PDF Summary:Expectations Investing, by Michael J. Mauboussin and Alfred Rappaport

The key to successful investing, according to Expectations Investing by Michael J. Mauboussin and Alfred Rappaport, lies in anticipating changes in the market's expectations for a company's performance. Rather than forecasting distant cash flows, the authors introduce a framework for reverse-engineering the stock price to reveal the expectations already priced in by investors.

They explain how to capitalize on mismatches between market expectations and likely outcomes. The book discusses how different business types influence expectations and provides guidelines for evaluating common corporate actions like mergers and leadership changes. Throughout, the authors emphasize relying on a company's ability to generate cash over metrics like earnings per share.

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• Create a "future diary" for your company, imagining entries six months to a year from now based on current assumptions. After writing these entries, analyze them to identify which assumptions may be overly optimistic or pessimistic, and adjust your strategies accordingly.

Capitalizing on Opportunities to Adjust Market Expectations

The second key part of expectations investing shifts to assessing the potential for those expectations to change. This step relies heavily on understanding how value is created and what factors can alter expectations for creating future value.

Framework Identifies Drivers of Expectations Revisions

Mauboussin and Rappaport unveil a framework, the "expectations infrastructure," to systematically assess what contributes to shareholder value and identify factors that can drive changes in investor assumptions. Their framework introduces three analytical tiers. Notably, they argue that investors focus too much on the drivers of operating value as the source of variability, and their approach digs deeper.

Value Triggers Initiate the Expectations Revision Process

Value catalysts, the foundation of the framework, are the fundamental forces that initiate updates in expectations. These triggers involve shifts in the organization's sales projections, cost expectations, and how efficiently it deploys capital through investments. Recognizing possible alterations in triggers is essential because they set off a chain of events that can significantly impact investor value, and ultimately, share price.

Context

• Companies may respond to these triggers by altering their business strategies, such as entering new markets, adjusting pricing strategies, or restructuring operations to maintain or enhance competitiveness.
• Events like geopolitical tensions or pandemics can disrupt supply chains or demand, impacting sales projections and cost expectations.
• Broader market trends and investor sentiment can amplify the impact of triggers, as collective investor behavior can lead to significant shifts in share price.

Influence of Factors on Operating Value Drivers (Volume, Price/Mix, Leverage, Economies, Cost, Investment)

Each trigger connects to certain value factors, a type of examination neglected by most investors according to the authors. These are the mechanisms by which triggers exert their influence. The six elements—volume, pricing and product composition, leverage in operations, scale economies, cost effectiveness, and investment efficiencies—interact in complex ways. Understanding how these value factors are likely to play out in different scenarios gives investors a powerful lens for predicting changes in what the market expects.

These insights illuminate a core principle of expectations investing: predicting shifts in what the market anticipates. By meticulously analyzing the catalysts and their associated value factors, investors can identify mismatches between current market prices and a company's likelihood of delivering on the expectations embedded in those prices.

Practical Tips

• Experiment with a DIY approach to product composition in your household to enhance cost-effectiveness. Instead of buying ready-made products, try creating your own versions at home. For example, you can make household cleaners using vinegar, baking soda, and essential oils, which can be more cost-effective and environmentally friendly than purchasing brand-name cleaners. Keep track of the cost of ingredients and compare it to the prices of commercial products to measure your savings over time.

Other Perspectives

• Many investors do indeed focus on value factors, as they are fundamental aspects of financial analysis and investment decision-making.
• The interconnectedness of value factors can lead to complex interactions that are difficult to disentangle and accurately forecast.
• The approach assumes that the market is not efficient and that there are regular opportunities to exploit mismatches, which may not hold true in highly efficient markets where information is quickly reflected in stock prices.

Focus On the "Turbo Trigger" - The Key Value Driver Likely to Significantly Revise Expectations - Enhances Odds Of Finding High-Potential Investments

Once you understand how the various triggers and factors interact, you can pinpoint the single element that will probably most significantly affect worth. For most businesses, increasing sales is that trigger, because larger shifts in sales generally have a greater overall impact on value than do changes in expenses or spending.

Turbo Trigger Outcomes and Effects on Stockholder Wealth

To find the turbo trigger, project the range of sales growth from lowest to highest, taking into account historical information, competitive analysis, and the specific value factors. Then, utilize the expected framework to determine the corresponding upper and lower operating margins and compute the effect on shareholder value.

