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Tuesday, 23 October 2018

THE DATASONIC TRADE - WHEN A SCANDAL PAYS OFF

Just like the majority of normal, flawed human beings, we love disasters and scandals. We love reading about them. We gossip about them and waste valuable time and productivity. We read about them in the papers and instantly feel better about ourselves, at least for not paying credit card bills with charity money meant for orphanages.


This time, it wasn't him.


Unlike the majority of normal human beings, we have developed a capacity for trading stocks based on disaster and scandals. This is not necessarily a positive thing as we worship companies with real value first and foremost. But we feel that there is little research currently done in this space.


We know that disasters and scandals create mispricings in stocks. This can create a genuine investment opportunity with massive profit potential. As always, we are obligated to identify and execute such trading opportunities once they arise.


Trading based on pure sentiment requires a more cerebral mind set. We are under pressure to make instantaneous decisions in real time. Not only that, we are also forced to analyse a stock's potential for complete collapse in real time. It is the equivalent of selling life jackets on the Titanic while it's already halfway underwater.


It is also incredibly difficult to buy into a stock which for all intents and purposes has collapsed quickly under the weight of a disaster or scandal. But we managed to do so anyway, and we will show you how we made real, meaningful profits.


But why buy collapsing stocks? It's because we feel that most investors out there put too much weight in a company's value by the price or performance of the company's stock. This is somewhat misguided, even though it's also somewhat accurate; a stock's price is a representation of investors' sentiment of the company's future earnings expectations plus dividend potential. That's pretty much it.


The extremist view would be to see stocks the way someone looks at himself in the mirror. If he feels that he looks good, he feels better about himself. Thus, if investors, analysts, and financial media feel enthusiastic about a stock, the sentiment itself is enough to propel it to new heights, and new lows if they feel otherwise.


Credit : Zunar

You would think that investors would not treat value or defensive stocks in such a way (we get it if this happens with overhyped, capital gains-oriented growth stocks), but this distinction is rarely made. Things such as net asset value are considered irrelevant by most people during the boom times; they arguably become even more irrelevant during a crisis.


Our point: a stock's price does not efficiently reflect a company's value. Sometimes it might, but most times it is distorted by our collective belief and sentiment, whether it's internal (the stock itself) or external (other factors including the current market environment). Because of this, we believe that a stock's price is an absolutely pure representation of investors' hopes and fears. And just like our feelings towards Malaysian politicians, our emotions magnify when a surprisingly unpleasant situation develops.


This is what happened with Datasonic, a firm with a serious dependency towards government contracts. But just like some airline tycoons, we know that a company's best interest is to serve the government of the day; it hardly matters which government it is and who's in charge.


The same case can be made for MYEG, another company hit with scandal but is so entrenched (it helps to have a monopoly in e-payments and an acceptable, profitable product) that it will not evaporate into the night anytime soon. As you may know, both DSONIC and MYEG were hit by scandal and saw a collapse in their stock prices; we only had time to trade the former as its cheaper stock price provided more bang for the buck.


The source of the malaise experienced by long term shareholders of DSONIC and MYEG came from an unexpected source; the former Deputy Prime Minister himself, whom the Malaysian Anti-Corruption Commission is accusing of a long list of utterly dodgy behaviour.


"You have 32 charges? I have 45." Image source.


The news traveled quickly and immediately triggered an epic selldown in their stocks. At midmorning on Friday, 19 October, both DSONIC and MYEG hit their limit down thresholds, or the lowest allowable point for their stocks to trade at on that day.


We are not here to debate the merits of the accusations, or even trade based on the subsequent newsflow. Our foray into DSONIC is purely based on what we consider to be an artificial mispricing in the stock. Bad sentiment is creating a distortion in the stock price. Once panic sets in, we bought into the stock, wagering that a recovery is not to be ruled out. It's peak fear all over again, but there's also more to it.


