Expectations Investing – Michael Mauboussin And Alfred Rappaport: Review And Summary

  • 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:

  1. Estimate price-implied expectations (using a reverse DCF model)
  2. Identify expectations opportunities (where the company is most sensitive to revisions in expectations, ie. sales, costs, investments)
  3. 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:

  1. Estimate price implied future free cash flows using consensus estimates and back into the current stock price through a reverse DCF model
  2. Evaluate the industry, the competitive environment, and the company’s historical performance to determine whether or not the price implied expectations are reasonable.
  3. 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:

Data:

  • Price-implied expectations
  • Historical Results

Analytical Tools:

  • Competitive strategy analysis
  • The expectations infrastructure

Using these four building blocks, there are three steps to finding expectations opportunities:

  1. Estimate bull and bear cases for the sales trigger
  2. Identify the turbo trigger (the variable with the highest impact on shareholder value between sales, cost efficiencies, and investment efficiencies)
  3. 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:

  1. The stock reaches your updated expected value (your new expected value is lower than the stock price)
  2. You find better opportunities
  3. 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:

  1. Is this the appropriate measure? (is the standard of measurement linked to long-term shareholder value creation)
  2. 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.

If you enjoyed this review and summary of Expectations Investing, check out my other book reviews

 

Dead Companies Walking – Scott Fearon: Review And Summary

  • The six most common business mistakes that lead to failure
  • Tips for investors on both the long and the short side
  • Common behavioral biases facing investors and how to overcome them

General Thoughts

Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity in Unexpected Places by Scott Fearon with Jesse Powell, is an engaging and easy read detailing experienced asset manager Scott Fearon’s investments in failing businesses (both on the short and the long side). The book isn’t set up as a how-to guide, but there are quite a few valuable nuggets of wisdom littered throughout. I did my best to distill what stood out the most to me in my summary below, but I would highly recommend checking the book out yourself!

Introduction

Hedge fund manager Scott Fearon starts the book by detailing his first encounter with a large market crash, the oil boom and bust in East Texas. He goes on to describe how this event, along with subsequent manias and crashes including the tech bubble in the late 90s and the housing bubble in the mid-2000s, shaped his views of markets and thinkings on failure. He describes failure as a “natural-even crucial element” of a healthy economy, and that people who are willing to accept this fact can “make a hell of a lot of money”. Through his long career in the asset management business, and experience interviewing managers to invest both on the long and short side, Fearon detailed the six most common business mistakes that lead to failure.

  1. They learned from only the recent past
  2. They relied too heavily on a formula for success
  3. They misread or alienated their customers
  4. They fell victim to a mania
  5. They failed to adapt to tectonic shifts in their industries.
  6. They were physically or emotionally removed from their companies’ operations.

Importantly, Fearon notes that the vast majority of executives of failing companies are neither stupid nor fraudsters, and that most are in fact intelligent and hard-working. These six common mistakes are traps that anyone can fall into, and that’s why it’s so important to understand and recognize them.

Chapter 1: Historical Myopia

“You can be richer, smarter, and more successful than anyone else. But if you’re not brutally honest with yourself about your own potential for failure, you’re going to have a problem—and you’re going to lose money, maybe a lot of money.”

Most people have a behavioral tendency to overweight the importance of recent history in their analyses (whether they be management teams or investors/analysts). Businesses move in both small and large cycles, and the latter are often ignored. Fearon’s mentor believed it was critical for investors to speak to and evaluate management teams, but to do so with a healthy dose of skepticism as they are often overly-optimistic, and prone to fall into these same behavioral traps. Falling prey to historical myopia is one of the greatest risks for value investors who focus on recent performance and financials (current multiples) to decide something is cheap, while simultaneously ignoring larger cycles, trends, and secular changes; investments of this type are often called value traps. This lead Fearon to the growth at a reasonable price ((GARP)) model, and to his focus on businesses with increasing cash flows and intrinsic values.

