Thursday, 2 August 2012

Why successful shares are like the Czech football team

It's not how good you are that counts, its about how much better you are

A quick digression, and apologies to the wildly informed who know this already. Like much about equity markets, it isn't rocket science.

Often people are confused why shares can report good results and go down. Facebook grew revenues a cool 29% this quarter, but the shares then tanked 15%. What gives?

The most important thing to remember is that what determines how a share price reacts to results is not how good its numbers are, but how good they are relative to what the market was previously expecting.

(as I said, apologies to those who know this all already, but if there's any consolation there's some quite fun stuff to follow).

Why Spain weren't the best team at Euro 2012


I've always found a good way to explain this to the generalist is by showing a neat little piece of sporting analysis which I do every time there is a major football (soccer) tournament on (World Cup, European Championship):



This chart shows how well teams did in the recent European Championship on the vertical axis, and how well they were expected to do before the tournament on the horizontal axis.

I determine the rankings on the vertical axis based on (in descending order of importance) 1) How far they got in the tournament, 2) How many points they scored (Win = 1, Draw = 1, Loss = 0), 3) Goal difference, 4) Goals scored.

I determine the rankings on the horizontal axis by placing the countries in the order they appeared on the FIFA World Rankings issued directly before the tournament started (6th June 2012).

Now on one measure Spain were the best team at Euro 2012. They won the tournament after all, and had a stonking goal difference of +11 (next best team Germany at +4).

However on another measure the Czech Republic performed the best. As you can see from the chart they were the further above their expected position. They finished 5th in the tournament, but before the tournament they were only the 14th-based ranked team in Europe. (by the same logic the worst team weren't Ireland, with their mighty -8 goal difference, but actually the Netherlands who were ranked 3rd but came 15th).

The same logic applies to shares on the day they report results (or the day after for overnight reporters). Whether they move up or down depends on whether they have beaten or missed prior expectations.

More specifically a share generally moves up and down in proportion to the average full year earnings upgrade/downgrade from brokers the day after results. The correlation isn't perfect, but in my experience that's a good rule of thumb.

And why you should never go to Michelin Three Star Restaurants


Amusingly the same logic applies to restaurants. Now I'm a pretty massive foodie, but one thing I've noticed is how much you enjoy a restaurant is not actually tied to how good it is, its tied to how much better/worse it is than you were expecting.

You can have meal cooked to very high standards in a three-star restaurant, but if it isn't perfect you will leave disappointed because you were expecting the world (and paying accordingly). In contrast you can have a plain but well cooked piece of grilled lamb at a Turkish mangal (grill), but it can taste like the world if all you were expecting was burnt rubber.

So there you have it. Don't go to the Fat Duck. Go to the FM Mangal and save a bucketload of cash at the same time....

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