- Investors can earn superior returns by reading the price-implied expectations in stock prices and correctly anticipating revisions in those expectations.
- Expectations Investing provides the tools investors need to read expectations and anticipate revisions of those expectations by manipulating the traditional discounted cash flow model, and by bridging the gap between valuation and competitive strategy.
Overview and Thoughts:
Expectations Investing: by Michael Mauboussin and Alfred Rappaport, provides investors with a fantastic framework upon which to make critical investing decisions. The book is a quick read, and the core concepts are relatively straightforward to apply, especially for investors with previous valuation experience. It’s critical today to be able to understand what expectations are embedded in a stock’s current price (what’s priced in?), and this book provides a useful set of tools to estimate these price implied expectations. One question I always ask in my personal investing process is, how does the market view my target?. Expectations Investing also bridges valuation (through the expectations investing framework) with competitive strategy analysis and the evaluation of management decisions.
Part 1: Gathering the Tools
Chapter 1: The Case For Expectations Investing
The authors argue that investors can achieve superior returns by reading the expectations that are currently embedded in the price of a stock, and correctly anticipating revisions in those expectations through competitive strategy analysis, and by reading management signals. Active investors have underperformed for a variety of reasons including but not limited to: costs, incentives, style limitations, and ineffective tools. The expectations framework doesn’t distinguish between styles like growth or value, leads investors to reduce the number of trades they make, and provides them with the correct tools they need to succeed. Here are the three steps in the expectations investing process:
- Estimate price-implied expectations (using a reverse DCF model)
- Identify expectations opportunities (where the company is most sensitive to revisions in expectations, ie. sales, costs, investments)
- Make a buy, hold, or sell decision
Chapter 2: How the Market Values Stocks
Research shows that despite popular belief that the market is short-term, it actually values stocks based on the magnitude, timing, and riskiness of long-term expected cash flows. In order to understand what expectations are implied in a stock price, investors need to understand a few key concepts:
- How to get from a company’s financial statements to free cash flow
- The time value of money and the relationship between discounting and compounding (here’s a cool visual from KeyDifferences.com)
- Traditional DCF analysis
The expectations investing framework uses the future free cash flow performance implied by the stock price as a benchmark for decision making. The author’s argue (and I would agree) that this is a lot more useful than either struggling to forecast these future cash flows, or using poor short-term valuation proxies like P/E ratio’s.
Chapter 3: The Expectations Infrastructure
In order to correctly anticipate revisions in expectations, investors need to understand the framework of what drives shareholder value. The author’s detail the relationship between value drivers, (influenced by) value factors, (influenced by) and value triggers.
The three main triggers are sales, costs efficiencies, and investment efficiencies, and you can determine the influence that changes in each of these areas will have on the price of a stock by tinkering with them in your model. Investors should focus on the area with the largest expectations revision potential, which is usually sales.
Chapter 4: Analyzing Competitive Strategy
The way to anticipate changes in expectations is to foresee shifts in a company’s competitive dynamics. The author’s recommend a few standard frameworks for analyzing a company’s competitive strategy including:
- Michael Porter’s Five forces framework: for industry analysis
- Michael Porters value chain analysis: to understand the company’s choice of business activities
- Disruptive technology analysis: to analyze if the company will be helped or hurt by innovation
- Information rules: to evaluate information based business
It’s also important for investors to analyze historical competitive strategy and financial performance, and to compare them with the future performance implied by the price.
Part 2: Implementing the Process
Chapter 5: How to Estimate Price-Implied Expectations
I’ll give a brief overview of the chapter, but this is likely one you’ll need to read for yourself, as this is where the authors dive into the nuts and bolts. I’d also recommend hopping over to the, where you’ll find the necessary resources (including spreadsheets!) to implement the process. These are essentially the key steps though:
- Estimate price implied future free cash flows using consensus estimates and back into the current stock price through a reverse DCF model
- Evaluate the industry, the competitive environment, and the company’s historical performance to determine whether or not the price implied expectations are reasonable.