For example, if you estimate that a company's stock price would fall by 20% if sales growth were on the lower side and increase by 30% at the higher side, this would provide a strong indication that sales are the most important trigger for this company. In contrast, if shareholder value is more sensitive to expenses or how efficiently investments are managed, then one of those value drivers would serve as the main catalyst.

Practical Tips

• Implement a 'what-if' analysis for different sales scenarios using a free online simulator. Find a tool that allows you to input variables such as customer acquisition cost, conversion rate, and average transaction value. Experiment with different values to see how they could impact your sales growth, helping you to understand the range of possible outcomes and prepare for them.
• You can analyze your career trajectory by creating a personal "competitive analysis" against industry benchmarks. Start by researching the average salary, qualifications, and career progression in your field. Then, assess where you stand in comparison and identify areas for improvement or unique strengths you possess. For example, if you're in marketing, compare your skills and achievements to industry standards for a marketing manager and set goals to exceed them.
• Engage in a monthly "financial experiment" where you adjust one variable in your budget (like dining out, entertainment, or groceries) to see its impact on your overall financial margins. Document the changes and analyze how this affects your ability to stay within your set financial boundaries.
• Engage with a community of amateur investors through social media groups or forums. Share observations and ask for insights on how sales growth influences stock prices in different sectors. This peer-to-peer learning can provide diverse perspectives and real-world examples that deepen your understanding of the sales-stock price dynamic.
• Engage in a 'value audit' of your time to ensure you're investing it in activities that align with your personal goals. Keep a time log for a week, recording how you spend each hour of your day. Then, evaluate which activities contribute to your long-term objectives and which are inefficient uses of your time. For instance, if you find that scrolling through social media takes up two hours of your day but doesn't add value to your life, consider limiting your usage and reallocating that time to more productive activities like learning a new skill or spending time with family.

Beware Of Biases Like Overconfidence and Confirmation Bias When Estimating Ranges

This step requires care and a candid look at your own approach to making estimates. Overconfidence, particularly when manifested as overprecision—the tendency to be overly sure of your forecasts—often causes problems. If your outcome projections are too limited, you might overlook the true catalyst for the company. Try to compare your estimates with the company's historical data, peer companies, and companies of similar size to evaluate the appropriateness of your anticipated range.

Confirmation bias may also sneak in as you process novel details. We tend to overemphasize details that validate our existing views and give insufficient weight to disconfirming information. Challenge your cherished beliefs by explicitly seeking disconfirming information. Mauboussin and Rappaport recommend an independent and skeptical mindset and deliberate efforts to gather a diverse set of perspectives to counteract this tendency.

Other Perspectives

• The idea that overconfidence leads to problems assumes that all estimators will interpret confidence levels similarly, but cultural and individual differences can mean that what is perceived as overconfidence in one context may be seen as appropriate assertiveness in another.
• Market dynamics and consumer behavior can shift rapidly, rendering comparisons with historical or peer data less relevant or even obsolete.
• In some instances, what appears to be confirmation bias could actually be a correct interpretation of the available data, where the data genuinely supports the existing view, and the issue is not with the bias but with the interpretation of the bias's influence.
• Actively seeking disconfirming information might lead to a false balance, where one gives equal weight to both sides of an argument even when the evidence is overwhelmingly in favor of one side.
• Overemphasis on avoiding biases could lead to second-guessing valid intuitive judgments that are often valuable in decision-making processes.

Using Expectation Investing for Various Businesses and Actions

Companies come in different shapes and sizes, and they have unique operating and strategy-related characteristics. Corporate actions, both planned and unplanned, can also affect how much value a company can generate. Using the expectations investing framework across different business types and corporate initiatives will help refine investment decisions.

Business Types Impacting How Expectations Change

Mauboussin and Rappaport introduce the three broad categories of businesses—physical, service, and knowledge—and discuss their unique characteristics and how they can potentially impact revising expectations. The authors emphasize that although core economic principles apply universally, the distinct characteristics of each category can lead to widely varying outcomes in terms of scalability, competition, and, ultimately, shareholder value generation.