STOCKS CAN COLLAPSE OVERNIGHT; COMPANIES DON'T


So how do you analyse a collapsing stock in real time? You start by asking many, many questions. The most important one for us is always this : is it an existential crisis for the company? By this we meant : will the company collapse immediately?


In 99% of cases, the answer is no, no matter how bad or scandalous the news might be. But investors do not see it this way. To us, an existential crisis for a company happens due to two things - complete value destruction and an inability to operate as a going concern (think Enron). Quite obviously this was not happening to DSONIC.


Scandals come and go. Companies go through it all the time, and faced with serious allegations, they will refute and fight them to the death. When we first read about the charge involving DSONIC, we were wondering when did the offence allegedly occur and who were the key players? We also considered the possibility of rogue individuals claiming to act on behalf of the company, or even MACC mischaracterising their charges. This is pure conjecture and deserves to remain as gossip fodder, of course; we don't know these things.


What we do know is that despite the charges, DSONIC is not a fraudulent company. It will continue to operate in the coming years, with real products and real cash flow. But processing the news did lead us to the next important questions - how bad will the stock be impacted? Will it hit limit down?


We began observing the stock almost as soon as the news hit. At the time, DSONIC, which closed at 69.5 sen the previous day, had already begun losing value, easily breaking the 60 sen mark in midmorning on Friday. MYEG was already in free fall as it slipped from RM1.50 to RM1.30 in under 20 minutes; we thought this was going to be equally painful for DSONIC.


In about 75 minutes, DSONIC hit its limit down point of 39.5 sen at around 12:05PM. MYEG hit its own limit down of RM1.05 at around the same time. There was a cascade of panic stricken investors selling their shares at virtually any price; they did not wish to become trapped at limit down, where trading would virtually cease due to the massive sell orders and no buyers.


This brings us to the most crucial question of all - is this the time to go in and trade this thing?


THE LIMIT DOWN TRADE


Limit down, bad news, and panic selling; we have read these headlines before. We have written extensively about them for our readers' benefit. Read about our entries on Sapura Energy and KRETAM, for starters. Then read about our little adventure in TOPGLOV, and how possible fraud could not hold down a good company for long.


Here we write about it again, just to demonstrate that trading this angle requires a clear-cut plan and a decision making process that is formed by experience, not pure gambling. We'd also like to emphasise that this angle is not only tradeable and repeatable, but also leads to outsized profits.


For DSONIC, we only look for one thing at that limit down point; an immediate buying support and a small but significant recovery. This basically means that we are planning for the possibility of a strong rebound, right there and then. It's a calculation that the extreme price point ('peak fear') marks the end of the trend, and that those who were desperately dumping shares have already done so.
 

DSONIC price chart, 5-minute intervals, 19 October, 2018


We expected to find out within minutes whether the stock is tradeable or otherwise. Given that investors have priced in the accusations as reported in the papers, the possibility of a rebound is apparent (to us). We got our first signal by 12:10PM, as the stock made a marginal recovery and moved away from 39.5 sen. It went to 41.5 sen; not much, but it's a start.


In chart form, you may not be able to appreciate how volatile the situation was. We saw thousands of lots change hands in seconds. There was some selling desperation, but there was also a willingness by some opportunistic investors to snap the shares at its depressed level; we wanted to be part of that. So the first signal was met easily - no sustained pressure at the limit down point, followed by a marginal recovery. 


Things were quite risky at this point; there was a real possibility that a new wave of selling would engulf the stock, sending it back to 39.5 sen. But this did not happen over the next 20 minutes, giving us our second signal; the sustained buying just above the limit down point suggests that there is real buying interest. We made a decisive move and bought a large number of shares at 42 sen.




During a selldown, the selling pressure overwhelms the buy orders. But as a stock recovers, this imbalance starts to reverse. By 12:25PM, there were larger buy orders for DSONIC but much lower selling orders. This could lead to a buying frenzy as the stock was illiquid at upper price points (43, 43.5 sen, and beyond). We were willing to wait and ride this thematic; our price target at this time was 46 sen and above, or about 10% in return on investment. We'd be happy with those numbers.


