Expectations Investing: Reading Stock Prices for Better Returns by Michael J. Mauboussin and Alfred Rappaport

1 The Case for Expectations Investing

stock prices are the clearest and most reliable signal of the
market’s expectations about a company’s future financial performance.

The key to successful investing is to estimate the level of
expected performance embedded in the current stock price and
then assess the likelihood of a revision in expectations. Most
investors agree with these ideas, but very few execute the process
properly.
Flip on CNBC or read any popular business magazine and you’ll
get a familiar story. The growth money manager will explain that
she looks for well-managed companies with rapid earnings growth
that trade at reasonable price-earnings multiples. The value manager

will extol the virtues of buying quality companies at low
price-earnings multiples. It happens every day.
But think for a moment about what these investors are really
saying. When the growth manager buys a stock, she’s betting that
the stock market isn’t fully reflecting the company’s growth prospects.

The value manager bets that the market is underestimating
the company’s intrinsic worth. In both cases, they believe that the

market’s current expectations are incorrect and are likely to be
revised upward.
Although investors do talk about expectations, they’re usually

talking about the wrong expectations. The mistakes fall
into two camps. Investors either don’t appreciate the structure
of market expectations or they do a poor job of benchmarking
expectations.
A focus on short-term earnings is an example of a faulty structure.

Short-term earnings are not very helpful for gauging expectations

because they are a poor proxy for how the market values
stocks. Yet even the investors who embrace an appropriate economic

model often miss the mark because they fail to benchmark
their expectations against those of the market. It is hard to know
where expectations are likely to go tomorrow without knowing
where they are today.
The central theme of this book is that the ability to properly
read market expectations and anticipate revisions of these expectations

is the springboard for earning superior long-term returns.
Stock prices express the collective expectations of investors, and
changes in those expectations determine investment success.
Seen in this light, stock prices are gifts of information waiting
for you to unwrap and use. If you’ve got a fix on current expectations,

you can evaluate where they are likely to go. Like the great
hockey player Wayne Gretzky, you can learn to “skate to where
the puck is going to be, not to where it has been.”1 That’s expectations investing.
In a sharp break from standard practice, expectations investing is a

stock-selection process that uses the market’s own pricing
mechanism, the discounted cash flow model, with an important
twist: Rather than forecast cash flows, expectations investing
starts by reading the expectations implied by a company’s stock
price.2 It also reveals how revisions in expectations affect the stock
price. Simply stated, expectations investing uses the right tools to
assess the right expectations to make the right investment choice.

Expectations Investing: Reading Stock Prices for Better Returns by Michael J. Mauboussin and Alfred Rappaport