Physical and Service Businesses Face Capacity Limits, While Knowledge Businesses Experience Growth

Physical businesses like steel producers and many consumer products companies create value through their tangible assets, and service businesses like financial institutions and consulting firms depend heavily on their employees to deliver their offering. But tangible and service-oriented businesses face capacity limits because they require fresh cycles of investing in physical assets and employees to meet demand.

Knowledge businesses, on the other hand, typically invest heavily in the creation of offerings, often at great expense. But if successful, they can see growing returns as their products, such as software, music, or pharmaceuticals, are copied and shared at low cost. Network effects play a particularly important role in the success of knowledge businesses as the product or service becomes more valuable as more users join the network.

Context

• Maximizing the efficiency and utilization of tangible assets is crucial for profitability, requiring strategic planning and operational expertise.
• Employees in these sectors often possess specialized knowledge and expertise that are not easily replicable by technology. This expertise is critical for problem-solving and providing strategic advice to clients.
• Many physical and service businesses must adhere to strict regulations and compliance standards, which can add to operational costs and limit expansion capabilities.
• These businesses depend heavily on skilled professionals, such as engineers, scientists, and artists, whose expertise is crucial for developing high-quality offerings.
• Once a knowledge product is developed, the cost of producing additional copies is negligible, which contributes to higher profit margins as sales increase.
• The success of network effects often depends on robust technological infrastructure that can support rapid scaling and ensure seamless user experiences as the network grows.

Examining Business Types Reveals Unique Opportunities in Anticipated Structures

Mauboussin and Rappaport explore how each business category influences various catalysts, elements, and mechanisms of value. The expectations infrastructure provides a systematic and flexible way to distinguish between the dynamics of each category and highlight potential sources of mismatch between market expectations and how a company will probably perform in the future.

For instance, the authors highlight how the combination of volume, pricing, and product mix in knowledge businesses can differ significantly from those of physical or service businesses. While growth for companies focused on physical goods and services is largely tied to linear increases in tangible assets or employee headcount, knowledge businesses often experience an S-curve growth trajectory fueled by economies of scale from the demand side. A product, after attaining a critical mass of users, becomes valuable to new customers. Social networking platforms like Facebook have succeeded by rapidly building a large user base, which then makes the network valuable to those placing ads.

Further, leverage on operations plays out differently for each business type. Knowledge businesses often have high pre-production costs but relatively low costs for duplication and distribution of the product. In contrast, companies providing physical products or services typically face limits on operating leverage as they must periodically make investments in new capabilities to accommodate demand.

Finally, scale efficiencies are largely supply-driven for physical and service companies, whereas knowledge businesses often capture scale efficiencies on the demand side as network effects make an offering more valuable.

Context

• Business categories refer to the classification of companies based on their primary activities, such as manufacturing, services, or technology. Each category has distinct characteristics that affect how value is created and sustained.
• The expectations infrastructure is adaptable, allowing investors to apply it across different industries and business models to assess potential mismatches and investment opportunities.
• Knowledge businesses can face lower barriers to entry due to the digital nature of their products, allowing new competitors to emerge quickly. Physical businesses often require substantial capital investment, creating higher barriers to entry.
• This refers to a pattern where growth starts slowly, accelerates rapidly, and then levels off as the market becomes saturated. Knowledge businesses, such as software companies, often follow this trajectory due to initial development costs followed by rapid scaling as the product gains popularity.
• High user engagement is essential for maintaining a valuable network. Platforms invest in features and algorithms to keep users active and engaged, which in turn keeps advertisers interested.
• Protecting intellectual property is crucial in knowledge businesses, as the initial high costs are often tied to creating unique and innovative products that need to be safeguarded from competitors.
• Physical assets depreciate over time, requiring companies to reinvest in new equipment or infrastructure to maintain efficiency and productivity.
• In physical and service companies, scale efficiencies are achieved by reducing the cost per unit through increased production. This often involves optimizing manufacturing processes, negotiating bulk discounts for materials, or improving logistics to distribute products more efficiently.

Corporate Actions Such as Merging, Acquiring, Share Repurchases, and Management Changes Signal Expectation Revisions

Mauboussin and Rappaport explore how common corporate actions offer investors clear signals for revising expectations. They offer specific guidelines to evaluate the economic implications of such actions as acquisitions, buybacks of shares, and alterations to senior management. The overarching message is that by applying the expectation investing framework to these events, you can better understand where and when to allocate capital.

