Tuesday, October 9, 2012

Winning (losing) by losing (winning): The power of expectations

If you are a baseball fan, I am sure that you know that both the New York Yankees and the Baltimore Orioles made the playoffs last week. While there was some celebration in New York on the news, it was nothing compared to the jubilation in Baltimore. The reason is not hard to fathom. In the last 16 years, the Yankees have made the playoffs in all but one, and with their payroll and heritage, Yankee fans view the playoffs as an entitlement, rather than a bonus. For Baltimore fans, whose team has not had a winning record (forget about making the playoffs) in a long time and was not expected to have one this year, it is a hugely positive surprise. It reinforces the message that it is now how well you do, but how well you do, relative to expectations, that determines the response.

Expectations and Outcomes
The expectations game is not restricted to sports. It spills over into politics, as attested to by the Obama and Romney teams jockeying to set expectations for the presidential debates and it definitely permeates markets. In particular, there are two news stories over the last couple of weeks that illustrate how critical expectations are in determining how we gauge performance.
  • On September 27, 2012, Research in Motion came out with its  earnings report, revealing that revenues dropped 31% and that it lost $235 million in the most recent quarter. Terrible news, right? The company's stock jumped 18% on the news!!
  • A few weeks ago, Apple introduced its newest iPhone, selling more than 5 million iPhone 5s over the first weekend and setting itself on target to beat prior records for smart phones sold. The big story, though, was about a free Map app that Apple was offering with the iPhone, that was misbehaving. The company has lost almost $40 billion in market value in the last two weeks!!
To a first-time market observer, the market reactions may seem perverse, with the market rewarding a company reporting bad news (RIM) while punishing a company (AAPL) for its success, but bringing in expectations levels the playing field. The news about Research in Motion in the last couple of years has been unremittingly negative, and investor expectations for the company have hit rock bottom. In fact, the very fact that RIM did not see revenues go to zero and operating losses wipe them out may be such positive news that investors bought the stock. Conversely, almost everything that Apple has touched over the last decade has turned to gold, and people seem to expect the company to be perfect in executing everything that it does. Thus, the negative reaction to the Maps fiasco may be more a recognition on the part of some investors that Apple is not infallible and that the next error they make could be much more damaging.

Playing the expectations game
The crucial role that expectations play in how markets read outcomes is not a secret and companies try to manage the game, with varying degrees of success. For publicly traded companies, this involves walking a very fine line, where you talk down expectations without talking down the stock price. Yesterday, for instance, Meg Whitman, CEO of Hewlett Packard, told the world that it would take a lot longer for HP to fix its problems. Was she trying to be honest with markets or trying to bring down expectations to the point that she will be able to beat them more easily? It is almost impossible to tell, but whatever her rationale, the stock dropped 13% on the announcement. 

Why do some companies manage expectations better than others? Here are some factors to consider.
  1. The audience: In providing guidance to markets, companies have conventionally thought of equity research analysts (especially sell side) as their primary audience. Ultimately, though, it is investor expectations that drive the game, and while analysts may influence those expectations, they are (in my view) more follower than leaders. The companies that are best at moulding expectations talk to investors, though they might use analysts as their messengers.
  2. The information: For a company to try to guide expectations, it has to have better information than investors do and be able to convey that information to markets. In particular, rather than just suggest that earnings expectations are too high, providing information on specifics such shipments or margins to back up the guidance will increase the impact it has. Companies argue that the Reg FD, the SEC's rule restricting selectively providing information to analysts, has restricted their capacity to provide meaningful guidance but note that the regulation does not prevent companies from making public disclosures to all investors.
  3. Credibility:  To be credible, companies that try to manage expectations have to be seen as trying to do both manage them down (when they are too high) and up (when they are too low). Too many companies seem to think that managing expectations just implied lowballing earnings and revenue numbers. A study of company guidance statements, the primary device for managing earnings expectations by Factset found that almost 80% of guidance provided by firms in the third quarter of 2012 was negative & designed to lower expectations (rather than raise them). A company that always tries to talk down expectations, while beating expectations each period, is like the boy who cried wolf, more likely to be ignored than listened to.
  4. Results: The game's denouement occurs when the actual news (earnings or other) comes out and investors measure it relative to expectations. If investors feel that companies are fudging the number or cooking the books to deliver actual earnings that beat expectations, they will at some point stop reacting to the news
It is the fact that information disclosures have become a game that has led some companies to choose not to play the game at all, either because they view it as a distraction from their mission of creating long term value for stockholders or because they think it is futile. In fact, my sense is that the payoff to companies from playing this game is become smaller over time and that more companies should consider the option of not playing.

