Expectations Investing #102

Going through the concept of expectations investing and studying multi-baggers

The potential gap between the value that comes out of a discounted cash flow model and what we see in the markets today has never been higher. 

Whether you're looking at real estate or stocks, it is increasingly harder to justify the valuations we see today. 

Does that mean that the discounted cash flow model is irrelevant? Probably not. This study from Morgan Stanley explains the notion that 'Everything is a DCF Model.' The key message from the study is to really understand the drivers of a DCF model (e.g. terminal growth rate, risk-free cost of capital and etc) when analyzing the valuation of a cash flow generating asset. 

So why is there a gap between the theoretical value and actual value of companies/assets today? A lot of it comes down to expectations. Investors who can read the market's expectations and anticipate changes in those expectations will more likely generate superior investment returns.

The easiest way to gauge expectations is to compare. How are similar companies valued? Do you believe that this company should be valued lower, similar or higher? Depending on how you answer the second question, this can be a fairly lazy way of identifying investment opportunities. 

Enter: Expectations Investing by  Michael J. Mauboussin (who also helped write the study above) and Alfred Rappaport . 

This is a great read on how to navigate market expectations and make investment decisions around them. While I wouldn't use the book/summary below as your sole guide to investing, it provides a fairly practical way to approach public market investing. 

Here's a quick summary of key lessons/excerpts. 

How the Market Values Stocks

  • The magnitude, timing, and riskiness of cash flows determine the market prices of financial assets, including bonds, real estate, and stocks.

  • You can estimate the value of a stock—its shareholder value—by forecasting free cash flows and discounting them back to the present.

  • Rather than struggle to forecast long-term cash flows or employ unreliable short-term valuation proxies, expectations investors establish the future cash flow performance implied by stock prices as a benchmark for deciding whether to buy, hold, or sell.

The Expectations Infrastructure 

  • The expectations infrastructure—which stems from the fundamental value triggers through the value factors to the operating value drivers that determine shareholder value—should help you to visualize the causes and the effects of expectations revisions.

  • Sales growth expectations are your most likely source of investment opportunities, but only when a company earns above the cost of capital on its investments.

Analyzing Competitive Strategy 

  • The surest path to anticipating expectation shifts is to foresee shifts in a company's competitive dynamics.

  • Management 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.

  • Historical performance provides insight into potential value driver variability by showing which operating value drivers have been most variable in the past. This type of analysis provides a reality check on expectations ranges. Track record/trust in management can really influence the discount factor associated with future growth. 

Estimating Price-Implied Expectations 

  • Before you can consider the likelihood and magnitude of expectations revisions, you need to clearly understand where expectations stand today. This is by far the biggest mistakes that retail/novice investors make. It's important to form a view on what's priced in vs. what isn't. 

  • To read expectations properly, you must think in the market's terms. Expectations investing allows you to tap the benefits of the discounted cash flow model without requiring you to forecast long-term cash flows.

  • You can estimate price-implied expectations by using publicly available information sources.

  • You should consider revisiting an expectations analysis when stock prices change significantly or when a company discloses important new information.

Buy, Sell or Hold? 

  • The magnitude of the excess return depends on how much of a discount a stock trades relative to its expected value and how long the market takes to revise its expectations. The greater the stock price discount and the sooner the market revises its expectations, the greater the return.

  • As an investor, you have three potential reasons to sell: a stock reaches its expected value, a more attractive stock exists, or your expectations have changed.

Here's a pretty good talk between Patrick O'Shaughnessy and Michael Mauboussin at Capital Camp 2019 to support the above. 

Studying Multi-Baggers

This is a very detailed study on multi-baggers by Alta Fox and the common characteristics of businesses that grow over 350%. I personally like the idea of focusing on financially healthy companies. It often feels easier to convince myself of a turnaround story vs. betting and/or doubling down on financially healthy companies.