Stage theory and changing your mind and shorting yourself

How stage theory can help fundamental investors, an example.

As a fundamental investor, my primary focus has always been analyzing companies through key factors such as the management team, capital allocation, financials, margins, durability, competitive advantages, cash conversion, and valuation. I have generally disregarded any form of technical analysis. However, after reviewing my past trades, I discovered valuable insights that can be learned from technical analysis without straying from my fundamental investing principles.

This article explores how stage theory can be effectively utilized to inform when to enter new positions, particularly emphasizing the importance of buying quickly in Stage 2 due to momentum and exercising caution in Stage 4 by building positions slowly at low normalized earnings multiples.

Understanding Stage Theory

Stage theory divides the life cycle of a stock into four primary stages:

1. Stage 1: Accumulation - This is the period when a stock is consolidating after a prolonged decline. It is characterized by sideways movement, where savvy investors start accumulating shares at low prices, anticipating a future breakout.

2. Stage 2: Advancing - Often considered the most profitable stage, Stage 2 is marked by a significant upward trend. Momentum drives the stock price higher as increasing numbers of investors recognize the company’s potential.

3. Stage 3: Distribution - In this stage, the stock’s price reaches a peak and begins to plateau. Early investors might start taking profits, leading to increased volatility and a struggle between bullish and bearish sentiments.

4. Stage 4: Decline - The final stage is characterized by a downward trend as the stock price decreases. This stage often occurs when a company’s growth slows, and its earnings multiples shrink.

The Case for Buying Quickly in Stage 2 if valuation remains low and fundamentals are strong

Stage 2 is often described as the "advancing" phase, where the stock experiences strong upward momentum. There are several reasons why investors should consider buying full positions quickly during this stage:

1. Momentum Drives Performance: Stocks in Stage 2 benefit from positive momentum. As the stock price rises, more investors take notice, driving further buying activity. This creates a self-reinforcing cycle where momentum begets more momentum. Entering a full position quickly allows investors to capitalize on this upward movement.

2. Market Recognition: During Stage 2, the broader market begins to recognize the stock’s potential. Positive earnings reports, analyst upgrades, and favorable news can lead to rapid price increases. Hesitating to build a position can result in missing out on significant gains as the stock continues its ascent.

3. Strong Fundamentals: Stocks entering Stage 2 often have strong underlying fundamentals. Companies may report robust earnings growth, innovative products, or expansion into new markets. These factors contribute to sustained price increases, making it advantageous to establish a full position early. It is even better for me as a fundamental investor, if the valuation still remains low while it has upward price momentum.

Caution in Stage 4: Gradual Position Building. Buy only at low normalized earnings multiples

Stage 4, the decline phase, presents a different set of challenges. Here, the focus shifts to caution and prudence, especially when the stock is still trading at high multiples. The reasons for building positions slowly in this stage include:

1. Increased Risk: Stocks in Stage 4 are on a downward trajectory, often due to declining fundamentals, reduced earnings, or negative market sentiment. The risk of further declines is high, and entering a full position too quickly can result in significant losses.

2. Valuation Concerns: While low earnings multiples can make a stock appear cheap, it’s essential to determine whether the low valuation is justified. A stock may be trading at a low multiple of past earnings, but at a high multiple of future earnings. Make sure if you buy at this stage, that it is at a low multiple of normalized earnings.

3. Market Sentiment: Stage 4 stocks are often out of favor with the market. By building a position slowly, investors can gauge market sentiment and wait for signs of stabilization or a potential turnaround. This cautious approach helps mitigate the risk of catching a falling knife.

4. Opportunistic Buying: Gradually entering a position provides flexibility to take advantage of further price declines. Investors can average down their cost basis if the stock continues to drop, ultimately leading to a more favorable entry price if the company recovers.

5. Patience and Discipline: Building a position slowly in Stage 4 requires patience and discipline. This approach allows investors to avoid emotional decisions and carefully analyze the stock’s performance and broader market conditions.

Example: Auto Partner

The best moment to buy is a Stage 1 just before a Stage 2. I had great timing and bought Auto Partner just before the advance. One we reached Stage 3, I was fundamentally worried about margins, so I started to reduce my position (at some points I re-bought since I thought it would be compensated by revenue growth). It is now pretty clear that Auto Partner could soon enter Stage 4, with lower growth and margins contracting, so I finally exited the early May. As you can see, a combination of fundamental analysis and Stage theory, can be very useful for investors.

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