Just before the market closes at 12:30PM, we noticed another crucial development; MYEG's stock also rebounded strongly from its limit down point of RM1.05. We literally saw five million shares change hands in mere seconds; given that the stock is far more liquid and pricier than DSONIC, we deduced that the buying interest is real. As both stocks were reacting to the same newsflow - they hit limit up at almost exactly the same time - it probable that both stocks could stage strong recoveries simultaneously too. (Editor's Note : this trend exists but only for very limited durations)


MYEG hit a peak of RM1.18 just before closing at RM1.13, while DSONIC closed at 44 sen.


AND THEN....


The situation develops. The companies, most definitely unnerved by the their stock price collapses, decide to go on the offensive. MYEG decided to halt trading on its stock for the afternoon session. DSONIC went one step further to publicly rebuke the MACC's assertion in a stock exchange filing.


We were asked this question - did we know about this?


Another answer : we considered the possibility of the company denying the accusations seriously, although we had no clue when this might happen or in what form. As always, we were trading based on the price and volume activity, not the anticipation of a favourable development.


DSONIC's stern reply supercharged buying interest in the stock. We believe that the public's logical reaction is this - if the accusations are untrue, why shouldn't the stock recover to it pre-crash level completely? Why shouldn't it go back all the way to 70 sen?


We don't necessarily agree with this point of view, but we understood its appeal. At any rate, this would be favourable to our holdings. And so, as the market opened at 2:30PM, DSONIC shot up to a peak of 55.5 sen, or an immediate 30% gain from our entry price point. 


The result:


That had been a very eventful five hours. Now we're back to hibernation as we await Budget 2019 and an increasingly likely stock market collapse worldwide...











Monday, 15 October 2018

MEAN REVERSIONS AND PEAK FEAR : HOW WE MADE PROFITS WHEN GLOBAL MARKETS PLUNGED

For many investors, 8-12 October 2018 was the week from hell. The KLCI fell like a rock with a 5% decline at its worst point, or a whopping 90-point drop within two days. Hong Kong's Hang Seng Index, which takes its cues from movements in the US markets, similarly exhibited its rock-meets-gravity tendencies; it fell by 5% to a 17-month low.


On one particularly bad day, Bursa Malaysia's total number of counters exhibited this statistic; 900 losers (decliners) and 56 gainers, with the rest untraded. In other words, assuming you're holding one particular stock or warrant, there was only a 5% likelihood of making money on this day. Elsewhere, retail and institutional investors fled in droves, completely uncertain of where the bottom of the market is.


Amid all this, we managed to make a total of RM3,900 in profits from two trades. We do not see this as a trifling amount at all, and it was not down to luck or incredible intellect. To make meaningful profits when the markets are on fire, you have to understand two things that keep everybody awake at night; fear, and maths.


Our ideal readers are those who were not dissuaded by terms like 'mean reversions' in the blog title. If you're still reading, we love you. Source


We will elaborate on two key concepts that allowed us to derive relatively low-risk but high returns. A 10% gain from a trade lasting under 48 hours is a good outcome. Achieving this outcome when markets were in free-fall is an.. awesome outcome?


Anyway, here are the two things to keep in mind if you really want to make profits during tough times. This is the only way to prove that you're truly contrarian; by doing it in practice instead of just talking like the stock market 'gurus' out there.


1) MEAN REVERSION : WHAT GOES DOWN...


From time to time, you will encounter a market situation that can only be described as a perfect storm. A confluence of factors combined to achieve, in this case, a truly frightening outcome for many. Last week, both domestic and external factors pretty much drove the KLCI into a seemingly bottomless pit.


Just look at the following headlines, listed in chronological order over a 48-hour period:

Wednesday, October 10, 2018. Full story here


Wednesday, October 10, 2018 (US time). Full story here.  

Thursday, 11 October 2018. Asia markets react horribly to the declines in the US. Full story here.
 
