About Expectations Investing
Expectations investing represents a fundamental shift from the way professional money managers and individual investors select stocks today. It recognizes that the key to achieving superior investment results is to begin by estimating the performance expectations embedded in the current stock price and then to correctly anticipate revisions in those expectations.
Conventional wisdom suggests that investors need a host of approaches to value different businesses. Expectations investors recognize that while various businesses have different characteristics, it is important to value all companies using the same economic approach.
The Ten Rules for Expectations Investing
Here are ten expectations investing rules to increase your odds of generating superior returns.
1. Follow the cash. Investor returns come from two sources of cash—dividends and changes in share prices. But a company cannot pay dividends unless it is able to produce positive cash flows. So without the prospect of future cash flows, a company commands no value. Stock prices therefore reflect transactions between investors willing to sell the present value of a company’s expected cash flows and buyers who are betting on higher cash flows in the future. Cash flow is how the market values stocks.
2. Forget earnings and price-earnings multiples. Savvy investors don’t rely on short-term metrics such as earnings and price-earnings multiples because they fail to capture the long-term cash-flow expectations implied by the stock price. Indeed, the most widely used valuation metric in the investment community, the price-earnings multiple, does not determine value but rather is a consequence of value. The price-earnings multiple is not an analytic shortcut. It is an economic cul-de-sac.
3. Read market expectations implied by stock the price. Rather than forecast cash flows, expectations investing starts by reading the collective expectations that a company’s stock price implies. By reversing the conventional process, you not only bypass the difficult job of independently forecasting cash flows but you can also benchmark your own expectations against those of the market. You need to know what the market’s expectations are today before you begin to assess where they are likely to move in the future.
4. Look for potential causes of revisions in market expectations. The only way for an investor to achieve superior returns is to correctly anticipate meaningful differences between current and future expectations. Investors do not earn superior returns on stocks that are priced to fully reflect future performance. Where do you look for revisions? Changes in volume, selling prices, and sales mix trigger revisions in sales growth expectations. Revisions in operating profit margin expectations originate from changes in selling prices, sales mix, economies of scale, and cost efficiencies.
5. Concentrate analysis on the value trigger (sales, costs, or investment) that has the greatest impact on the stock. Identifying the so-called turbo trigger enables investors to simplify their analysis and channel their analytical focus toward the changes with the highest payoffs.
6. Use competitive strategy analysis to help anticipate revisions in expectations. The surest way for investors to anticipate expectations revisions is to foresee shifts in a company’s competitive dynamics. For investors, competitive strategy analysis integrated with financial analysis is an essential tool in the expectations game.
7. Buy stocks that trade at sufficient discounts from expected value. The greater the discount from expected value, the higher the prospective excess return—and hence the more attractive a stock is for purchase. The sooner the stock price converges toward the higher expected value, the greater the excess return. The longer it takes, the lower the excess return.
8. Sell stocks that trade at sufficient premiums over expected value after accounting for taxes and transactions costs. The higher a stock price’s premium to its expected value, the more compelling the selling opportunity. Investors should sell a stock for three reasons: It has reached its expected value, better investment opportunities exist, or the investor revises expectations downward. But even these reasons may not be decisive after incorporating taxes and transactions costs into the analysis.
9. Don’t overlook other significant value determinants that are misplaced, or don’t appear, in the financial statements. For example, companies are increasingly investing in intangible assets that show up as expenses on the income statement. Reclassifying those investments results in higher earnings and a higher rate of investment, but do not change free cash flow. Further, real options, the right but not the obligation to make investments with the potential to create value, are often a meaningful source of value for startups and companies in sectors with rapid change.
10. Heed the signals sent when companies issue or purchase their own stock. An acquiring company’s choice of cash or stock often sends a powerful signal to investors. Under the right circumstances, buybacks provide expectations investors a signal to revise their expectations about a company’s prospects. Correctly reading these signals provides investors with an analytical edge.
Frequently Asked Questions
1. What is Expectations Investing about?
Stock prices are the clearest and most reliable signal of the market's expectations about a company's future performance. The key to successful investing is to estimate the level of expected performance embedded in the current stock price and then to assess the likelihood of a revision in expectations. Investors who properly read the market expectations and anticipate revisions increase their odds of achieving superior investment results. The expectations investing process allows you to identify the right expectations and effectively anticipate revisions in a company’s prospects. Expectations investing comprises the following three-step process:
Estimate Price-Implied Expectations. The expectations investor “reads” the expectations for cash flow embedded in a company's current stock price.
Identify Expectations Opportunities. The expectations investor then assesses those expectations, evaluates the company's competitive position, and considers the likelihood of upward or downward revisions in those expectations.
Buy, Sell, or Hold? The expectations investor makes a buy, sell, or hold decision, making sure that all investments have a clear-cut after-tax "margin of safety" between the stock's price today and the expected price tomorrow.
