INTERVIEW WITH THE AUTHORS
Studies show that three-quarters of active professional managers consistently under-perform passive funds that track market indexes such as the S&P 500 and Wilshire 5,000. Is active stock management even worth the effort? The problem is not active management itself, but rather the suboptimal strategies that active pros use. Consider the two major investment styles most professionals follow. Growth managers talk about buying stocks that have rapidly growing earnings but trade at reasonable price-earnings multiples. Value managers extol the virtues of buying quality companies at low price-earnings multiples or price to book ratios. In both cases, they believe that the market’s current expectations are incorrect and are likely to be revised upward. But in both cases, they’re chasing the wrong expectations.
Explain what you mean by that. Most investors have a near-messianic focus on short-term earnings and price-earnings multiples. But short-term earnings are not very helpful for gauging expectations because they are a poor proxy for how the market values stocks. Even investors who do embrace an appropriate economic model often miss the mark because they fail to benchmark their expectations against those of the market. Without knowing where expectations are today, it is hard to know where they are likely to go tomorrow.
It seems as if the entire investment community fixates on earnings. Why do you say this measure is largely worthless when it comes to valuing stocks? There are profound differences between short-term earnings and the long-term cash flows that establish a company’s value. That’s why current earnings are such a poor proxy for expectations. More specifically, reported earnings have three major shortcomings that make them a poor proxy for estimating shareholder value. One is that a company can grow earnings without investing at or above the cost of capital—and therefore higher earnings don’t always translate into higher value. Another shortcoming is that earnings exclude the incremental investments in working capital and fixed capital needed to support a company’s growth. And finally, companies are allowed to use a wide range of permissible accounting methods to compute earnings.
So the earnings game is essentially a lose-lose proposition for both investors and managers. Absolutely. Companies can manage expectations by guiding analysts to an earnings number that the company can beat. And to beat expectations easily, companies often downplay their near-term prospects. If a company can’t meet or beat expectations, then it can either manage expectations downward or manage earnings. Flexible accounting conventions often allow managers to avoid unfavorable earnings surprises even amid an unexpected slowdown in business. Not surprisingly, about 20% of the S&P 500 companies beat the consensus earnings by just a penny in a typical quarter and most earnings surprises are positive. Investors must separate companies that genuinely achieve better-than-expected operating performance from those that skillfully manage expectations and earnings.
And expectations investing helps you do that? The expectations investing process allows you to identify the right expectations and effectively anticipate revisions in a company’s prospects.
You say that everything you need to know to “read” expectations is embedded right in the stock price. That seems almost too good to be true. Many investors and managers view stock prices with some misgivings, thinking that prices don’t always accurately convey value. But expectations investors take a different view. For them, stock price is the best and least-exploited information source available. It expresses the collective expectations of investors at any given time, and changes in these expectations determine their investment success. Seen in this light, stock prices are gifts of information, just waiting for you to unwrap and use. If you’ve got a fix on current expectations, then you can figure out where they are likely to go. Of course, correctly reading the price-implied expectations (PIE) in the stock price is only the first step.
Why do you say that most people will be surprised the first time they read PIE? Investors who assume that the market focuses on the short term are amazed to find that it actually takes the long-term view. Corporate managers, who instinctively believe that the market undervalues their stock, are often startled to find that the market’s expectations are much more ambitious than their own.
In a market where investors hold stocks for shorter time periods than ever, it’s hard to believe that the market really does take the “long-view.” Why do you say it does? The reasoning is actually quite simple. Investor holding periods differ from the market’s investment time horizon. To understand the horizon, you must look at stock prices, not investor holding periods. Studies confirm that most companies need over ten years of value-creating cash-flows to justify their stock price. Investors make short-term bets on long-term outcomes.
The expectations investing process represents a radical departure from traditional investing. Can you explain briefly how it works? Expectations investing is a stock selection process that uses the market’s own pricing model—the discounted cash flow model, with an important twist. While traditional discounted cash-flow analysis requires you to forecast cash flows to estimate a stock’s value, expectations investing reverses the process. It starts with the stock price—and determines the cash flow expectations that justify that price. Those expectations, in turn, serve as the benchmark for buy, sell, or hold decisions.