- Make buy, hold, or sell decisions
Chapter 6: Identifying Expectations Opportunities
The goal of investors is to take advantage of expectations mismatches. There are four building blocks that will help investors find these opportunities:
- Price-implied expectations
- Historical Results
- Competitive strategy analysis
- The expectations infrastructure
Using these four building blocks, there are three steps to finding expectations opportunities:
- Estimate bull and bear cases for the sales trigger
- Identify the turbo trigger (the variable with the highest impact on shareholder value between sales, cost efficiencies, and investment efficiencies)
- Estimate bull and bear values for the turbo trigger
Investors should also strive to mitigate the effects of behavioral traps such as overconfidence and anchoring. Always allow for a margin of safety, don’t overestimate your abilities, challenge your estimates, and seek feedback from others.
Chapter 7: Buy, Sell, or Hold?
When to Buy?
- Convert anticipated expectations revisions into expected values (basically scenario analysis); buy when your expected value trades at a significant discount to the current share price
- Account for possible behavioral biases including recency bias, confirmation bias and loss aversion; always allow for a wide margin of safety to help mitigate these traps
- If the range of expected shareholder values (between bull, bear, and consensus case) is high, a stock can be attractive even when the consensus is the most likely outcome.
- If the range of expected values is narrow, you must have a contrarian view
When to Sell?
There are three main reasons to sell:
- The stock reaches your updated expected value (your new expected value is lower than the stock price)
- You find better opportunities
- You revised your expectations downward
Finally, make sure to account for taxes!
Chapter 8: Beyond Discounted Cash Flow
This chapter details how investors can value real options for future company projects, essentially using the Black-Scholes option pricing formula. This is useful for valuing companies with very uncertain outcomes like start-ups, which traditional DCF analysis tends to undervalue. Remember to always consider the potential moves of competitors when valuing the real options of a company.
Chapter 9: Across the Economic Landscape
The fundamental principles of economics have not changed, and we do not need new rules for value. There are three main categories of businesses, physical, knowledge, and service, and they can each be understood through the lens of of the value factors in the expectations infrastructure (volume, price, mix, operating leverage, economies of scale, cost efficiencies, investment efficiencies). Understanding the characteristics of these categories can help investors anticipate expectations revisions.
Part 3: Reading Corporate Signals
Chapter 10: M&A
Traditional EPS accretion/dilution analysis of mergers and acquisitions is useless. Investors should instead focus on shareholder value added and Shareholder Value at Risk, or SVAR. For the acquiring company this is equal to the present value of synergies less the premium paid. SVAR shows acquiring shareholders what percentage of their stock price they are betting on the acquisition. Investors can also gauge management’s confidence in the deals by analyzing the consideration; typically all cash deals imply a higher confidence level because the acquiring shareholders take on all the synergy risk. The choice between a cash and stock deal can also signal to investors if the management of the acquiring company thinks their stock is over or undervalued.
Chapter 11: Share Buybacks
The author’s present their golden rule for buybacks in this chapter:
“A company should repurchase its shares only when its stock is trading below its expected value and when no better investing opportunities are available”
Share buybacks can tell attentive investors a lot about a management team’s view of a company. There are different reasons for share buybacks, some that send positive signals, and some that send negative ones. If management is buying back stock because they believe it is undervalued this is likely positive, conversely, if management is buying back stock because they ran out of investing opportunities, or they’re trying to hit EPS targets, this is probably a negative sign.
Chapter 12: Incentive Compensation
“Show me the incentive and I will show you the outcome”
– Charlie Munger
This final chapter dives deep into employee compensation (for upper management, operating executives, and middle management), and shows how paying close attention to incentives of management can help investors anticipate expectations revisions. The two questions investors should ask about employee incentives are:
- Is this the appropriate measure? (is the standard of measurement linked to long-term shareholder value creation)
- Is this the appropriate threshold level?
The trade-off to keep in mind when evaluating a management team’s measure and threshold level of compensation is that there is a trade-off between the strength of an incentive and losing an executive.