What lies beneath: Anatomy of a stock sell-off

Introduction

Over the past two years, we have seen several instances where our holdings experienced sharp price movements that appeared disproportionate to the underlying news. These moments often raise immediate questions about company fundamentals. Yet, in many cases, short-term price reactions reveal less about fundamentals than one might assume.

To explore why markets are not always driven by fundamentals, this newsletter takes the form of a dialogue between a fundamental investor, a discretionary hedge fund manager, an algorithmic trader, and a high-frequency market maker, each operating on a different time horizon, and therefore pursuing different objectives. Their combined behaviour helps explain why short-term price action can diverge sharply from long-term value.

Our case study focuses on Compounding Inc., a large-cap company with a long record of steady, predictable growth. The firm reported a mixed set of fourth-quarter results: revenue and earnings came in slightly below expectations, and guidance for the coming year — 6–8 per cent organic growth — disappointed analysts who had been anticipating around 10 per cent. The reaction was all the more striking given Compounder’s consistent history of meeting its targets and compounding earnings at a low double-digit rate over many years. Management attributed the slowdown to temporary caution among customers and corporate clients in a more uncertain macroeconomic environment. While the company emphasised that its long-term strategy and 10 per cent medium-term organic growth target remain intact, the share price reaction was far more severe than the numbers alone would suggest. Through the lens of our four market participants, we explore how an apparently modest miss can trigger large, self-reinforcing moves, and how money flows, not fundamentals, can dominate in the short run.

Fundamental Long-Term Analyst:

I’ve been following this company for over a decade, the -20 per cent share price drop looks exaggerated. The earnings miss was real, and the guidance cut is concerning, but if you run the numbers through a discounted cash flow (DCF) model, the effect on intrinsic value is maybe -5 per cent at most. Unless you assume that management’s lowered outlook is the start of a structural decline in market share, the long-term cash-generation story remains intact. Markets often extrapolate short-term weakness into a permanent shift, and this looks like one of those moments.

Hedge Fund Manager (Algorithmic Fund):

That assumes investors price stocks by weighing long-term cash flows — but most flows are anything but patient. We don’t interpret the news — we process it. When a company cuts guidance, the revisions feed directly into our models. Its exposure to the “quality” factor weakens, its volatility score spikes, and its momentum rank turns negative. Those signals trigger automatic risk reduction across portfolios. This isn’t a judgment call — it’s a model response. Also, remember that the scale of quant capital is pretty big, those rotations alone can push prices well below what fundamentals imply.

Fundamental Long-Term Analyst:

But should we really attribute another -10-15 per cent fall purely to factor flows? That suggests markets are completely detached from fundamentals. At some point, rational investors step in, no? If the long-term compounding story remains valid, I’d expect a rebalancing where buyers are attracted by the gap between price and fair value.

Hedge Fund Manager (Algorithmic Fund):

In theory, yes, but in practice, fundamental investors are a small slice of daily flows and long-term investors are even smaller. The problem is time horizon mismatch. If quant strategies are offloading billions over hours and days, but the fundamental buyers evaluate positions over weeks, the equilibrium clears at much lower levels.

ETF rebalancing adds another layer of pressure. When a stock’s price falls sharply, its weight in the index automatically shrinks. To stay aligned with the benchmark, ETFs must sell shares to bring their holdings back in line with the new, lower weight. That means the worse a stock performs, the more these passive vehicles sell — creating a feedback loop that reinforces the downward move, even if nothing fundamental has changed. The price at that moment is not intrinsic value, but rather the point where systematic sellers finally exhaust themselves and longer-horizon investors feel confident stepping in.

Hedge Fund Manager (Long-Short Discretionary Fund):

Both of you are right about mechanics and valuation, but you’re missing the issue of credibility. Compounding Inc. has long been viewed as one of the most reliable compounders in its sector — a business that delivers +10 per cent organic growth each year with the regularity of a clock. When a company like that lowers guidance, the market doesn’t just see softer numbers – it sees a crack in that story.  Investors start wondering if management really has visibility on demand, or if the growth engine is losing momentum. A company once seen as predictable suddenly looks uncertain —and the “trust premium” in its valuation disappears. That shift in perception alone can justify a much sharper short-term reaction than any DCF model would suggest.

Fundamental Long-Term Analyst:

I take your point about credibility, but markets have short memories. If management stabilizes performance over the next quarter or two, investors will recalibrate. The narrative shouldn’t permanently reprice the equity if the fundamentals remain solid.

