Anatomy of a Trade
Anytime you trade you want to ask, why is this asset I am buying underpriced and why is the asset I am exchanging for it overpriced? Or vice versa, why is the asset I am selling overpriced, and why is the asset I am getting for it underpriced? The usual answer to a value investor in stocks is the asset is underpriced because it is an ugly stock that is beaten down but then there are value traps where the stock remains underpriced for years. So we then ask what are the catalysts that make a stock reprice and wait for those in event-driven trading. Fundamentally a stock or any asset can only reprice on a shift in supply and demand. Supply of a stock may shift from stock issues if the stock price is too high or buybacks if the stock is too low. Moreover there may be generally more sellers of the stock if some news occurs that changes how a stock is viewed by the market. A stock can gain on a repricing in demand if there is a new growth story or if there are earnings surprises that lead to a better story. So the worst thing that may seem to happen is to get yourself a few stocks with no story just a valuation. These are boring stocks so how are you supposed to bet on them? Supply and demand. It’s not about the story which you can leave behind but the stock which develops. A stock with seemingly no connection to the news can be a great stock if you understand what drives stock prices together is not news but supply and demand. A boring stock with no story and no connection to the news has a valuation and that is enough, as we can form a relative value hypothesis and form a relative value trade on price to earnings alone, recognizing that multiples arbitrage is nearly impossible, we never can predict whether multiples are going to expand or fall. So we assume a higher price to earnings stock will remain overvalued in that sense and a lower price to earnings stock will remain undervalued in that sense but earnings growth will be higher in the lower price to earnings stock counterintuitively, because otherwise the market would be unfair for stocks of lower price to earnings, as these businesses could never issue stock to get enough money to come in to stay solvent and competitive.