Monday, May 25, 2009

Brick by Brick

Probably the most frustrating situation from the perspective of fundamentals is when you find yourself having all of the pieces of the puzzle together and know almost beyond a shadow of a doubt that your prediction about the future value of the company is going to pan out, and yet the stock is slowly meandering towards the inevitable. The easier it is to draw your conclusion, the harder it is to figure out what's keeping investors from jumping all over it. To set this paradox aside, first recall that a stock's fundamentals change over time. The second thing to consider is that fundamental valuations are only driven by breaking news, emerging financial data, and insider information etc, all types of cold hard facts that are known to at least some investors. Check back to Covert Newspaper Interception for a refresh on the subject.

Now, within the large volume of information available that can be used to come up with fundamental evaluations, there are essentially two types of facts:
  • Facts that are true right now. These are facts that are immediately actionable and give indications as to the present value of the corporation. Information of this nature has an immediate impact on the stock that is only limited by the reliability of the information.
  • Facts that are true over time. These are facts that are forward looking. A lot of things can happen in between now and then, but barring the emergence of any conflicting data, the information will become more and more like the first type of fact as the time of the prediction draws near.
To put it simply, a check on the way to the bank isn't quite the same as a check in the bank. The risk involved in forward looking predictions affects the price traders are willing to pay for future earnings. The desire to take profit on these earnings leads the market to get ahead of itself quite often, but these are localized variations that fit within the chaotic trading range. By and large, stocks will meander towards predictions rather than trading in the eventual range right off the bat.

To look at this another way, every prediction has a time point associated with it. In between now and the time the prediction is targeting, the part of the prediction that is exposed to risk will start off at maximum risk. As time goes by, if nothing negates the prediction, it will become more and more certain. If the time of the prediction target is reached with no contradicting information, the prediction will have become like fact, within the accuracy limits of the initial prediction. People don't pay for risk unless they're playing the lottery. The value in information that is forward looking will be directly proportional to the risk fading out as the potential for large surprises dwindles because of the nearness of the prediction target.

The best example of this is earnings forecasts. A company issues an earnings forecast at the beginning of the quarter. Parts of the forecast will be fully effective on the day of the prediction. Other parts will be forward looking and will take time to fully pan out. As time goes by in the quarter and there are no earnings warnings or revisions, it's usually assumed that the company has hit their target forecast or only slightly performed outside the predicted range. Then earnings are reported. This information is immediately actionable and 100% accurate, excepting gross accounting errors. Hindsight is 20/20. Foresight becomes hindsight in the absence of new information.

Putting all of the information together, all of these facts and predictions will assemble over time. The concrete part of what is known and used to establish fundamental valuations takes shape over time. Only the concrete parts matter. Some of this information is concrete today. Some of it only becomes concrete over time. Brick by brick, the facts that you can bank on come together.

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