ABOUT EXPECTATIONS INVESTING

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.

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 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 don’t appear in the financial statements. For example, ignoring employee stock options can lead to a significant underestimation of costs and liabilities. Past grants are a genuine economic liability and future option grants are an indisputable cost of doing business. In contrast, real options, the right but not the obligation to make potentially value-creating investments, are often a meaningful source of value for start-ups and companies in fast-changing sectors.

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.

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