Humans communicate every second of their lives; it doesn't necessarily have to be from their words; it can be the way you dress, the way you speak, the things you do, etc. The problem occurs when we are on the receiving end; how do we make sense of the millions of signals being bombarded to us every minute from a hundred individuals? What do we do when most of them contradict each other and don't know what's true? We will just end up confused and lost. Enter signalling theory! This article will aim to form a mental model from signalling theory to find better stock opportunities and avoid false ones.
Signalling theory comes from evolutionary biology. It aims to study communication among individuals of the same and different species by identifying honest and false signals. What are honest signals and Dishonest signals? Honest signals are difficult to produce and can't be replicated easily; hence, they have a higher chance of being true.
Dishonest signals are easy to mimic and can, hence, be used to indicate something that isn't true.
Let me give you an example to make it easy. If I want to portray that I am brilliant and a genius kind of a guy in economics, what signals can I use to prove that and how can they be honest or dishonest? I could order many economics books and arrange them visibly in my room without actually reading them. I can easily blabber about cool topics and act like I know everything without getting into its depths. I can forecast the economy with fancy terminology without much backing. These are dishonest signals. I don't require much effort to do this, and they come off as if I know economics. However, getting into a good university with a scholarship, writing a quality research paper or reading those books are honest signals. These signals require a lot of effort and are hard for many people to produce, but they signal what I have been trying to prove.
In nature, Male Peacocks have tails, and the ones with a longer and bigger tail are generally considered sexually fitter for reproduction. These tails are honest signals because they are hard to maintain and make them visible to predators. Another example is poisonous frogs, which have vibrant colours, such as yellow or red, that signify their toxic nature. These can be honest signals as the pigment required to get that colour is tough to produce.
Source: wikipedia
This theory works well in identifying potential multibaggers and avoiding multibeggers as well. There are some signals that are honest in the stock market, which translate to something, and others that mean nothing and should be avoided. Let's study and understand what these signals could be:
Dishonest signals to be aware of
Overly optimistic forecast: This is so popular during the bull markets. During a bull market, efficient market theory is at its best, and every guidance management gives is digested in valuations. Guidance of 40/50% earnings is very easy to give but equally challenging to deliver over an extended period of time. This happened to me a while ago. I bought a very expensive stock, thinking the growth was sustainable, but it failed to deliver after two quarters, and my portfolio suffered the brunt of it. Hence, I would suggest taking a step back and analysing using second-order thinking if it's possible for a business to grow at a high rate for more than two years, and ENSURE that there is a margin of safety with the price you pay. I understand that is easier said than done, but trust me, the key is not to make hasty decisions, and then it suddenly becomes easy.
Fakeouts: For a stock to perform, it has to be in a steady uptrend. However, not all uptrends are the same and, hence, should be looked at accordingly. No rules written in stone help identify true trends and breakouts against cat bounce and fakeouts, but there are some ways that could translate into being more right than wrong. First, Focus on the volumes; a high volume breakout is more likely to sustain as institutional buyers aid it. Second, do not go for 90-degree stock movements. A steady uptrend at around 45/60 degrees is something that we should look for. These signify a steady improvement in a business, while a sudden burst could be because of some news. It could end up improving the business, but I look for steady, trackable activities or changes that are more likely to persist. And one more thing on a personal front: it is not easy to handle those rapid movements on either side; I just don't know what's happening.
Focus on publicity: It bothers me when a management team starts becoming a sales team that starts marketing their shares. It's fine to do interviews and attend conferences to answer questions about their business. However, I think it is a good idea to raise your eyebrows when you see a company's management all the time, talking about their stock and how everything is rosy. It is generally better to let the results speak and let investors discover the business.
Honest signals to track
History: Giving guidance is easy, but consistent performance over the years is very difficult. Except for turnarounds and cyclical, we can understand the true strength of a business when we study the history behind the stock. When a business has grown its earnings over 25% for a few years back to back, it is worth noting because, sooner or later, everyone else will start to. These businesses won't come cheap, but following the mental model discussed in the blog "Identifying stock correction as opportunities" can help immensely.
Cash flow: An earnings report is done on an accrual basis of accounting, allowing misleading investors with inflated earnings. There is a big difference between recording profit and actually receiving the cash. Understanding the cash flow statement can be of great help in such scenarios. A business that can convert profits to Cash flow will have inherent advantages that the same business without this potential won't. It allows the business to not depend on debt, invest in other activities, increase other income and much more. An easy way to do this is to see if any of these activities are being done: Dividends, share buybacks, expansion financed by internal accruals, etc. It is a signal worth tracking.
Warrants/Promotor buying: If management truly believed in the future potential of their business, would they focus more on advertising that or buy that opportunity themselves? Warrants give the existing shareholders the right to buy or sell a specific number of shares at a predetermined price at a future time. Putting your capital to bet on your business is a true signal as there are risks involved with it, and their gain depends on how the business will perform in the future.
I enjoy combining two fields and developing a model that could be very helpful. I read about the signalling theory in a few books and podcasts and recognised how simple and useful it could be. That is what prompted me to develop my own set of ideas surrounding this theory.
Until then, message me and let me know what other fields I could combine with the stock markets and what observations you have noticed that distinguish honest from dishonest signals.
Key takeaways:
Signalling theory identifies honest signals from and dishonest signals in nature when communicating.
Signalling theory can also be used to correctly identify multi baggers and multibeggers.
Dishonest signals to be aware of: Overly optimistic forecasts, fade-outs and Publicity stunts.
Honest signals to track of: History, cashflow and Promotoer buying/issuing warrants.
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