(Highlights from Expectations Investing by @mjmauboussin. As @fdestin points out, there are a lot of interesting parallels between public and private market investing.)
If you invest without expecting future cash flows, then you might as well collect art or play the slot machines.
The price-earnings multiple does not determine value; rather, it derives from value. Price-earnings analysis is not an analytic shortcut. It is an economic cul-de-sac.
The fundamental law of investing is the uncertainty of the future.
Financial markets are nothing more than arenas where investors who need cash today can obtain it by selling the present value of future cash flows to other investors willing to wait for the cash payoffs from their capital.
The key to successful investing is to estimate the level of expected performance embedded in the current stock price and then to assess the likelihood of a revision in expectations.
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.
If the company’s actual earnings meet or just beat the consensus, both the company and the analysts win: The stock goes up, and everybody wins. The game might not sound so hard, but it requires a lot of cooperation.
Companies have two levers in this game. They can manage expectations, manage earnings, or do both. To manage expectations, they guide 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.
Investors must separate companies that genuinely achieve better-than-expected operating performance from those that skillfully manage expectations and earnings.
The earnings expectations game has two unintended consequences. First, it induces security analysts to fixate on quarterly earnings estimates at the expense of independent analysis. Second, it causes managers to mislead themselves in a misguided attempt to please investors.
The smooth progression of reported earnings can mask fundamental business problems that require urgent managerial attention. Left unattended, these problems inevitably lead to downward revisions of market expectations.
If you know which expectations revisions are most important, then you improve your odds of finding high potential payoffs.
An important feedback mechanism materializes when stock prices affect business fundamentals, which is important to consider in expectations investing—particularly for young, high-technology companies, which depend heavily on a healthy stock price.
George Soros calls this dynamic feedback loop reflexivity. He sums it up this way: “Stock prices are not merely passive reflections; they are active ingredients in the process in which both stock prices and the fortunes of companies whose stocks are traded are determined.”
In cash acquisitions, the acquiring shareholders assume the entire synergy risk, whereas in stock transactions, the selling shareholders share it.
A stock deal sends two potential signals to expectations investors: that management lacks confidence in the acquisition and that the acquiring company’s shares are overvalued
Standard stock-options programs miss the pay-for-performance mark. In a bull market the conventional stock option rewards even mediocre performance. That’s because executives profit from any increase in shareprice even one well below what competitors or the overall market realize
And since bull markets are fueled not only by corporate performance but also by factors beyond management control, such as lower interest rates, executives enjoy huge windfalls simply by being in the right place at the right time.
On the other side of the coin, executives who outperform their peers in down markets lose out. With standard option packages, bear markets overshadow superior performance and cause executives to lose wealth precisely when they provide the best relative results.
Standard stock-option plans do not distinguish between below-average and superior performance. In other words, boards are not setting the right level of required performance for incentive pay.
An indexed-option program best aligns the interests of managers and shareholders. The exercise price that executives pay is tied either to an index of the company’s competitors or to a broader market index. Indexed options reward superior performance in all markets.