Thursday, October 11, 2018 (US time). Total damages. Full story here


A quick quiz: when was a good time to trade profitably? Our very specific answer : when the KLCI fell below 1,700 points, given that it was about 90 points higher barely 24 hours before.


During periods of severe market volatility such as this one, we are just like you; we are concerned about what this decline ultimately means for the market, the state of the economy, and the state of the world. Although we agree that extreme caution is appropriate, which means you should take your money out of the markets, we have also trained ourselves to identify very specific pockets of opportunity.


To put it another way, we know that there are chances to make low-risk returns relative to the rest of the market. This is where mean reversion comes in.


Mean reversion is the financial equivalent of the old adage 'what goes up must come down', in reverse. But we never deal with absolutes. Instead, we believe that markets that have fallen steeply (5% in two days) are fairly likely to rebound.


Furthermore, we are confident that the steeper and faster the decline, the more meaningful the rebound will be. In numerical terms, when a market has fallen 5% over a three-day period, a rebound of at least 1.5% is likely to follow.



You may be wondering... 


We have grounded reasons for saying this, based on our own empirical observations over the past three years. As we are currently in a fully risk averse position with zero stock holdings for the long term, we welcome these periods of volatility as an opportunity to deploy cash and derive substantial short term trading profits.


Just a historical sample of recent mean reversions. Feel free to do your own research on this.


But before we go into the actual trades, we will elaborate a bit on why these steep declines were good trading opportunities. This is where it's good to understand history and have a sense of context.


2) PEAK FEAR : WHERE THE EASY MONEY IS


This concept is fairly self-explanatory. With enough observations and market experience, we are more confident in our ability to identify specific situations where a stock, or warrant, loses its value purely due to fear and desperation, then trade into them. We have already documented many instances where this occurs due to negative company-specific news. The same applies to negative broader markets news, and we dare say it's easier to identify.


In the context of the KLCI, what happened last week was a classic case of peak fear. It exhibited the following characteristics; in hindsight these seem obvious, but not in real time (Editor's Note : we are not immune to thoughts of market collapse or an apocalypse).


1) A very steep decline in the Index (90 points in two days).

2) A very fast decline in the index (90 points in two days!!).

3) A sudden loss of liquidity, as shown by the 'gap down' in the KLCI when it opened steeply lower.

4) Indiscriminate dumping of stocks across the board (blue chips, GLCs, etc).

5) Negative reaction to domestic issues, then external ones (explained earlier).

6) An immediate breach of the supposed 'support point' for the index (1,700 points; anywhere below is a buy call for us).

7) Investors' panic conveyed broadly in financial media (oh yes, this is an indicator of peak fear for us).


Armed with this knowledge, and our rigid, tightly defined game plan, we decided to commit to a couple of trades on 11 October; nothing too big relative to our usual activity. It could've been done on a bigger scale, but we are also risk averse.




We laid it out here, on 11 October. Follow us on Twitter.


We always have a call warrant or put warrant in mind to trade in case a situation like a steep market decline develops; more on choosing the right call/put warrants here. In this case we settled on FBMKLCI-C3Y, a largely previously ignored call warrant with great liquidity characteristics. It was also trading in the 15-20 sen range that we are typically comfortable with (it traded at this price range after the KLCI fell by 5%).


Due to the sudden shock in market volatility, the call warrant fell to its lowest since issuance. We happened to buy in at around 15 sen, or right at the bottom. During this period, the FBM KLCI fell near its intraday low of 1,684 points; it quickly rebounded thereafter.


 FBMKLCI-C3Y; October daily chart. 

5-minute movements in the KLCI on 11 October. Note the huge 'gap down' opening and subsequent rebound.


24 hours later, as the KLCI rose beyond the 1,710 points mark, we exited the call warrant position at 17.5 sen for a 12% gain. As is usually the case, we played it very safe. The warrant actually ended the day on 12 October at 19.5 sen, or a gain of 30% from our entry level.  (Editor's Note: we will always stick to our game plan. When we exited the position there was little indication that the market would head higher as it did)




And remember what we said earlier about markets rebounding by at least 1.5% after a 5% decline? The KLCI ended the day up by 1.3%.


