Q: What’s wrong with the way companies currently value stocks?
A: Companies typically impose their own world view, and determine if it is different from the market’s price. While these tools are a proxy for reality, they don’t reflect how the market really works – and that’s why most active investors fail to beat indices.
Rather than try to independently forecast the parameters that establish a company’s value, ‘expectations investing’ starts with the stock price. Then, using the market’s basic tool (a discounted cash flow approach), we reverse-engineer the expectations needed to arrive at that stock price. We compare those expectations to what the company anticipates about its strategic plans and competitive position and look for discrepancies. A key management responsibility is to use those expectations to devise, adjust and communicate strategy.
Q: How exactly can they do that?
A: If the company is undervalued, IROs might take the current stock price and reverse-engineer the expectations built into it. They might find the company is more optimistic than the market on, for example, operating margins.
You can then either explain to investors how wrong they are, or – and actions speak louder than words – you can repurchase stock. Conversely, if the market is more optimistic than management, you may decide to issue more shares or sell the company entirely.
Either way, it is economically disastrous to establish company goals without knowing where investors have set the bar.
Q: Are you saying the market is always right?
A: Stock markets are similar to collective decision markets, which are uncannily accurate. For example, 40 years ago the US Air Force lost a nuclear bomb in the Mediterranean when a plane crashed. It asked a group of experts to place bets on where the bomb landed and, after aggregating the bets, the bomb was quickly found. No individual had the answer, but the wisdom of the collective did.
The same goes for stock markets, but there are two caveats: first, managers often have information they don’t disseminate for competitive reasons. Second, markets periodically go haywire. That’s because heterogeneity is a precondition for an efficient market. In the bomb example, each ‘expert’ used his or her own technique for discerning where the bomb was, without knowing what others were predicting. That way, not everybody went to the ‘same side of the ship’ – when investors do that, booms and crashes result.
Q: But if everybody uses, say, P/E multiples to value stocks, isn’t that where all the investment funds will flow anyway?
A: All evidence indicates that when earnings and cash flow diverge, the market tends to follow cash. For example, when Coca-Cola announced a couple of years ago that it would expense employee stock options, its earnings declined. But the company’s cash flows and overall economics didn’t change, and neither did its stock price.
On an individual level, investors appear to be using P/E multiples and earnings. But what really matters is what happens at the aggregate level. Markets are like ant colonies – complex, adaptive systems with properties distinct from the underlying agents. If you studied a colony at the ant level you’d see an ant with decision roles but seemingly random activity. Studied at the colony level, you’d see a robust adaptive system with no leader. The lesson is that local interaction leads to global outcomes – you can’t understand an ant colony by interviewing individual ants and adding up the results.
The same goes for stock markets. When companies talk with individual analysts and investors, they are confusing the ant with the colony. When a market has a difficult problem to solve, the collective usually solves it better than individuals.
Q: Like yourself?
A: Self-servingly speaking, analysts play a vital role in helping investors make decisions. The bottom line, however, is that the people trading the stocks make the decisions. Managers and communicators often fail to see that. Change your attitude from misgiving to one that the market is smart and your perspective completely changes.
