Many novice traders don't buy individual stocks, let alone short them, because they believe they can't possibly have an edge on professional traders. Others, particularly the finance geeks, believe in the efficient market hypothesis and take the view that a stock's current price must be the "right" price because all expectations are already embedded in it. Both are dead wrong.
While you or I certainly can't compete with research analysts when it comes to assessing the value of Bank of America's (NYSE:BAC) mortgage loan portfolio, we do have an edge when it comes to certain companies and brands we encounter on a daily basis(*). This is due to several reasons:
- Wall Street analysts typically don't cover companies less than $5 billion in market capitalization. Most companies are much smaller.
- Analysts have a lot more to lose (their job) than gain (pat on back, a small bump in year-end bonus) from a bold prediction that goes against the grain, particularly if it's negative. They don't alter their opinions until they see hard data, typically in company statements and quarterly earnings calls. Often, the writing's already on the wall if you look closely enough.
- A key assumption of the efficient market hypothesis is market participants are perfectly rational. Frankly, this assumption is ludicrous. Instead, think of a stock's price as the equilibrium level at which the number of potential buyers equal the number of potential sellers. Just like how the vast number of Pittsburgh Steelers fans betting on their team tends to shift betting lines toward the Black and Gold, stock prices are affected by the sentiments and biases of market participants.
Case study: Netflix (NASDAQ:NFLX)
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- July 12, 2011: Announces a 60% price increase... no more DVD-by-mail and streaming subscriptions for $9.99 per month. Instead, customers have to pay $7.99 separately for each service or $15.98 combined. Unsurprisingly, customers hate it. The stock starts sinking from its $295 record high.
- July 26, 2011: On 2Q earnings call, Netflix says the price backlash won't last. Stock drops from $288 to $261.
- Sept 15, 2011: Admits that it will likely lose 600,00 customers this quarter instead of adding 400,000 as previously forecast on the 2Q call. Stock plunges from $209 to $169.
- Oct 26, 2011: Whoops, it turns out it actually lost 800,000 customers. Stock falls off a cliff, going from $119 to $77.
If you were a Netflix subscriber when it announced the price increase, how did you feel? Especially since the company had raised prices from $7.99 to $9.99 earlier in the year. Many who supported the stock assumed that customers would just take the increase in stride merely because there were no better alternatives. Some commentators even recommended the stock after the pricing increase. Did those opinions really jive with how the subscribers you know reacted?
To be fair, it's never cut-and-dry. Any bold view requires some degree of risk. However, it's telling that the sharpest drops in Netflix's price came after company statements confirming the cancellation firestorm that was already visible on social media. But while Wall Street analysts can't change their views on Netflix simply due to what people are saying on Twitter, there's nothing preventing a savvy trader like you from exploiting your built-in edge on them.
In the 4Q earnings call last week, Netflix announced that the company had regained 600,000 of those lost subscribers. The stock promptly jumped from $95 to $116 and is currently trading at $124.
However, 97% of those new subscribers were still on the free 1st month trial. Many of those probably subscribed clicking on the Netflix app that came bundled with Christmas iPads and Kindle Fires. Will they stick around?
* For more information on how you can use your everyday insights to beat Wall Street, check out the venerable Peter Lynch's One Up on Wall Street
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.