Predicting Stock Prices: Use of the Second Derivative

Derivative, not in the sense it's used in Future and Options (F&O), but the concept from Differential Calculus.

The Power of the Second Derivative

The article "The Power of the Second Derivative" recently published on X (formerly Twitter) by Brett Caughran (@FundamentEdge) offers insights into stock picking and alpha generation by emphasizing the concept of the "second derivative," focusing on acceleration or deceleration in growth rates. Here's our critical analysis of an article that is otherwise intended for a specialised or esoteric audience. In the concluding paragraph, we explore the potential applicability of this concept to other macroeconomic parameters.

Clarity and Structure

The article is clearly structured, outlining its central theme and providing examples to explain complex concepts like the "second derivative." It progresses logically from basic principles to specific instances, aiding in understanding.

Key Insights

• Second Derivative Definition: The second derivative refers to the acceleration or deceleration in the rate of change of a variable. In the context of the article, it's primarily used to measure the acceleration or deceleration in year-on-year (YoY) revenue growth. This concept is pivotal in predicting stock price movements.

• Relevance in Stock Picking: The article argues that stocks with accelerating growth rates (positive second derivative) tend to perform well, whereas those with decelerating rates (negative second derivative) are at risk of downward price movements.

• Examples to Illustrate Points: The use of real-world examples like Amazon and Nvidia helps contextualise the concept of the second derivative. These examples demonstrate how stocks with significant revenue growth can achieve high valuations, driving home the point about acceleration being a critical factor.

Critical Observations

• Challenges in Valuation: The author acknowledges the difficulties in valuing stocks, particularly in today's market, where many are long-duration assets with unclear future cash flow streams. This realistic perspective is valuable, illustrating the inherent uncertainty in stock picking.

• Importance of Tools Beyond Traditional Value Investing: The article emphasizes that traditional valuation methods may not be sufficient in today's market, suggesting a need for more dynamic tools. This is crucial in light of the evolving financial landscape, where technology and innovation play a significant role.

• Potential for Overemphasis on Second Derivative: While the second derivative is useful, overreliance on it could lead to misinterpretation of stock trends. There should be a balanced approach, considering other factors like market sentiment, industry trends, and broader economic conditions.

• Lack of Discussion on Other Risks: The article could benefit from a deeper exploration of other risks associated with high-growth stocks, such as competition, regulatory changes, and macroeconomic factors. A broader risk analysis would provide a more comprehensive view of stock picking.

Concluding Thoughts

1. Understanding the Second Derivative in Stock Picking

The article offers a clear explanation of the second derivative concept and its relevance in stock picking. It outlines a practical framework for evaluating stocks and promotes a dynamic approach to investing. However, to strengthen its utility, the article could include a more comprehensive discussion on risk factors and caution against relying too heavily on a single metric. The real-world examples and the focus on the evolving landscape of modern investing add value, making this a useful read for those interested in stock market trends and strategies.

2. Extending the Concept

Additionally, this concept can be applied beyond earnings to encompass the growth rates of various economies or even the rate of inflation, with the appropriate caveats. By exploring these broader applications, the article could offer deeper insights into market dynamics and economic trends.