Hedge Fund Manager (Long-Short Discretionary Fund):

Perhaps, but in the near term, positioning matters. Many long-only funds crowd into high-quality large caps like Compounding inc. for their perceived safety. Hedge funds join that trade too — going long ahead of results when they expect the company to beat earnings and deliver another steady quarter. It’s a short-term trade on sentiment and positioning rather than intrinsic value. When the story wobbles long/short managers move first, cutting exposure or flipping the position within hours or days. Their goal isn’t to hold through the cycle but to avoid being caught on the wrong side of momentum. That synchronized de-risking compounds the sell-off, turning a modest earnings miss into a sharp, momentum-driven correction.

High-Frequency Trader:

What you’re both describing unfolds over days or weeks. For us, that’s an eternity. We operate on sub-second horizons, seeking to profit from tiny inefficiencies in price formation rather than from any view on fundamentals. Our objective isn’t to forecast earnings or evaluate management credibility — it’s to provide liquidity and capture fractions of a cent per trade across thousands of transactions a day.

What happened today was much faster. We saw bid-ask spreads widen almost instantly. Liquidity evaporated as market makers – including us – pulled bids and hedged options exposures. Once volatility spikes, our systems automatically cut inventory to stay within tight risk limits, accelerating the decline. At that moment, the price wasn’t about valuation — it was about absorbing the order imbalance. That liquidity vacuum turned a -5 per cent move into a -20 per cent spiral within minutes.

Fundamental Long-Term Analyst:

So, you’re saying that the fall is more mechanical than informational. If so, then it should revert, no?

High-Frequency Trader:

Not necessarily. Microstructure overshoots don’t automatically bounce back. If the decline pushes the stock into new technical ranges, it triggers additional algorithmic strategies, like momentum funds, volatility traders and risk parity reallocations. That can cement the lower price as the new reference point, even if it began as an overshoot.

Hedge Fund Manager (Algorithmic Fund):

Exactly. Once the stock is reclassified across multiple dimensions—momentum, volatility, quality—those systematic signals don’t flip back just because the fundamental narrative looks overdone. It can take several quarters of stable beats and rising guidance for those signals to repair. In the meantime, the stock trades with a discount imposed by the quant ecosystem.

Hedge Fund Manager (Long-Short Discretionary Fund):

Maybe so. But from where I sit, markets trade on stories as much as numbers. A clean narrative is worth a premium — and once it’s broken, it takes quarters, not days, to fix. Once guidance is cut, the market starts watching for the next shoe to drop. Profit warnings rarely travel alone. Even if the fundamentals stabilise, investors remember the stumble. Once that trust premium evaporates, it doesn’t just bounce back — prices settle lower until confidence is rebuilt.

Fundamental Long-Term Analyst:

I accept that in the short run, flows, narratives, and liquidity shape outcomes. But that’s precisely what creates opportunity. A -20 per cent drop driven by mechanical selling, not a permanent change in fundamentals, is the sort of dislocation long-term investors wait for. If you’ve done the research and believe in the compounding engine, this is when conviction matters most. Over three to five years, cash flows will dominate again. The only scarce asset in moments like this is conviction, and that belongs to those willing to look past the noise.

High-Frequency Trader:

That’s probably true. Fundamentals often have the last word — but they take their time to speak up. The question is who’s still listening when they do. In my corner of the market, three to five years might as well be a different era. By then, my code will be obsolete, and I’ll be sipping cocktails on the beach, watching a new generation of traders react to the same old story.

Conclusion

Episodes like this remind us that price discovery and value discovery are not the same thing. Short-term volatility often reflects the structure of the market rather than the substance of the company. Each market participant reacts differently—not because they disagree on fundamentals, but because they operate under entirely different mandates, time horizons, and incentive systems.

In our example, the fundamental investor focuses on long-term intrinsic value, the discretionary manager trades the narrative and earnings momentum, the algorithmic fund responds mechanically to data, and the high-frequency trader reacts to milliseconds of flow. And that represents only part of the ecosystem — retail traders, ETFs, and macro funds add further layers of complexity and feedback.

The case of Compounding Inc. shows how a -5 per cent adjustment in fundamentals can translate into a -20 per cent collapse when algorithms, liquidity constraints, and positioning interact. For long-term Quality Growth investors, the key is not to predict these dislocations but to understand their mechanics—and to remain disciplined when they occur. Most of the time, such moves say more about how capital and incentives collide in the short term than about any lasting change in business value.