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5 Responses to “Expectations Investing: Reading Stock Prices for Better Returns”

1. Nick Ripostella says:

   June 10, 2010 at 5:11 pm

   This book should be required reading for every active investor today. Too often pundits throw out terms like market leader,growth stock, value stock, recession resistant as reasons to buy a stock, and try to predict where the “market” will go for the next six months. Expectations Investing will help you learn to throw away these lazy investor labels and instead provides a framework for evaluating a particular stock in terms of what the current price is saying about how good or bad the future for the company may be and whether it merits your purchase or sale. You will learn that every stock, market leader or not, has a whole set of assumptions embedded in the current valuation- this book will help you learn to think in these terms and evaluate whether those assumptions embedded in the current price are reasonable. The book debunks some popular myths and provides highly illustrative examples that make some technical issues easy to understand. For the pro, coverage of executive compensation, option analysis as well as key chapters on competitive strategy and other operating issues will definitely stimulate the thought process. At the same time the basics of valuation are covered in an easy to read fashion. Finally, the Notes section itself can lead the intellectually curious to a “pot of gold” of information. Turn off the business TV and put your popular financial magazine on the coffee table and read this book instead !
   Rating: 5 / 5
2. Elizabeth Spiers says:

   June 10, 2010 at 3:13 pm

   Rappaport and Mauboussin expertly utilize the often misapplied DCF model to identify and analyze market assumptions that determine stock price. In the age of irrational exuberance, the disparity between market value and intrinsic value is often dismissed as the product of a fickle and unpredictable market. Rappaport and Mauboussin, however, remind us that the market is indeed rational in the long term and changes in stock prices are the result of changes in market expectations. The “Expections Investing” methodology helps investors to understand current expectations and anticipate expectation revisions.

   A financial model is only as good the assumptions behind it. The forecasting process invariably reflects the assuptions of the analyst, which tend to be biased by experience and preconception. “Expections Investing” teaches investors to avoid predilection by reverse engineering DCF models from stock prices, allowing them generate figures that reflect market assumptions rather than their own.

   This value-agnostic process produces greater accuracy in many areas that are frequently overlooked. Rappaport and Mauboussin expose the fallacious nature of models based on forecast periods and discount rates that are assigned in an arbitrary fashion. They correctly state that the finger-in-the-wind approach is not sufficient and can greatly distort the final analysis. “Expectations Investing” also highlights topics (i.e., valuation of employee stock options) of which the significance is often underestimated or ignored in traditional valuation analysis.
   Rating: 5 / 5
3. Satya says:

   June 10, 2010 at 1:47 pm

   “Expectations Investing” presents a powerful idea – From a company’s stock price, derive what the market is expecting of the company’s performance. Then, based on your own expectations, decide if the stock is a worthy investment. One might say, isn’t this what investors do all the time, using multiples like P/E? The book talks about the drawback of such multiples. Then it presents a clear and elegant framework to identify the true drivers of a company’s value. You need to perform a strategic analysis of the company and industry to identify the plausible ranges for these value drivers. You can see where your assumptions stand with respect to market expectations (which you reverse engineer from the stock price and consensus estimates for future performance). You assign probabilities to various outcomes based on your convictions, and decide to buy/sell.

   In 195 pages, this book presents a bunch of insights. The presentation on valuing a company’s stock options, as well as discussion of value capture by buyers/sellers in mergers and acquisitions, are the clearest I’ve seen in any finance/valuation book. The discussions on incentive compensation, as well as management signals in share buybacks, are also quite impressive and accessible to the general reader. The accompanying website for this book is highly complementary, and presents excel models for all topics covered. I adapted them for a sample company and was quite delighted! While DCF valuations are not every investor’s cup of tea, this book goes the farthest in trying to make its DCF-based framework manageable by the average person.

   Now for the caveats which I hope are minor – A couple of earlier chapters pack the gist of several MBA classes (corporate finance, strategy, behavioral finance). If you are not an MBA, the profoundness of the ideas might be lost on you in the rat-a-tat-a-tat rapid fire presentation. Also, you will appreciate this book better if you have some conceptual understanding of corporate finance, such as cost of capital issues.
   Rating: 5 / 5
4. Befragt says:

   June 10, 2010 at 11:30 am

   An interesting read for the serious investor. The central tenet of the book might be stated as “investors do not earn superior rates of return on stocks that are priced fully to reflect future performance – even for the best value-creating companies – which is why great companies are not great stocks.” This book posits that investors can read market expectations contained in a stock’s price and anticipate revisions in those expectations to achieve superior returns. It book provides a detailed, step-by-step way to accomplish this process.