Synergies Determine M&A's Effect on Investors

M&A activities are high-stakes events that frequently have immediate and significant impacts on the stock price of both the buyer and the seller. The authors caution against the common fallacy of evaluating M&A based solely on their impact on earnings per share (EPS), highlighting how focusing on EPS accretion can be misleading and often masks underlying issues of value creation.

Instead, Mauboussin and Rappaport emphasize that it's essential to evaluate the potential synergies created by combining two companies. These synergies, which are the extra cash flows generated as a result of the merger, are the primary drivers of value creation. They suggest a simple way to assess synergies by capitalizing on management's post-tax synergy estimates with the cost of capital, and then comparing that to the acquisition premium—the amount paid beyond the standalone value of the seller. They also highlight the value of using the expectations infrastructure to gauge the plausibility of these synergies.

To illustrate the risks associated with mergers, the authors use the tool of "at-risk shareholder value," which measures the proportion of the buyer's value that's vulnerable in the event of a failed merger. By quantifying this risk, investors can gain a more nuanced understanding of the potential downside involved in an acquisition. They also introduce "premium at risk", which measures the potential value lost by shareholders of the selling company if synergies don't materialize.

The authors also reveal how the method of payment—cash or stock—used by the company acquiring another can signal management's confidence in the deal. According to the authors, a cash deal, where the acquiring shareholders assume the full risk and reward of the transaction, often reflects greater conviction. Conversely, offering stock frequently signals a lack of confidence in achieving synergies or a belief by management that the firm's stock is overvalued.

Practical Tips

• Develop a simple checklist of non-EPS factors to consider when evaluating M&A deals, such as strategic fit, cultural alignment, and potential for innovation. By having this checklist on hand, you can quickly assess deals beyond the surface-level EPS data. For example, when you read about a merger in the news, use your checklist to evaluate the deal's potential success based on these broader criteria.
• Consider forming a cross-functional team to tackle a common challenge in your organization. Choose a project that requires input from multiple departments and set up regular meetings where team members can brainstorm solutions together. This approach encourages the sharing of diverse perspectives and can lead to innovative solutions that benefit the entire company.
• Use social media to crowdsource ideas for synergistic partnerships. Post about your business and ask your followers for suggestions on companies or entrepreneurs that could form a beneficial merger with your business. This could lead to unexpected opportunities, like a tech startup offering to develop an app for your retail store, increasing your online presence and sales channels.
• You can use a simple spreadsheet to simulate potential synergies in hypothetical business mergers. Start by listing possible synergies (like shared marketing costs or combined purchasing power) and estimate their post-tax value. Then, compare these values against the cost of capital for each company involved. This will give you a hands-on understanding of how synergies can impact a business's bottom line.
• Develop a "Synergy Spotting" habit by setting aside 10 minutes each day to reflect on interactions and processes you've been involved in. Consider if there were any missed opportunities for synergy that could have been leveraged for better outcomes. This daily practice will sharpen your ability to spot potential synergies as they arise and think critically about how to harness them effectively.
• Engage in online investment simulations or games that feature mergers and acquisitions. Many of these platforms allow you to practice buying, selling, and holding stocks through simulated market conditions, including mergers. This hands-on approach will give you a feel for how at-risk shareholder value can fluctuate and what strategies might mitigate risks in your real-life investment decisions.
• Develop a habit of conducting "what-if" analyses for major financial decisions. When faced with a significant purchase or investment, such as buying a house or starting a business, take the time to consider and write down what could go wrong and how it would affect the value of your investment. For instance, if you're buying a house, consider what would happen if the market value drops or if interest rates rise, and plan accordingly.
• You can observe and analyze real-world M&A announcements to gauge management confidence. When a company announces an acquisition or merger, look for details on the method of payment in their press releases or financial statements. If they're using stock as the primary currency, it might indicate less confidence compared to an all-cash deal. Track these deals over time to see if the outcomes align with the initial payment method, which can help you understand the practical implications of this signal in the business world.
• Create a personal finance game with friends or family where you simulate cash deals and track their outcomes. Each participant starts with a virtual budget and proposes investments in real or fictional businesses, explaining the synergies they anticipate. Over time, track which investments would have been successful and analyze why. This game can help you understand the importance of conviction in synergies when making cash deals and improve your ability to identify them in real life.

