Friday, 27 April 2012

How the stock market works

"Company X crushes estimates; Shares Soar" screams the headlines in Forbes,  a respected business magazine. "Company X profits slip 35% as spending continues"  proclaims the equally loud headlines of The Wall Street Journal, a respectable business newspaper. Both refer to the same company - Amazon - and the same piece of news, the first quarter results of the company. Flummoxed ?? Read on.

Can both headlines be right ?? Surely they can't.  Only in the rarified world of finance , especially the even more ionospheric world of stock markets can both statements be true. Yes.

You see, company performance and movement of share prices is based on "expectations" and not on reality. Expectations of whom, you may ask ?  Of a unique sub species of the human race called homo sapiens analystensis (hereinafter referred to as HSA).

Cut to business school. Some of the best brains in the land want to "go into finance" after they graduate. Their ambition is to mutate into this unique sub species I referred to earlier. There are distinct variants even in the subspecies that you can aspire to become - HS Brokerensis, HS Sellsideanalystensis, HS Buysideanalystensis, HS Fundmanagerensis, etc etc.

All of them have only one aim in life. They aspire to make predictions of the future. These predictions are called "expectations" or "estimates" in the lingo. Never mind that humanity has not yet discovered how to foretell the future. All through history, many quacks have attempted to do this - astrologers, palmists and charlatans of various kinds. To this tribe has now been added the aforementioned HSA. Their tool is not a parrot or a horoscope, but an abomination called the Excel spreadsheet. For their quackery, HSAs earn only in seven figures.

Based on their wise gazings, they come up with an Estimate (with a capital E). Then they all flock together , total up all their Estimates, divide it by the number present and come up with a "Consensus Estimate". This is the magic target for the company to beat. This is what Amazon beat by 4X prompting the Forbes headline.

Companies are of course wise to all this. They cuddle up to this species. They ply them with booze in events called Analysts Meet. They provide them with "guidance" so that the fertile minds of the great members of HSA can be fertilised. Sharp readers may note that along with other humans, company honchos are equally clueless about the future. But that doesn't stop them from pontificating. They  whisper, allude, provide crystal balls etc etc so that the sainted HSA can come up with the "right" Estimate. Then they spend all their life trying to beat the millstone around their neck.

The stock market formula is simple. Beat the Estimate and your share price will soar. Miss the Estimate and the share price will tank. Never mind if you made a profit or a loss. Never mind that you sold more or less. Never even mind if you made cornflakes or condoms.

Now you see why both Forbes and Wall Street Journal were right. Amazon's profits actually dropped by 35% from last year's first quarter. Signor Bezos continues to thumb his nose at any naysayer and spends money like water (made respectable by calling it investment). But he beat the consensus estimate of the HSA. Not just beat it, but licked it.  

Amazon's share price rose 14% yesterday.


sriram khe said...

I will leave it to Warren Buffett to comment on stock market prices ...

What is more exciting is what he says after 3:00 minutes ...

sawnpatitson said...

A good way to sum up the conflicting signals that the markets are giving from a short-term perspective is to look at our comments from Wednesday. Before the market opened, we posted charts that had a bullish slant. At 2:30 p.m. IST, we said the session was weaker than it appeared. Know More :

Shachi said...

I know this all too well after having followed Intel stock for so many quarters :). If we know we are doing great, we sell the day before earnings announcement. If we didn't do so great, we keep the stock :P! Finally after years of being stuck in the early 20's, its getting some respect and hovering around $28. A lot of people have said they will retire once it reaches $30.....lets see :)

Ramesh said...

@Sriram - Yes, he is one of a kind. Nice articulation of how luck is the most important ingredient in life ...

@sawnpatitson - I rest my case.

@Shachi - Alas, the glory days of Intel stock are over. Great company, but the stocks are likely to plod along rather than soar.

You are allowed to retire only in 2072 :):)

Ravi Rajagopalan said...

As you know, Ramesh, my company is in the midst of an HS Analystensis mediated PE deal. I am consistently frustrated by this "forecast" business. We are entering a new arena, and my view is to tread cautiously and use as much of experimentation and sampling to getter a finer feel on business potential. The fact that the projections are based on assumptions does not wash with these guys, nor does it with these PE guys. It is sad to see so much of intellectual firepower directed at an bloody Excel sheet - and that Excel sheet assumes a life of its own.

May be I am too old for this shit.

Sandhya Sriram said...

I have heard this story somewhere, to make it interesting for you (given that we now know a few secrets), i call the main character on the plot as Rajalakshmi.