If the discounted cash-flow method is so useful, why do so few professionals use it? To accurately read the expectations wrapped in stock prices, you must think in the market’s terms. The long-term discounted cash flow model best captures the stock market’s pricing mechanism. After all, without the prospect of cash flow, a company’s assets are essentially meaningless and will create zero shareholder value. Yet investors justifiably think forecasting distant cash flows is extraordinarily hazardous. Credible long-term forecasts are difficult to make, and they often serve only to reveal the forecasting investor’s underlying biases. The ideal solution allows you to retain the discounted cash-flow model but frees you from the burden of cash-flow forecasts—which is precisely what expectations investing does.
While correctly “reading” expectations is essential, you say superior returns come only from correctly anticipating revisions in those price-implied expectations. Where should investors look for expectations revisions? The surest way for investors to anticipate expectations revisions is to foresee shifts in a company’s competitive dynamics. These shifts lead to a revised outlook for sales, costs, or investments—what we call the “value triggers”—and initiate the expectations investing process. So the best place to begin is with the value triggers.
You say that competitive strategy analysis is a critical component of expectations investing. But doesn’t competitive strategy focus largely on prescriptions for management—not investor—action? Managers and investors have different performance hurdles. Management tries to achieve returns above the cost of capital. Investors try to anticipate changes in market expectations correctly. But although their objectives are different, investors can use the same strategic tools—albeit in a different way.
What is the “turbo trigger”? All expectations revisions do not carry the same weight—some are inevitably more important than others. When you can focus on what matters, you can more efficiently allocate your time to increase your odds of finding high potential payoffs. The most effective way to accomplish this is to isolate the value trigger likely to have the greatest impact on shareholder value. We call this value trigger the “turbo trigger.” The goal is to increase the odds of finding expectations mismatches—meaningful differences between the current price-implied expectations (PIE) and future revisions. Revisions in sales growth expectations are your most likely source of investment opportunities.
How do you know when you should recalculate PIE? You should do so either when stock prices change significantly or when a company discloses important new information such as merger and acquisition deals, share buyback programs, or meaningful changes in executive incentive compensation. Frequently, both happen at the same time. For example, companies that experience relatively large stock-price responses to earnings surprises are logical candidates for a fresh look at expectations analysis.
Announcements like M&A deals and share buybacks almost always significantly affect the stock price. How can investors know whether such deals truly represent buying or selling opportunities? There are a number of tools investors can use to analyze a deal’s implications both upon announcement and during the postannouncement period. For example, shareholder value at risk (SVAR) shows acquiring shareholders what percentage of their stock price they are betting on the success of a particular acquisition. In terms of buybacks—investors can rely on one “golden rule” for assessing their impact: a company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available. If these two conditions are not met—the buyback is not likely to serve the interests of continuing shareholders.
How do employee stock options affect the expectations investing analysis? Expectations investors must understand incentive compensation to gauge the probability that a company will deliver results different from what the market expects. Companies that embrace compensation programs with superior performance standards send a powerful message to investors about their aspirations and are more likely to be the subject of positive revisions. Negative revisions are more likely for companies that pay for mediocrity through weak, equity-linked compensation programs.
Why are great companies not always great stocks? If a company’s stock price fully anticipates its performance—even if the company is among the best value-creators—then shareholders should expect to earn a normal, market-required rate of return. The only investors who earn superior returns are those who correctly anticipate changes in a company’s competitive position (and the resulting cash flows) that the current stock price does not reflect.
Does the EI process work for all companies—even startups? The three-step EI process is all you need to conduct analysis for most companies. Certain startup companies and established companies undergoing dramatic change and uncertainty require additional analysis—because the cash flows from existing businesses may not justify the stock price. In fact, many investors have questioned the role of the discounted cash-flow model in valuation because the model doesn’t easily explain why some money-losing startups enjoy such large market capitalizations. But we argue that the discounted cash-flow model is as relevant as ever—even for startups—as long as you complement it with a real-options analysis that enables investors to estimate the potential value of uncertain future opportunities for these companies.
Is expectations investing only for professionals, or can individuals who invest on their own use it as well? Anyone who currently manages their own investments—or is considering the possibility—can use expectations investing to improve their odds of achieving superior performance. It provides investors with a complete stock-selection framework or at a minimum, a useful standard by which they can judge the decisions of their portfolio managers. The process requires “doing your homework”—but the beauty of expectations investing is that everything you need to read the market is publicly available—beginning with the most obvious piece of information of all, stock price.