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Expectations Investing: Reading Stock Prices for Better Returns Paperback – February 18, 2003
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From Publishers Weekly
Instead of focusing on the short term--earnings per share, price-earnings multiples--Rappaport (Creating Shareholder Value), formerly a professor at Northwestern's Kellogg School of Management, and Mauboussin, chief investment strategist at Credit Suisse First Boston, recommend "expectations investing," which "starts with the current stock price and uses the discounted cash-flow model to `read' what the market implies about a company's future performance." They discuss sample companies (Gateway), historical patterns, competitive strategies and share value. Though they expertly simplify a complex topic, beginners may find the book overly technical. However, the authors' credentials, a national interview campaign and author appearances should attract deserved attention. Tables.
Copyright 2001 Cahners Business Information, Inc.
About the Author
Alfred Rappaport directs Shareholder Value Research for L.E.K. Consulting and is a Professor Emeritus at Northwestern's Kellogg School. Michael Mauboussin is Credit Suisse First Boston's Chief U.S. Investment Strategist. He is also an adjunct professor at Columbia University and runs the New Economic Forum at the Santa Fe Institute.
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"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").
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.