The Role of Expectations in Investing

The Role of Expectations in Investing

By Jack Forehand, CFA (@practicalquant)

I am not one to go out to fancy restaurants very often. Most of the time, I tend to prefer cooking at home to eating out. My wife would tell you its because I am cheap and don’t want to spend the money, but I think its more a function of just enjoying the relaxation of being at home. So when we do go out, especially to a high end restaurant, I tend to have a high bar for what I expect.

A few years ago, I had the opportunity to try one of the best steakhouses in the country. Despite the fact that I don’t love going out, I was really excited to go. There is nothing I enjoy more than a good steak and I fully expected it would be the best steak I ever had.

But when our food was served and I took my fist bite, I can remember my first reaction being one of disappointment. I just didn’t think it was that good. At the time, I thought that was because the restaurant was overrated, but upon reflection, I realized it wasn’t that at all. The steak was perfectly prepared. It tasted great. The service and experience at the restaurant were both excellent.

So what was the problem?

The problem I had with that steak is also one that all of us often run into as investors. It had little to do with its quality and everything to do with my expectations. I started off with high expectations because I don’t eat out often. The fact that this was considered one of the best steakhouses in the country only added to that. The combination of those two factors created a situation where I am not sure it would have been possible for that restaurant to make a steak that lived up to them.

This concept of the relationship between expectations and reality is in my opinion one of the most important ones for every investor to understand. Every stock has a series of expectations embedded in its price. For growth stocks, those expectations are high ones. For value stocks, they are much lower. But either way, investors profit when they are able to identify a mismatch between expectations and reality.

I have learned a lot on this topic by following the work of Michael Mauboussin. If you haven’t read his book, Expectations Investing, I would highly recommend that you do. In the book, Mauboussin suggests a framework where investors ask themselves what the expectations are that are embedded in a company’s stock price and then compare that to their view of what the reality is.

Here is how we explained the issue in a research report he wrote:

Having been on the sell side for many years and then on the buy side, I can say categorically that the single greatest error I have observed among investment professionals is the failure to distinguish between knowledge of a company’s fundamentals and the expectations implied by the company’s stock price. If the fundamentals are good, investors want to buy the stock. If the fundamentals are bad, investors want to sell the stock. They do not, however, fully consider the expectations built into the price of the stock.

Let’s look at a concrete example.

Investing in growth stocks typically affords investors an opportunity to own companies that are doing well. Investing in value stocks typically involves owning companies that have some significant issues in their businesses. To most investors, choosing the first option seems like the obvious choice. But over the long-term, the second option has worked far better. The reason comes down to expectations. The high valuations of growth stocks set a high bar in terms of the results these companies have to deliver. The low valuations of value stocks do the opposite. So value stocks, on average, have been more likely to exceed those expectations, while growth stocks have eventually been unable to exceed the high bar that their valuations have set. Growth stocks may have offered investors an opportunity to hold better companies, but value stocks have been better investments.

This certainly hasn’t always been the case, though. It can work in the opposite direction too, as those of us who have been value investors in the past decade know all too well. Going into the past decade, it turns out that the expectations for value stocks, even though they were certainly lower than growth stocks, were too high. And the expectations for growth stocks, although they were much higher than those of value stocks, were too low. If you look at what the FAANG stocks have done in the past decade, they have likely exceeded even the most optimistic estimates. Even though they had high valuations relative to past earnings going into the period, they were actually very cheap relative to the results they ended up producing in the future. 

Source: Industry Indicators: FANGs – Yardeni Research

But my point here is not to argue in favor of any type of investing. My point is that when investing in any type of company, it is important to understand what the market expects, and why you think reality will be different than that. We have seen a great run for growth stocks in the past decade, but just like my expectations were for that steak, eventually the expectations for growth companies will become so high that they can’t possibly be met. Its also possible that even at their current valuations, value stocks still do not reflect the true problems that these companies are experiencing. I can’t say which one will be true. But what I can say with a high level of confidence is that the end result will be a function of the difference between expectations and reality. 

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.