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A news-based investment strategy

  • 2000 3 Feb
A news-based investment strategy
Reprinted with permission from World Finance Net IPO Newsletter, written by By Irv DeGraw, Research Director

News can be a powerful investment tool that every investor should know how to use. Heres why. It is a well known principle that stock prices respond very quickly to new information. More importantly, they also respond in a statistically predictable manner. By paying close attention to news announcements, investors may lock in gains and avoid disappointments.

On the surface, a news-based investing strategy is intuitively obvious: stock prices rise when positive new information about a stock is revealed, and they fall when the new information is negative. However, as a practical matter, making this strategy work is considerably more complicated.

Any news-based strategy is very short term. The effects of new information on a stock can disappear very rapidly, rarely lasting as much as a day. Investors have to be constantly on the lookout for new information and then must react immediately. Once stock prices respond, and they often do so within hours, the window of opportunity is gone and further investing is futile.

This form of investing can be very speculative. New news rapidly becomes "old" news, and old news causes problems. Investors who miss the new information effect, thereby buying on "old" news, end up buying at a price top and overpay for the stock. Prices may also drop once the news effect is over.

Unfortunately, the usual sources of business information, such as The Wall Street Journal and Investors Business Daily, are inadequate for a news driven strategy. By the time their news is available, the information is usually more than 36 hours (or more) old. Any short term benefits from this information are by then long gone. Trading short term based on this "old" news is a likely prescription for disappointment.

So where can an investor find the new information needed to pursue this strategy? The Internet has become an invaluable resource. Another source is our Daily Stocks to Watch feature located in the Stock Journal section. This feature is designed specifically to support a news-based investment strategy and contains a daily selection of companies about which news has been released between the prior market close and the current days opening.

We have identified approximately 5 classes of news that can have an immediate effect on stock prices. Historically, certain classes have more intense effects on prices than others. The following section orders these classes in terms of their historical impact.

When a public company announces its quarterly earnings numbers, this can have a dramatic influence on the companys stock price in the short term. Various organizations and market analysts regularly compile data on public companies and forecast what a particular company will earn. How the real numbers match up against Wall Street expectations is very important. There can be an "earnings effect" caused by the difference between actual earnings and expected earnings estimated by Analysts. Prices often rise when earnings exceed expectations and fall when expectations are not reached. And if they meet expectations, often nothing happens to the stock price.

Theres also an unwritten rule which all public companies are expected to follow regarding earnings announcements. Whenever a company realizes it will fall short of the predicted earnings, it is expected to immediately "pre-announce" or warn of this shortfall. Companies that fail to pre-announce and thereby create negative earnings surprises are often penalized with more severe stock price declines.

Analyst Reports/Recommendations
Financial analysts, both independent and employed by brokerage firms, regularly follow public companies and, based on their analysis, issue recommendations whether one should buy, sell or hold a particular stock. These recommendations can have an influential effect on short-term prices. Stock prices can rise when Analysts upgrade their recommendations (e.g., hold to buy) or when Analysts increase their earnings expectations. Prices can fall on downgrades and reductions in earnings expectations.

The purchase of one company by another is usually announced with fanfare, often after lots of early hints about the prospect of an acquisition. In general, the company being acquired will experience a stock price increase while the stock of the company making the acquisition decreases. The general reason for this dynamic is that the market assumes that the acquiring firm has overpaid (which they typically do) and the acquisition will negatively influence near term earnings. While a good acquisition can therefore improve the overall quality and future earnings potential of company, in the short term its stock can actually fall in value as a result.

Contracts & Alliances
Companies announcing the award of large contracts or alliances with immediately obvious benefits usually experience quick stock price gains.

Announcements of reorganization can have a more "spotty" and less reliable record of predicting stock price impacts. Two types of reorganization are common. When companies announce "spin offs" (i.e., separating a company into 2 organizations) the stock prices of the new unit usually increases and the stock price of the "parent" may (but not always) also increase. When companies announce stock "buy backs", where the company has decided to take in some of the stock in circulation, share prices usually increase. There is often no guarantee the company will actually buy its stock back.

News-based investing strategies have a reasonably reliable track record. But they are certainly not 100% perfect. There will always be exceptions, and this is a speculative form of investing. But over the longer term, and "on average," the strategy may produce better than average returns for the astute active investor.

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