Amid all this, we actually took this angle of peak fear (and mean reversion) to another level. We understood that the market selloff was a global phenomenon; Malaysia/HK takes the cue from the US, and the cycle goes on. So we also decided to take a position in Hang Seng Index (HSI) call warrants, the ultimate barometer of the global stock market's whims.


We have a somewhat unhealthy obsession with the HSI, having tracked the index closely over the past two years. We had maintained a very bearish view on the index and anticipated a decline below 30,000 points. It ultimately did this, but we were spectacularly unsuccessful in achieving profits despite being right. (Editor's Note : this trading lesson was very expensive)


Due to the HSI's world-class volatility (which is reflected in the day-to-day movement of its call and put warrants traded on Bursa Malaysia), we no longer trade them based on momentum. Instead, we switched to the 'peak fear' approach. The principle is the same as the KLCI; in periods of sudden volatility, the 'easy' money is made by taking a contrarian approach.


To do this, you absolutely have to buy into the selldown. After a steep decline and the eventual recovery, there is a good chance that our entry point is good enough to achieve substantial profits from; again, this is defined as a 10% return on investment or more. 


So we bought into a HSI call warrant - HSI-C3T - on the same day as FBMKLCI-C3Y. Our angle is that the HSI will exhibit a recovery on an equal, if not a better, level with that of the KLCI. (Editor's Note : As a general rule, the KLCI is much less volatile than global indices due to a myriad of factors. All else being equal, relative to the KLCI, the HSI would fall further yet rebound more intensely)

The eventual outcome:


There is no conceivable universe where earning RM1,000 a day can be considered bad.


So, to tally up the market recoveries around the world on 12 October:

1) FBM KLCI - up 1.3%
2) HSI - up 2.2%
3) S&P 500 - up 1.42%  


WHEN CNBC SAYS RUN FOR YOUR LIVES, IT'S TIME TO BUY


We are not chest thumpers and we will never claim that we are true contrarians (everyone will say they are), but we are aware that we will make contrarian moves from time to time. Going against the entire market (and the entire world, even) is not for the fainthearted, but sometimes you will see certain signals indicating that indeed, the time to make a contrarian move is now.


One of our favorite signals to trade is based on notable excessive coverage by financial media on market panics. We do believe that sometimes the media perpetuates market fears, influencing investors' decisions to dump their stocks. It creates a self-perpetuating cycle; more breathless media coverage on 'markets in turmoil' creates an environment of fear, driving even more shareholders to sell their holdings at all costs. The outcome of this? Peak fear.


If you follow the markets (and the accompanying media coverage) fairly closely, you will be able to sense it. There is a degree of exaggeration in the reporting ('S&P 500 Falls the Most In x /Weeks/Months', 'Stock Market Meltdown as Dow Loses 3%', etc), and you will see special TV segments covering the bloodbath. In fact, CNBC pretty much did this last week, with zero subtlety (Editor's Note : you will also see the same type of coverage, to a lesser extent, by international or Malaysian media).


 Panic on Wall Street. Source.

We have to make a brief but important distinction here; even though global markets fell 5% last week, we do not view this as a genuine panic, or market crisis. Financial pundits and investors have short memories; The February market shock was arguably worse, and so was the post-general election dip in Malaysia. What goes up must come down, and we can only provide guesses as to why the markets fell as much as it did last week.


But panic can occur without substance, of course. It's a consequence of peak fear, and it creates a window of opportunity for trading. We profited by understanding mean reversion and market psychology, not by having grand thoughts about the state of the market (we have those, too, but they are currently not very useful for making money). So the next time you see a special report on how markets are falling steeply, consider the other side of the equation; when everybody's selling, have some courage and buy into the panic.


Except when there's a real financial crisis, of course. But we're not there yet... just maybe.

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