You Probably Should Be Using Probabilities

Investing is all about probabilities, the probability of reward versus risk. It doesn’t mater whether you’re a value, growth, fundamental or technical trader or investor you should be using probabilities to help you be a better investor. I use the Kelly Formula for comparative analysis of my portfolio and new opportunities and will discuss that in depth another day. Today I’d like to focus on short term probabilities. If you sit firmly and unflinchingly in the long term buy to hold camp then move along there is nothing for you to see here. For everyone else I hope to illustrate how using probabilities helps me answer the question of whether to buy or sell prior to an earnings release.

There are two main reasons why we should even consider the question of buying or selling prior to earnings. Behaviourally investors experience heightened emotional turmoil prior to earnings. This is because earnings act like steroids for the competing emotions of Fear and Greed. This is especially true for volatile companies, for smaller companies or any company that you are considering selling or buying.

Before we go on I’d like to instill some faith in you that probability is one of keys to investing. Charlie Munger, Warren Buffett, Mohnish Pabrai and countless other superstar investors have talked and written extensively on the probability. It is one of the essential tools in their belts and they even pursue probability in their leisure activities. Buffett is drawn to Bridge as it is a game of probabilities.

I’d like to use this quarters reporting season as an example of my use of probability. I’m currently trying to trim down my bloated personal portfolio and get back to my concentrated ways. Concentrated for me means 10-20 companies, while for various reasons I found myself holding 49 companies late in 2007. My diet is going OK, I’m now down to 44 companies with 21 of those being meaningful positions. Anyway, back to the point.

Prior to earnings my thinking went like this. I want to sell at least a few companies. I want to do it prior to earnings as a significant portion of price movements occur around earnings time. In general the prices of stocks are static for 70% of the time with real movements occurring 30% of the time. I want to sell companies with uncertain long term futures.

My initial list was eResearchTechnology (ERES), Netflix (NFLX), CryptoLogic (CRYP), American Reprographics (ARP), Take-Two Interactive (TTWO), Harmonic (HLIT), Alvarion (ALVR), American Eagle Outfitters (AEO), II-VI Inc (II-VI) and Nuance Communications (NUAN).

I posted on a number of those companies and this post on ARP illustrates my thinking. ARP had good earnings and as it was so beaten down and investors had low expectations the price gained significantly for just good earnings.

I didn’t post the following as by writing my question I answered it. (If you don’t already write down yhour investing thoughts, then start an investing journal today.)

So tell me, what would you do with the following? No this is not a trick question it is a real life question and I am interested in your opinion, naturally everyone should feel free to reply.
Netflix hit my final sell point of $40 last Thursday [April 17] so I stayed up Friday night to sell it. I was selling a part positions in a couple other companies as well, II-VI and NUAN, so when I turned to NFLX to enter my limit order I was happy to see it trading at $40.85 bid and so entered my sell limit at $40.85. The bid then started falling away quickly, very quickly. I decided, like me, there would be a lot of people who had $40 as their price target and that the selling would quickly abate and my order still had a good chance of being filled later that day. I went to bed content with the dual thought that I always use limits orders and due to intra-day volatility they are hit 90% of the time, plus I always liked the saying that amateurs open the market and professionals close it.
I awoke the next morning to see NFLX down at $38.56, my order had not filled. Both of my other orders had been filled and they were entered at prices higher than the stock was trading at.

NFLX earnings are out today, 21st April. I expect good earnings as Netflix has beaten all competition into a pulp. While NFLX isn’t quite priced for perfection it is certainly priced with good things in mind, so excellent earnings and guidance will be required to push NFLX higher.
Long term I like the Netflix strategy, but it has been a volatile company and I am confident it will continue to be volatile as competitors will continue to assault the NFLX castle. Hence I sell NFLX when it approaches my valuation targets, this has worked well before and I’d wager it will again. I sold half of my large position at around $33, my cost basis is around $20 from June last year. It is not in a tax deferred account, so capital gains will bite a little.”

By the time I had finished typing that and ran some quick numbers I decided to sell NFLX and placed an order for $39.95. Like most investors I am plagued by fear and greed. I use numbers to stop the pathetic, debilitating, irrational arguments. The probabilities supplemented with an understanding of investor behaviour drummed in me to David Dreman led me to sell.

This is already getting to long and I’m gagging for a cuppa so here is how my decisions this earnings season turned out.
NFLX – Sold. Excellent, I feel good about selling, but as I like the long term potential of NFLX I am now faced with a decision on when to get back in. I consider the current price good, but not a slam dunk.

ARP – Held. Excellent, but I am still concerned about their lack of organic growth and the probability of a commercial building slowdown. I need to look closer, but my gut says sell.

ERES – Sold. This didn’t work out so well as ERES is now around 30% higher than where I sold. What went wrong, what can I learn. I invested in ERES as a turnaround opportunity. They sell cardio monitoring for clinical trials and the FDA had mandated heart monitoring. Their previous management were clowns and investors had no faith. I set firm targets for the new management and tracked what they said and delivered very closely. The new management proved to be excellent, my thesis was validated I profited. I sold based on a high valuation. If they had of delivered OK or worse earnings the price was going to tank. I should fell OK about my decision as based on the probabilities of investing it was the smart thing to do and ERES could easily trip in a coming quarter and present another opportunity for me. However, I don’t feel good, as I believe I didn’t rank the chances of this earnings being good as high as I should. I had grown to admire the new management, but was blinded by my valuations. I believe my valuations affected my probabilities. This is a mistake I make over and over again and one day hope to counter it. Here are my pre-earnings thoughts.

CRYP – Sold. Lucky. I had been looking to sell CRYP as it was never a company I was happy holding. It is the only company I’ve ever held that I would never mention to my partner or friends. I think less of myself for holding it and am glad to rid myself of it. As I dislike it so much I ignored it. A couple days prior to spreadsheet highlighted the upcoming earnings and coincidentally they announced a deal. The price shot up I sold. I didn’t run numbers, but my gut told me to grab the opportunity.

This is getting way to long, my mouth is so fury that I’m coughing up fur balls.
TTWO – Held, they’re worth more. Though my probabilities tell me to sell if I find a better opportunity.
HLIT – Added to, good earnings, market stupidly focused on guidance and price is now a bit lower.
ALVR – Added to, good earnings and guidance, market loved it.
AEO – Held
II-VI – Sold half
NUAN – Sold half

I am not advocating short term trading here. I’ve never calculated my average holding period, but it is probably around two or three years. Quickly checking my current portfolio I see the average purchase date is August 2006. I don’t run the probabilities for each my company every quarter, though I do try to update my Kelly targets after each earnings release. I find both my pre and post earnings probability calculations help me:
• contain fear and greed
• to have a rational basis to my decisions which I can check and hopefully improve on
• and force me to think about the company and its prospects at least once a quarter.

For anyone wanting to read more here are a couple articles to get you started
http://www.wallstraits.com/main/viewarticle.php?id=1397
http://en.wikipedia.org/wiki/Probability

Cheers
Dean

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