So the story goes like this, Rajalakshmi was heavily disturbed by a mouse in her house. so, in order to catch the mouse, she bought a cat. the cat had to be fed milk, so she bought a cow, the cow had to be fed hay, so bought a hay and for buying all this she took a loan and the loan couldnt be repaid and that she had to sell the house.

This may sound completely absurb, but i feel, we have a huge population thriving on this so called stock market.

What about HS auditensis fraternity..... there are so many boards that try to disect and resurrect the poor balance sheet and p & l trying to give more and "Transparent" information to homo sapiens analystensis

then are the HSregulatorensis, well i dont know what they regulate, but these are very busy and very important people, collecting loads and loads of information and dishing out loads and loads of guidances.

People have kind of forgotten that the purpose of all this is to kill the mice, not to feed the cat or milk the cow....

but i think, belonging to a fraternity whose USP is this, i think, i should keep quiet now.

Ramesh said...

@Ravi - That's why, in my book, Excel is a four letter word.

@Sandhya - Perfect story and a beautiful point. In all this madness, I think the original purpose - of diverting capital t productive uses has been lost. Well said Sandhya.

Love your repartee :)

Hema said... much for the HSAs! Interesting. Next time I see a geeky looking youngster in full suit with a tie in the powerless chennai airport in summer, my mind is gonna scream, here is a HSA and smile!

Thanks for the post, Mr. HSB..(Homo sapien bloggermasterensis )!!

Ramesh said...

@Hema - Ha Ha. Thank you Mme HSP (Homo Sapiens poetexcellensis) :)

Appu said...

One helluva post one helluva comments :P fun fun fun. Am wondering how you come up with names :) also wondering still did you have the liberty to name your Juniors :D

More tempted and determined to read fooled by randomness in an holistic fashion.

Still i would bet my money on Bezos call it gut feeling :)

and I rarely access the ATM of axis bank still when i do i see IMT info coming up and for a fraction of second in a fleeting moment a happy feel does comes :)

J said...

LOL! Great post and comments and Sandhya's story is so apt too. I think Wall Street is such a talent drain and it's a pity that these smart MBAs hide behind Excel when they could be doing something more productive. I wonder if the seven figure salary has something to do with it? :) The fact that Wall Street can justify paying these salaries itself suggests that not all practices are aboveboard. It is never clear what they really know and what they do with their information versus what they say publicly.

Ramesh said...

@Appu - Beware, for you are about to join the legion in 2 years time !!! Btw totally zapped that you even know of IMT :) Ravi - pl note.

@J - Much is wrong with societal valuation of professions when talent is most sought after in areas which are questionable in terms of actually producing anything.

sriram khe said...

More then ...
Valuation of Facebook ... is what this Slate piece is about:

"if Facebook is worth $100 billion, then its billion users are worth, on average, $100. ...

The generosity of the $100-per-user valuation really sinks in when you consider how much Facebook’s users bring the company right now. It’s not $100. Or $50. Or $25. Or $10. No, Facebook earns a mere $4.84 in revenue per user per year, and just more than $1 a year in profit per user."

Ravi Rajagopalan said...

@Appu: How nice of you to notice my logo? Thank you! That means more than a million dollars in valuation!

By July we should be on the ATMs of two more banks. The effort taken to get there has been enormous.

Thanks again, truly grateful.

Vishal said...

How about this for a definition of stock market - could not find a better time to share! :)

Once upon a time in a village, a man announced to the villagers that he would buy monkeys for Rs 10. The villagers, seeing that there were many monkeys around, went out to the forest and started catching them. The man bought thousands at Rs 10 and as supply started to diminish, the villagers stopped their effort. He further announced that he would now buy at Rs 20. This renewed the effots of the villagers and they started catching monkeys again. Soon the supply diminished even further and people started going back to their farms. The offer rate increased to Rs 25 and the supply of monkeys became so little that it was an effort to even see a monkey, let alone catch it! The man now announced that he would buy monkeys at Rs 50! However, since he had to go to the city on some business, his assistant would now buy on behalf of him. In the absence of the man, the assistant told the villagers. Look at all these monkeys in the big cage that the man has collected. I will sell them to you at Rs 35 and when the man returns from the city, you can sell it to him for Rs 50. The villagers squeezed up with all their savings and bought all the monkeys. Then they never saw the man nor his assistant, only monkeys everywhere! Welcome to the 'Stock Market'!

Appu said...

ha ha 2 years :))

@Ramesh & @Ravi why will i not recognize or notice when i even mailed you with my thoughts on the website :)))

Ramesh said...

@Sriram - Beatuiful illustration of the nonsensical valuation

@Vishal - Great story, unfortunately too close to the truth for comfort :)

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