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the case for
Flip on CNBC or read any popular business magazine, and you'll get a familiar story. The growth money manager will explain that she looks for well-managed companies that have rapidly growing earnings but that trade at reasonable price-earnings multiples. The value manager will extol the virtues of buying quality companies at low price-earnings multiples. It happens every day.
But think for a moment about what these investors are really saying. When the growth manager buys a stock, she's betting that the stock market isn't fully capturing the company's growth prospects. The value manager bets that the market is underestimating the company's value. In both cases, they believe that the market's current expectations are incorrect and are likely to be revised upward.
Although investors invariably talk about expectations, they're usually talking about the wrong expectations. The errors fall into two camps. Either investors don't appreciate the structure of expectations, or they do a poor job of benchmarking expectations.
An example of a faulty structure is a near-messianic focus on short-term earnings. As it turns out, short-term earnings are not very helpful for gauging expectations because they are a poor proxy for how the market values stocks. Yet even the 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 likelyto go tomorrow.
The central theme of this book is that the ability to properly read market expectations and anticipate revisions of these expectations is the springboard for superior returns—long-term returns above an appropriate benchmark. Stock prices express the collective expectations of investors, and changes in these expectations determine your investment success.
Seen in this light, stock prices are gifts of information—expectations—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. Like the great hockey player Wayne Gretzky, you can learn to "skate to where the puck is going to be, not where it is." That's expectations investing.
In a sharp break from standard practice, expectations investing is a stock-selection process that uses the market's own pricing model, the discounted cash-flow model, with an important twist: Rather than forecast cash flows, expectations investing starts by reading the expectations implied by a company's stock price. It also reveals how revisions in expectations affect value. Simply stated, expectations investing uses the right tools to assess the right expectations to determine the right investment move.
Why now? We need to integrate price-implied expectations into our investment decisions because the stakes are now higher than ever. Consider the following:
Over 50 million U.S. households—nearly one in two—own mutual funds. Many more individuals participate in the stock market directly through stock ownership and self-directed retirement accounts, or indirectly through pension programs. Around the globe, expectations investing can provide 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.
Investors quickly withdraw money from poorly performing funds. Money managers who use outdated analytical tools risk performing poorly and losing funds. Expectations investing applies across the economic landscape (old and new economy) and across investment styles (growth and value).
Lured by reduced trading costs, better access to information, the disappointing record of active managers, and the fun of managing money, many individual investors are shunning actively managed mutual funds and overseeing their own investments. In fact, individuals managed over 28 million online trading accounts in the United States in 2000, and online trades exceeded one-third of retail trading volume in equities. If you currently manage your investments or are considering the possibility, then expectations investing can improve your odds of achieving superior performance.
More than ever before, major corporate decisions such as merger-and-acquisition (M&A) financing, share buybacks, and employee stock options rely on an intelligent assessment of a company's stock price. These decisions to issue or repurchase shares might signal the market to revise its expectations. Expectations investing provides a way to read management's decisions and anticipate revisions in market expectations.
Expectations investing is a practical application of sound theory that many companies have used over the past couple of decades. The process includes the principles of value creation and competitive strategy analysis. We tailor these tools specifically for investors, creating a new integrated power tool kit for investors.
Succeeding at active investing will only get harder. With an accelerating rate of innovation, greater global interdependence, and vast information flows, uncertainty has notably increased. We believe that expectations investing can translate this heightened uncertainty into opportunity. Further, the U.S. Securities and Exchange Commission Regulation FD ("fair disclosure"), implemented in late 2000, requires companies to disclose material information to all investors simultaneously so that no one gets an informational edge.
ACTIVE MANAGEMENT: CHALLENGE AND OPPORTUNITY
Most active managers (both institutional and individual) generate returns on their investment portfolios lower than those of passive funds that mirror broader market indexes such as the Standard & Poor's 500 Composite (S&P 500). In fact, about three-quarters of active professional managers lag the passive benchmark in an average year, a remarkably constant statistic over time.
Investment performance is a zero-sum game: For every investor who beats the market, another underperforms it. In such a world, we expect the skilled investors to gain and the unskilled to lose. Thus the underperformance of the talented investment pros is baffling. Peter Bernstein, one of the investment world's most astute observers, notes that since 1984, the top quintile of professional fund managers have beat the S&P 500 by a narrower margin than in the past? Meanwhile, the bottom quintile performers have lagged by margins as great or greater than before.
Why do institutional investors underperform passive benchmarks? Does active management really pay? If so, then what approach offers the best chance of superior returns?
Before we address these questions, here's the bottom line: The disappointing performance of professionally managed funds is not an indictment of active management; rather, it reflects the suboptimal strategies that active pros use. Expectations investing offers the best available process to achieve superior returns.
Let's be clear. Active investing is not for the fainthearted. If you want to avoid underperforming the market, and if broad market returns will satisfy you, then you should choose low-cost index funds. Even the most astute and diligent investors struggle to beat the market consistently over time, and expectations investing offers no shortcut to riches. But its approach will help all active investors to meet their potential.
Now let's look at the four primary reasons that institutional investors underperform passive benchmarks—tools, costs, incentives, and style limitations—and see how expectations investing alleviates these constraints.
Standard practice: Most investors use accounting-based tools, like short-term earnings and price-earnings multiples. These inherently flawed measures are becoming even less useful as companies increasingly depend on intangible rather than tangible assets to create value. We expand on the shortcomings of earnings as poor proxies for market expectations in the last section of this chapter.
