Expectations Investing

After the interview I recently gave CNBC, as I typically do, I began rethinking the sound bites of mine the show’s producers included and how I could have better said what I did. One quote of mine that was included in the show but I really don’t think came out right is the following:

“It is an appreciation for all things that make a good business, not just the financials. Warren Buffett has been the best at allowing us to understand what makes up a good business.”

Here is what I meant, said far more eloquently:

Warren Buffett has a unique ability to assess a business holistically, or on an integrated functions basis. This allows him to recognize attributes and/or assets that may have been overlooked by Wall Street, where analysts are often more concerned with short-term trends or earnings announcements than with underlying business economics.

My point is that a stock represents a share of ownership in a business, not merely a security that trades on a large national market. Thus, there are many things that happen outside of the stock market that affect the stock’s value. Some people ought to be saying right now, “Well duh.” -- I never said this was rocket science.

I recently read a fantastic book describing an investment strategy that embraces this attitude while preserving a structured and disciplined approach to stockpicking. It would be perfect for the investor not confident enough in his own intuition about the future of individual companies to focus on only a few businesses, perhaps for the “know-nothing” investor that Mr. Buffett has referred to.

The book is called Expectations Investing and was written several years ago by two academics, Alfred Rappaport and Michael Mauboussin, and published by Harvard Business School Press. I should point out that I was not asked to review this book by anyone nor do I have any interest in the book’s success. I just bring it up because I liked it.

The book begins by making the assumption that outguessing the market is too difficult. A better method by which to make decisions uses the information provided by the market to infer expectations and then judges the reasonableness of those expectations. I think of it as a bottom-up-bottom-up approach. Not only are we analyzing the company on a fundamental basis first, but we are actually using the current price of the stock to read the market’s expectations for how those fundamentals will change.

For instance, a few months ago I blogged that although I do not know if Google is overvalued or undervalued, an investor in the company ought to be aware of what its current stock price implies. Namely, that at $700/share, the expectations of the market implied by this price are that Google will eventually become the largest company in our economy. I don’t know if that will happen or not, but that is what will need to happen lest Google’s stock will underperform.

The book describes how “value drivers” and “value factors” work to affect shareholder value. While, for example, sales growth will drive shareholder value, it is the value factors such as volume and pricing that affect sales growth. So by starting with the stock price and working backwards we can infer what the market seems to expect to happen to volume and pricing. At this point we can ask ourselves if these expectations seem reasonable and also if we should expect the market’s expectations to ever change. With a good holistic perspective of the business like that which makes Buffett so successful, we should be able to answer this question easily.

The book also makes the case that a discounted future free cash flow model is the only legitimate way to measure shareholder value. Frankly, I don’t see how anyone can argue with them on this point, but clearly many people cling to short-term metrics such as PE ratios even though such metrics incorporate only information about one period’s performance. Only future free cash flow directly affects changes shareholder value since it is this cash flow that represents the return on the shareholder’s capital investment. Of course, plenty of things indirectly affect shareholder value and these are the things about which we are trying to infer information when we employ the expectations investing methodology.

Alas, we have taken an alternative approach to answering the same question. Instead of deciding on an intrinsic value to which we will compare the current price, we infer from the current price what the market’s expectations must be in order for the current price not to exceed the intrinsic value of the business. Taking this backwards approach strikes me as much more judicious application discounted cash flow valuation because it allows us to focus on what we do know for certain (the market price) rather than what we don’t necessarily know (the intrinsic value of the business).

Although he probably has never thought of it in quite these terms, I am fairly confident this is the same type of intellectual exercise Warren Buffett engages in when making an investment decision. Nonetheless, this commonsense type of analysis does not happen very often in the market. Perhaps investors are just creatures of habit.

