with at least a few landmines, I thought it prudent to reach out to a professional to get their take on how to manage a blow-up.

To do that, I am joined by Dr David Allen from Plato Investment Management. He’s got the goods for the stocks that ail you this season.

The framework

The comments below are provided by Dr. Allen.

Shocks during reporting season are stressful events for fund managers and analysts alike and often lead to panicked value-destroying decisions. We believe every investor should have a pre-set framework to aid decision-making in these “man over-board” situations. This framework provides an anchoring point for decisions: do we stick or do we split?

Can you outline your process for dealing with a bad (or good) result?

The Plato framework recognises that a bad result means different things for different types of companies and warrants different responses. The research that underpins our investment process is based on hundreds of thousands of earnings releases globally over the last 20 years. Of course, every company announcement is different, but these are the “stylised facts” revealed by the data.

If the stock price had very weak momentum going into the bad news, on average this is a good buying opportunity, especially if the company has value support. On average these stocks outperform by about 10% over the 90 days following the bad news. If however, momentum was very strong, then bad news generally indicates it is time to sell, especially if valuations are stretched. 

The rationale for why this works is simple: high-momentum names are often held by the hedge fund community because they have strong momentum. Once that momentum is gone, so are the speculators.

Similarly, if a name trades on a growth multiple and it disappoints, it is more often than not best to exit. A case in point is Seek Ltd ( ASX: SEK). I do not hold it, but if I did, I would have exited on the day of the announcement. In the recent earnings announcement, they missed on net income and EPS and lowered guidance. It trades at a historic PE of 43, leaving little room for disappointment, so not one to hold onto.

If the results are good, how do you determine which action to take (i.e. buy more, sell part, sell all of the position, do nothing?)

If the results are good, and our investment thesis is confirmed we will often add more to the position, assuming that the valuation is still attractive. If the valuation has become unattractive we will look to trim or exit the position. A recent example is NVIDIA Corp (NASDAQ: NVDA) where we trimmed our position as the valuation became very demanding.

If the results are “bad”, how do you assess the impact on long-term profits?

If the results are bad, unless there is very strong value support we will tend to exit. Even if in the long-term profitability may return, it is much safer to wait until performance improves rather than trying to pick the bottom.

Do you ask whether the bad news is something that can be changed over a reasonable period of time? 

Our investment universe has 10,000 companies so when a stock disappoints, we will usually rotate into companies with better prospects. 

The problem with turnarounds is they often never turn!

How do you ultimately assess whether the risk has increased and what are some of the non-negotiables for you? (what would cause you to simply exit the position)

If revenue, earnings, and cash flow all materially miss expectations, or forward guidance is lowered, we are gone. Management always builds some slack into guidance, so when a company misses it can signal they do not have a good handle on things.

Reporting season can be a challenging time for investors, what are some key pieces of advice you can share?

Have a formal written decision-making framework that sets out how you will act in different circumstances. In much the same way as airline pilots use simple checklists every time they take off or land, a man-overboard decision-making framework can help you manage stress and improve outcomes. 

The second piece of advice is to know when to break the rules. A framework is just that and not a substitute for common sense.

Finally, it’s the unscripted moments that are often the most revealing. Savvy managers increasingly resort to more complicated language, sidestep direct inquiries, or present in an overly positive tone to obfuscate unfavourable news. Shifts in these communication patterns can hint at deeper issues not immediately evident in the financials – potential red flags for the discerning investor.

What is your method for exiting a position?

Share in the comments below your method for burning an underperforming stock and how you manage your losers (and winners). 

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