Expectations investing draws from modern finance theory to pinpoint the market's expectations. It then taps appropriate competitive strategy frameworks to help investors anticipate revisions in expectations.
Standard practice: John Bogle, founder of The Vanguard Group, correlates costs to mutual fund performance, averring that "the surest route to top-quartile performance is bottom-quartile expenses." Annual operating and management investment expenses for equity funds average about 1.5 percent of asset value. In addition, mutual funds pay broker commissions of another 1 percent or so because of high portfolio turnover. With total costs that average about 2.5 percent per year, investors earn only 75 percent of an annual long-term return of 10 percent—excluding the impact of taxes. In contrast, index funds have lower operating expenses and relatively low transaction costs.
Expectations investing establishes demanding standards for buying and selling stocks, resulting in lower stock portfolio turnover, reduced transaction costs, and lower taxes.
Standard practice: Fund shareholders generally compare their returns quarterly to a benchmark, usually the S&P 500. Fund managers often fear that, if they fail to achieve acceptable short-term performance, then they will lose substantial assets, their jobs, and, ultimately, the opportunity to achieve superior long-term returns. Naturally, these managers obsess over short-term relative returns. If they shift from identifying mispriced stocks to minimizing the variance from the benchmark, then they blunt their odds of outperforming index funds.
Expectations investing improves the probability of beating the benchmark over longer periods, provided that the fund manager can buck the system and embrace more effective analytical tools.
Standard practice: 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, sometime a minus—in the value equation."
Further, not only does expectations investing help identify undervalued stocks to buy or hold, it also identifies overvalued stocks to avoid or sell in the investor's target universe.
Does expectations investing offer insightful, dedicated investors a reasonable probability of achieving superior returns? We think so.
In 1976, Jack Treynor distinguished "between ideas whose implications are obvious" and those "that require reflection, judgment, and special expertise for their evaluation." The latter ideas, he argued, are "the only meaningful basis for long-term investing." When companies announce earnings surprises, mergers and acquisitions, a new drug, or a government antitrust action, the long-term valuation implications are rarely obvious. Investors quickly assess the effects, favorable or unfavorable, on current price, and they trade accordingly. Not surprisingly, trading volume typically increases after these announcements. Volatile stock prices and increased trading volume affirm that investors quickly respond to such information. But what distinguishes the winners from the losers is not how quickly they respond, but how well they interpret the information. Different investors interpret the same information differently, and some interpretations are much better than others.
In other words, stock prices quickly reflect revised but perhaps misguided expectations; therefore, to succeed, investors must first skillfully read expectations and then use the best available tools to decide whether and how today's expectations will change. Welcome to expectations investing.
THE EXPECTATIONS INVESTING PROCESS
In the following chapters, we'll walk you carefully through the three-step process of expectations investing.
Step 1: Estimate Price-Implied Expectations
We first "read" the expectations embedded in a stock with a long-term discounted cash-flow model. We thus reverse the common practice, which begins with earnings or cash-flow forecasts to estimate value. The benefits of this reverse engineering include the following:
The long-term discounted cash-flow model is the right tool to read expectations because it mirrors the way the market prices stocks.
Expectations investing solves a dilemma that investors face in a world of heightened uncertainty by allowing them to harness the power of the discounted cash-flow model without forecasting long-term cash flows.
Step 2: Identify Expectations Opportunities
Once we estimate current expectations, we then apply the appropriate strategic and financial tools within a tightly integrated competitive-strategy analysis and finance framework to determine where and when revisions in expectations are likely to occur. Here are the advantages of this approach:
Expectations investing methodology reveals whether the stock price is most sensitive to expectations revisions in the company's sales, operating costs, or investment needs so that investors can focus on the potential revisions that affect price most.
Expectations investing applies the best available competitive-strategy frameworks in the investor's search for potential expectations revisions.
Expectations investing provides the tools to evaluate all public companies—old and new economy, value and growth, developed and emerging market, start-up and established. Expectations investing applies universally.
Step 3: Buy, Sell, or Hold?
Finally, the process defines clear standards for buy and sell decisions. Central features include the following:
Prospective buys or sells must offer a clear-cut "margin of safety." A buy candidate, for example, must trade at a sufficient discount to its expected value.
Key insights from behavioral finance help investors avoid decision-making pitfalls.
The use of demanding buy and sell hurdles reduces transaction costs and income taxes.
THE TWILIGHT OF TRADITIONAL ANALYSIS
In 1938, John Burr Williams published The Theory of Investment Value, a seminal articulation of the usefulness of the discounted cash-flow model to establish value. Williams convincingly addressed investor concerns that the long-term discounted flow model is too intricate, uncertain, and impractical. Notwithstanding the extraordinary advances in financial theory since then, many investors still eschew the model and the full cadre of available financial and strategic tools to implement it.
The full demonstration of expectations investing in the following chapters will reveal its analytical superiority to widely used investment tools. But three pervasive misconceptions in the investment community deserve special mention:
1. The market is short-term.
2. Earnings per share (EPS) dictate value.
3. Price-earnings multiples determine value.
Excerpted from expectations investing by Alfred Rappaport - Michael J. Mauboussin. Copyright © 2001 by Alfred Rappaport and Michael J. Mauboussin. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.