FD: No position in GOOG

Thoughts on Index Investing

There are two general ways to play the equities game. You can try to pick individual stocks yourself in the hopes of someday replicating the success of Warren Buffett, or you can leave such aspirations to the more ambitious folks in our society and simply try to earn an average return. As I have argued before, although I do believe it is possible to beat the market consistently as Warren Buffett has done, this does not mean that just anyone can hope to do so. It takes a unique person. Of course, where does that leave the rest of us?

Mr. Buffett has said that the ordinary investor is better off investing in a passively managed index fund than an actively managed mutual fund. While the proponents and salesmen of index funds or fund families that try to capture the benefits of index funds love to use this quotation for their own self-serving benefit, it is hard to disagree with Mr. Buffett. He calls such ordinary investors “know-nothing investors,” although he doesn’t mean it as an insult. He just means that if you don't know what you are doing, it is safest to simply accept your mediocrity and guarantee yourself average returns. This begs the question, though, what is “average? “

This argument is also consistent with the efficient market theorist’s investment strategy. Since we can't expect to beat the market anyway, why not simply arrange to earn the relatively high returns equities offer us while minimizing fees through passive management? Note the underlying assumption behind all of this, that "the market" is best proxied by a value-weighted index, and this is where we get in to trouble. What is “the market?” Professor Richard Roll’s famous critique of the Capital Asset Pricing Model has stumped theorists for nearly thirty years now. He contended that we will never be able to truly quantify risk because the true “market” portfolio is unobservable – it includes all assets that contribute to wealth, everything from stocks to baseball cards to human capital.

So let me ask two simple questions. Why are market-value weighted indexes such as the Nasdaq Composite or S&P 500 the most generally accepted benchmarks by which to compare investment results? Is there any particular reason for such value-weighting other than convention?

Some fund companies have made a big business out of creating alternative indexes that try to outperform or by taking the components of existing indexes and weighting them equally, and yet others weight them according to the Fama-French Three Factor Model. Yet we continue to measure performance relative to value-weighted benchmarks. Perhaps, since as individual investors we likely never have sufficient wealth to affect the value of one stock purely through our individual trades, we should have no limit to how to we (passively) allocate our wealth. Hence, by benchmarking ourselves to the S&P 500 we are actually overstating our relative performance.

Exchange traded funds, ETFs, are very much in vogue at the moment. The original ETFs were broad-market index funds such as the SPDRs, which mimic the performance of the S&P 500, and appealed to two types of investors. The first type is the delusional folks that think they can actually predict the direction of the market. We can thank those geniuses, I suppose, for providing liquidity to the second type of investor who uses the SPDRs for true investment purposes.

But by purchasing shares of SPDRs or any other broad-market index fund, investors are inadvertently investing most heavily in those companies that are most likely to be overvalued. This is the crux of my argument. Since the S&P 500 is a value-weighted index, the value of one share of a SPDR will be dominated by the largest companies and those that have most recently appreciated. So while you may rest assured that your share does in fact represent the collective performance of five hundred different companies, why should you prefer that, among those five hundred companies, you are weighted towards the ones that are quite possibly the most overvalued?

For illustration, consider the three largest components of the S&P 500; ExxonMobil, GE and Microsoft. This trio is clearly not surprising - these companies are the three biggest in the economy. But what makes me think that these three companies deserve the largest portion of my money? Do I really want $5.88 of the $146.00 I pay for my SPDR to be allocated to ExxonMobil? Moreover, the mere fact ExxonMobil is so large (as measured by market value) may be because investors are paying too much for it.

These are philosophical questions. The index fund advocate will argue that investing in the largest companies is the point. That is, because ExxonMobil is so dominant in the economy, so too should it be dominate in my index fund. But to me this seems unnecessarily limiting, since both larger companies and those to have recently appreciated are likely to underperform their counterparts - provided we believe the evidence provided by Fama and French (1988, 1992) of long-term mean reversion in stock prices and the outperformance of small firms. (I do.)

As I have a habit of doing, I have raised some questions without suggesting any real answers. I will leave that up to anyone wishing to comment.