2. Do I need to be a financial guru to understand and apply the Expectations Investing approach?
If you feel comfortable reading The Wall Street Journal and other leading business and investment periodicals, you should easily grasp the basic concepts presented in the book.
To apply the expectations investing approach to selecting stocks, it helps to be familiar with spreadsheet software such as Microsoft Excel. We have made the spreadsheets presented in the book available for download at this web site, so don't worry; you won't need to create complex spreadsheets yourself!
3. Who should read this book?
This book brings the power of expectations investing to:
Institutional investors, security analysts, and investment advisors. Professional money managers who make investment decisions day-in and day-out, analysts who make stock recommendations, and investment advisors who often make buy and sell decisions for their clients will find that the Expectations Investing approach represents a fundamental shift from the way they evaluate stocks today.
Individual investors. Investment tools presented to the mass market are typically over-simplified so they can be easily understood, but as a consequence lack economic substance. Expectations investing is constructed on top of a solid economic foundation. Implementing expectations investing successfully, however, does require familiarity with the company and its competitive environment, finely honed insight, and dedication.
Corporate managers. We expect Expectations Investing to generate substantial interest in the corporate community. After all, both investors and managers accept stock prices as the "scorecard" for corporate performance. Companies seeking to outperform the Standard & Poor's 500 Index or an index of their peers can use expectations investing to establish the reasonableness of the goal.
Business students. All business schools offer finance courses that cover valuation and courses on competitive strategy. However, there are few courses that bridge valuation and competitive strategy. If you are eager to cross this chasm, Expectations Investing may be the book for you.
4. Can't I read market expectations using earnings per share (EPS) or price-to-earnings (P/E) multiples?
The answer is an emphatic "No"!
Investors who use EPS and P/E multiples may have their hearts in the right place, but their money is on the wrong idea. Granted, the investment community undeniably fixates on EPS. Business publications amply cover quarterly earnings, EPS growth, and price-earnings multiples. This broad dissemination and the frequent market reactions to earnings announcements might lead some to believe that reported earnings strongly influence, if not totally determine stock prices.
Extensive empirical research finds that the market sets the prices of stocks just as it does any other financial asset. Specifically, the studies show two relationships. First, market prices respond to changes in a company’s cash-flow prospects. Second, market prices reflect long-term cash–flow prospects. Static measures such as reported EPS or estimates of next year’s EPS do not capture future performance, and ultimately they let investors down—especially in a global economy marked by spirited competition and disruptive technologies. Without assessing a company’s future cash-flow prospects, investors cannot reasonably conclude that a stock is undervalued or overvalued.
The investment community’s favorite valuation metric is the price-earnings (P/E) multiple. Presumably a stock’s value is the product of EPS and an “appropriate” P/E multiple. But since we know the EPS denominator of the P/E multiple, the only unknown is the appropriate share price, or P. We therefore are left with a useless tautology: To estimate value, we require an estimate of value.
This flawed logic underscores the fundamental point: The price-earnings multiple does not determine value; rather, it derives from value. Price-earnings analysis is not an analytic shortcut. It is an economic cul-de-sac.
5. Does Expectations Investing fall into the "growth" or "value" investing style?
Please don't associate us with either camp!
Most professional money managers classify their investing style as either “growth” or “value.” Growth managers seek companies that rapidly increase sales and profits and generally trade at high-price earnings multiples. Value managers seek stocks that trade at substantial discounts to their expected value and often have low price-earnings multiples. Significantly, fund industry consultants discourage money managers from drifting from their stated style, thus limiting their universe of acceptable stocks.
Expectations investing doesn’t distinguish between growth and value; managers simply pursue maximum long-term returns within a specified investment policy. As Warren Buffett convincingly argues, “Market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component—usually a plus, sometimes a minus—in the value equation.”
6. Does Expectations Investing work for technology stocks?
Unquestionably!
Fundamental economic principles endure, and they are sufficiently robust to capture the dynamics of value creation across all types of companies and business models. The principles of value creation—which are central to the expectations investing process—are the ties that bind all companies.
While fundamental economic tenets apply to all companies, when analyzing technology stocks, we have to take into account their source of competitive advantage.
Most technology companies are essentially knowledge businesses that develop a competitive advantage by having their people develop an initial product that is then reproduced over and over again. This contrasts with physical businesses that leverage tangible assets to create a competitive advantage, and service businesses that rely on people as the main source of advantage and generally deliver their service on a one-to-one basis. We need to incorporate the primary characteristics of knowledge businesses into our analyses of technology companies: The importance of product obsolescence, high scalability, the production of "non-rival" goods such as software that can be used by many people at once, the difficulty of protecting intellectual capital, and the existence of demand-side economies of scale.