Chapter 2: The Fallacy of Formulas

“Oppenheimer & Co. put out in which it rated SPMD an “outperform” stock, boasting that the company “trades at 5x/6x our 2010/2011 EBITDA estimates.” There it is. The culprit, the root of Supermedia’s irrationally exuberant rally: the EBITDA formula.”

Markets are dynamic and ever-changing, and no one formula is going to lead investors to success. Fearon described how his personal favorite GARP formula led him to miss out on early investment opportunities in both Costco (COST) and Starbucks (SBUX), because he thought the multiples were too high. This is not to say that investment formulas and standards are not useful, they are most of the time, but all rules have exceptions. One such formula that Fearon singles out, is the valuation technique commonly used by analysts of slapping a comparable EBITDA multiple on the next years projected EBITDA. He also details a couple of his personal strategies for entering short positions and describes what investors should be wary of, stating that he will generally hold off until the stock has lost at least half of the value of its 52 week high (to avoid the wrath of momentum investors and the potential for a short-squeeze), and likes his positions to have, “enough downward velocity that there’s little chance it will stop before it hits bottom”.

Chapter 3: A Minor Oversight, Your Customers

“It’s okay to be wrong; it’s not okay to stay wrong.”

Probably the most important take-away from this book is the too often overlooked reality that customers are the lifeblood of any business. Too often, analysts and management teams misread their customers and mix up what they would personally want, with what the what the customers want. It’s critical to understand what people in the real world want, and how they actually behave. Fearon details a personal experience with this and writes of his own failure to account for his customers when he started a Cajun restaurant in Marin County, California.

Chapter 4: Madness and Manias

“Men, it has been well said, think in herds; they go mad in herds, while they recover their senses slowly, one by one.

— Charles MacKay, Extraordinary Popular Delusions and the Madness of Crowds”

Though we often think of the largest and most recent examples when we think of manias and bubbles, the truth is they are happening all the time, just on a smaller scale. Fearon argues that at their core, manias are about storytelling, and they happen when people convince themselves that something must be true no matter what. One common mistake that investors make is averaging down on positions that move against them. While it is true that sometimes this could just mean an undervalued stock is getting cheaper, it could also very well mean that your oginial analysis was wrong. The fact is that everyone is going to be wrong a lot, and it’s important to not keep chasing losing ideas and let them blow up your whole portfolio. As the saying goes,“Double-up, triple-up, belly-up.” Fearon believes that the best money managers are the best quitters. This advice rings true with what we’ve seen happen recently with famous money managers who became publicly attached to losing positions and poured massive amounts of money into them (ex. Ackman and Herbalife). Fearon also wrote about his time trading options in college, and detailed the four lessons he learned.

  1. Stockbrokers are useless and conventional wisdom/tips are usually wrong (groupthink)
  2. Trading on trends is a fool’s game
  3. Stocks tend to go up gradually but often go down rapidly
  4. Effective money managers do not go with the flow. “They are loners, by and large. They’re not joiners; they’re skeptics, cynics even.”

In Fearon’s mind, the top personality trait of a successful investor is intellectual curiosity. It’s important to be someone who can’t accept conventional wisdom, reads vociferously, craves new ideas, and isn’t afraid to try them out and fail.

Chapter 5: Deck Chairs on a Sinking Ship

Buggy Whip Syndrome: “they failed to recognize that their industry had fundamentally and permanently changed”

Failing businesses often hope small changes will guide them back towards prosperity, when in reality, a successful change would take nothing less than a complete overhaul of the dying core business. Fearon gives the perfect example of this scenario with the story of Blockbuster. Blockbuster had the opportunity to invest in its online business to compete with Netflix (NFLX), but that would have meant making the painful decision to close its stores and lay off thousands of people. Instead, the company went with easier, smaller changes to its stores, including selling more candy and other movie theatre snacks. We all know how that story ended. The same is often true of entire industries,

“Warren Buffett once said, “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”

Chapter 6: The Buck Stops…There

“The Bible says, “Pride goeth before destruction.” I think they should put that quote in business textbooks, because pride often goeth before bankruptcy, too.”