   “Expectations Investing” is divided into three parts. Part I details how to determine the expectations for a stock based upon its current market price. Interestingly, rather than determine a “fair price” based upon a company’s free cash flow, the book turns this process upside down, using a company’s stock price to determine the market’s expectations for free cash flow going forward. Next, the book helps identify “expectations opportunities” – places where revisions in the stock market’s expectations are likely to take place. By focusing on key areas where expectations opportunities may take place (so-called “turbo triggers”), the skilled investor can modify their discounted cash flow projections to determine the appropriate price. This section further provides a framework to determine when to apply buy, sell, and hold decisions. Lastly, Part III of the book explains how certain, specific corporate events (mergers, share buybacks, and incentive compensation) may signal that expectations revisions are in order.

   Within the book itself, I found the chapter on “Analyzing Competitive Strategy” to be an outstanding, investor-focused distillation of many of the points contained in Porter’s “Competitive Strategy.” Moreover, the chapters on specific corporate events were interesting insofar as they explain, in greater detail than I had read before, the quantitative analysis that underlies decisions related to mergers, share buybacks, and incentive compensation.

   Potential readers should be aware that the authors of this book, like many stock analysts, adhere to the so-called “Capital Asset Pricing Model” school of thought (that the value of a security equals the rate on a risk-free security plus a premium, beta, which is determined based upon the volatility of the security in question). This model is just one of many that investors may use. Moreover, although stock analysts may have access to customers, creditors, competitors, and company insiders, many individual investors will lack those contacts, and thus face some difficulty in determining possible expectations revisions. Even if an investor had access to such information, the developing field of behavioral finance (see Belsky and Gilovich, “Why Smart People Make Big Money Mistakes” as but one example) would caution that investors seeking to implement the methods set forth in this book need to be careful of confirmation bias (tending to view information in a way that supports their pre-determined preferences) and information cascade (too much information), among others.

   Lastly, readers should be aware that modeling out the process described by this book requires some math, and the ability to create spreadsheets of middling-level complexity. This is not a “buy low P/E” book – readers will have to do their homework to use these methods. Anyone who isn’t looking to put several hours into investigating each stock they are interested in should look elsewhere.

   In all, this is a well-written book that makes a very complicated process relatively simple. It is not designed for the casual reader, and implementing the expectations investing process certainly takes considerable work. However, the book provides valuable insights into how analysts function and how stocks are priced by public markets.

   However, if forced to pick a well-written, fairly sophisticated book on investing, I’d recommend a few other books ahead of this one, including “Security Analysis” by Benjamin Graham and either of Martin Whitman’s books (“The Aggressive Conservative Investor” or “Value Investing”).
   Rating: 4 / 5
5. Anonymous says:

   June 10, 2010 at 9:42 am

   When I started working on Wall Street ten years ago, I thought my colleagues would be fantastic stockpickers who used intelligence, foresight, and brilliant paradigms to pick great stocks.

   The last decade has taught me that most Wall Street analysts are very intelligent. However, I must report that as a whole, they have *no idea* what they’re doing. I’m not sure how it happened, but most investors have come to believe in a hodge-podge of rules-of-thumb that “everyone knows” but nobody can explain. Arbitarily, “growth” investors tell us to “Buy stocks that grow their earnings faster than their P/E multiples!” Just as randomly, “value” investors tell us to “Only buy stocks with low P/E’s with lots of book value!” If you try to integrate all these rules of thumbs into a single mental model, you have to make so many exceptions to every rule that your mind feels like Swiss cheese.

   In contrast, this book offers a clean, intelligent FRAMEWORK for thinking about investing in anything that produces a stream of future cash flows (including stocks, of course). It’s the investing Bible I wish I had when I started my career. It would have shaved years from my investing education, and saved me from numerous migraines.

   The book starts with the same first principles you read in your Corporate Finance textbook, makes relevant the practical arcana you learned in Accounting class, and incorporates Porter’s and other strategy frameworks into valuation. The book presents a CLEAN and FLEXIBLE way of thinking about stocks. For example, you can apply their approach to Dell from its IPO to today — and get useful data that would help with a Buy/Sell decision. Traditional value investing would have had you out of the stock way before it was a ten-bagger, and momentum investing would have whipsawed you in and out of the stock with no rhyme or reason.

   Don’t get me wrong, though. Rappaport and Mauboussin haven’t invented a new Theory of Investing tabula rasa. What they’ve done is integrate the best of academic research and practical finance into a single framework. And they’ve written great additional material, like the chapter on M&A (which is better than the entire Sirower “Synergy Trap” book) that presents an approach to analyzing deals sensibly. And the chapter on Employee Stock Options is critical to valuing tech companies, but isn’t even covered in the McKinsey Valuation book, Quest for Value, and other books I’ve read.

   If you want a confusing investing book full of fun (but useless) war stories, read the fictional Reminiscences of a Stock Operator or 99.9% of nonfiction investing screeds. Until Warren Buffet writes his book, if you want something that can help you invest intelligently and avoid headaches, this is the book to buy.

   Note: People who already know (or are willing to learn) how to analyze a company’s financial statements will get the most from reading this book.
   Rating: 5 / 5