Buybacks Reflect Management's Valuation View, yet Must Align With the Guiding Principle of Buybacks

While repurchasing shares is often presented as a strategy for returning value to shareholders and, in some cases, may signal management's belief that a company's stock is undervalued, Mauboussin and Rappaport caution against indiscriminate acceptance of this view. They contend that numerous firms buy back shares for reasons unrelated to benefitting shareholders. Some programs are designed to counteract the effect of dilution from equity compensation, and others are meant to increase EPS to enhance management incentives or to satisfy what the market anticipates.

The authors offer a key principle for repurchasing shares as a touchstone for evaluating the soundness of any repurchase plan: "A business ought to repurchase its stock only when the market price is lower than its anticipated worth and there are no superior investment options." This simple yet powerful rule provides a clear benchmark for aligning management's buyback decisions with the long-term interests of existing shareholders.

Practical Tips

• Develop a habit of regularly reviewing alternative investment options by setting up monthly reminders. Each month, take time to research and compare other investment opportunities, such as bonds, real estate, or new market funds, to ensure that buying back stock is the best use of your funds at that time. This practice will keep you proactive in seeking superior investment options.
• Create a simple spreadsheet to compare the executive compensation structure with share buyback announcements. If you notice a pattern where buybacks occur before executive bonuses are calculated, it could imply that the buybacks are being used to inflate stock prices and, consequently, executive compensation.
• Consider starting a virtual investment club with friends or online communities to discuss and analyze the impact of share buybacks on stock performance. By pooling your collective observations and analyses, you can better understand which companies are successfully using buybacks to enhance shareholder value. This collaborative approach allows you to learn from others and make more informed decisions about where to invest your money.

New Leadership May Reset Market Expectations, Positively or Negatively, Based on Strategy

Management changes, both planned and unplanned, are often significant events that can prompt a reassessment of market outlooks. Such changes offer opportunities to identify new value drivers and to reassess shifts in operations, strategy, and finance that may have been overlooked under prior leadership.

The authors emphasize the importance of evaluating new leadership groups, especially their orientation toward capital allocation, strategic vision, and financial discipline. They note that new leadership may bring different skillsets, long-term visions, and methods of enhancing value that can either unlock opportunities or exacerbate existing problems.

For instance, Mauboussin and Rappaport highlight the case of David Cote who took over Honeywell during a period of corporate weakness following a failed acquisition. His focus on operational improvements and a strategic shift towards long-term value creation led to the company's stock performing significantly better than the S&P 500 throughout his tenure. They contrast this with Jeff Immelt's succession of Jack Welch. When Immelt took over, expectations were high but the company's performance lagged behind, as inefficient capital deployment negatively impacted shareholder value. They argue that it is important to assess whether an incoming management team has the right skills for the situation, using examples of executives who left General Electric (GE) and had varying degrees of success based on whether the new company was similar or different to GE's businesses.

Other Perspectives

• Management changes do not always lead to a significant reassessment of market outlooks, as sometimes these changes are anticipated and already priced into the market.
• Reassessing operations, strategy, and finance can lead to disruption and uncertainty, which might negatively impact employee morale and productivity.
• The focus on capital allocation and financial discipline might bias the evaluation against leaders who prioritize social responsibility, sustainability, or other non-financial objectives that could be beneficial in the long term.
• Long-term visions introduced by new leadership may face resistance from existing stakeholders who are accustomed to the previous management's approach, which can hinder the implementation of new strategies.
• The focus on leadership changes might overemphasize the role of individual leaders and understate the importance of collective decision-making and the contributions of other employees at various levels of the organization.
• Outperforming the S&P 500 is a notable achievement, but it does not necessarily reflect the absolute performance of the company's stock or the total return to shareholders, including dividends.
• Capital deployment decisions that may seem inefficient in hindsight could have been based on strategic bets that were reasonable at the time, given the information available to GE's management.
• Focusing too much on the skillset of the management team might overlook the importance of the existing company culture and the ability of the team to adapt and integrate into it.
• The premise assumes that GE's business model and practices are a standard for success in other companies, which may not always be the case, as different industries and markets may require different strategies and competencies.