This chapter is on various red flags to look out, and is probably best summarized with a few concise pieces of advice:

  • Watch out for excessive leverage, especially in cyclical commodity-based businesses.
  • Beware of lavish execs/elitism in upper management, (Fearon gives the great example of Ron Johnson at JCP).
  • Watch out for companies that continuously make excuses and blame their poor performance on external factors or scapegoats, and check how their competitors are doing.

“Whenever I see the “sluggish economy” chestnut in a disappointing earnings report, I make sure to check how the company’s competitors are faring.”

This next quote also rings especially true as of right now, (TSLA) anyone?

“investors and corporate executives alike love to blame that old bogeyman, short-sellers. It’s a convenient way to justify unwise investments and deflect attention from the real reason companies lose value: the poor decisions of the people running them”

  • And lastly, be wary of growth driven primarily by acquisitions. This growth can often serve the interests of management teams more than the interests of shareholders.

Chapter 7: Short to Long

“failure might be more common than people like to admit, but it is not inevitable—even when things look irreversibly dire.”

Despite his success on the short side, Fearon has made the majority of his money on the long side. He presents some compelling reasons why short-selling isn’t as attractive as it used to be, along with a few tips for investing on the long side, which he argues will always be the best way to earn outsized returns.

  1. The investable universe has gotten smaller
  2. SOX reduced a lot of aggressive accounting
  3. Low interest rates have led brokers to charge short-sellers expensive daily borrowing rates
  4. Investors have gotten better at short-selling and the competition for good shorts is high.

On the long side:

  • Managements matter, don’t go “Excel crazy.” One of his earlier mentors would tell him,

“Get up and go outside, Scott…you’ll learn more in five minutes of talking to someone at a company than you will in a week crunching its numbers.”

  • Don’t average down, and don’t sell your winners too soon.

“Quit early and quit often”

  • Stay humble; recognize your own failures and learn from them.

“Peter Lynch, probably the most successful money manager in history, said the best you can hope for is to be right six times out of ten when it comes to picking winning companies”

  • And finally, Fearon recommends that investors look in less efficient areas of the market (small/microcaps), and keep from growing too large.

Chapter 8: Losing Money Without Even Trying, Welcome to Wall Street

“But for all of his talent, he also had a critical weakness: he thought he had friends on Wall Street.”

In this final chapter, Fearon tells a few stories about the many unethical actions he’s seen in his career in the investment management business. One story in particular stood out to me. It was about a time he called a broker to let him know of some serious downside risks that he had discovered in one of the stocks he (the broker) was promoting. Fearon was met with outright hostility by the broker, who warned him not to mess with his commissions, and then threatened to call his boss. Fearon describes that managers also tend to just be focused on what’s going to make them the most money, fees. This is why many are focused on growing AUM rather than on earning excess returns with the capital they already have under their disposal. This reminds me of the Charlie Munger quote, “Show me the incentive and I will show you the outcome.” As Fearon puts it, “Asset size is the enemy of returns.”

He next details why he thinks most people in the financial world are terrible investors.

  1. They’ve spent their whole lives going along to get along – prone to groupthink, manias, and bubbles
  2. They are hypercompetitive – don’t admit failure and adjust strategies, average down, and cling to bad ideas
  3. They worship rich and powerful people – defer to authority instead of questioning popular assumptions

Conclusion

“If we want to return to a growing and dynamic economy, we have to learn to embrace failure again.”

It’s important to recognize that failure is a normal and natural part of business and the financial system. The markets collective fear of failure has led to extreme policies like the tax payer bailout of the financial system in 2009, along with the simultaneous push to near 0% interest rates by the federal reserve.