Profiting from the investment game
Can you profit from the game? After all, there are lots of investors who try. In my earlier post on earnings reports, I noted the time and energy expended by analysts and portfolio managers trying to get ahead of the next report.  Without rehashing the evidence, I will draw on my favorite proposition in investing. Success at the investing table requires you to bring something to it, and to win the expectations game, you have to have an edge and here are the possible ones:
(1) Sector or company specific knowledge: You could invest resources in learning the inner details of companies in a sector (technology, health care) and use that knowledge to make judgments on which companies will deliver positive surprises and which ones will under perform.
(2) Forensic accounting skills: Accounting statements contain clues about future earnings, and a microscopic examination of current accounting statements may provide clues about the future.
(3) Inside information: I know, I know. It is illegal, at least in the United States, but that does not stop some from trying to use it to get an advantage.
I am too lazy to immerse myself into sector specific information, don't care much for delving deep into accounting statements and both too risk averse/outside the circle to get or use inside information.

Even if you don't want to play the quarter-to-quarter expectations game, you can perhaps turn the game to your advantage in one of two ways. The first is to use it in timing your investments, buying stocks that you think will deliver long term value (and were on your list of "buys" anyway) after they fail to meet expectations. Thus, if you have always wanted to add Apple to your list, you may feel that the Maps debacle is exactly the right time to jump in. The second is to build an investment strategy of buying (selling short) stocks right after "big" expectations failures (successes), on the assumption that investors are likely to be over reacting to the news. That is a strand of contrarian investing, albeit with a shorter time horizon and I posted on this strategy a few month ago.


Maria Rinehart said...

Expectations play a role. AAPL also has been going straight up since the summer. In the end 75% of stocks move together, and AAPL had for many reached its target. The question was should it go higher and for now the answer was no. It is about value in the end, eh.

Malloc Internal said...

Whether it is Apple (and it's stock) or it is Obama (and his debate), I believe, it is difficult to defend your top position. The change in expectations increase exponentially as previous expectations are met and expectations from AAPL weren't different. With respect to RIM (and Nokia), the company has one of the best assets, in the form of talent and defensive patents, in the industry. It wasn't a surprise to see phoenix rise from the ash as management realigned/showcased it's strategy.

Anonymous said...

Dear Prof
This has reference to implied risk premium calculator for Sensex in September 2007. As per your lecture note packet 1 - page 67, you have used dividend yield for Sensex in Sept 2007 at 3.05%. However, somehow I see that as per Sensex website it is 1.11% (http://beta.bseindia.com/markets/keystatics/Keystat_ratois.aspx?expandable=2)
I am wondering whether I have used the correct source.
Your help would be useful to me as guidance for my future computations.
Please let me know how dividend yield comes to 3.05% (website url as a source would help).

Jason DaCruz said...

Thanks for the post professor! In Apple's case, I've wondered whether they'd be able to keep up their 'innovation' momentum. Yesterday, after reading Farhad Manjoo's article in Slate re Apple's iPhone 5, it struck me that I only found the article interesting because of its contrarian approach: that all the frivolous subjective design nonsense that Jon Ives expounded upon summed up to a fantastic phone. Gives you an idea of where popular sentiment stands...

I'm not sure how much weight that story holds, but I am sure that Apple is having a hard time impressing consumers like myself.

Anonymous said...

On July 16, the NYT reported that “Early bird gets the worm”, referring to a study of 2004 which described handsome profits by investors timely reacting on analysts’ updates on their estimates during 1999-2002. By betting long on upwards revisions of small stocks and short on downwards revisions of large stocks, annualized gains were of the order of 30%/year.

Analysts’ estimates, like the expectations of economists are notoriously unreliable. It is amazing that investors still strongly react on missed estimates and revisions thereof although they know they rarely come through. I don’t believe that it makes sense to pinpoint to the expectations of a certain stock like Apple. Valuations and expectations thereof are statistical quantities that may or may not be true. When you want to play the expectation game, make sure you hedge positive expectations with negative ones. For instance, weekly select the dozen or so small stocks with the highest positive estimate revisions and hedge those with the dozen or so large stocks with the lowest negative estimate revisions. From 1999 onwards, that gave you annualized gains of 30%/year with a maximum drawdown of 10%. If you would have known these revisions a week earlier, your profits would have ballooned to over 60%/year: Early bird gets the worm.

Anonymous said...

“you don’t win by predicting the future; you win by getting the odds right”

Anonymous said...

"Thus, if you have always wanted to add Apple to your list, you may feel that the Maps debacle is exactly the right time to jump in."

eventhough you sold AAPL. do you put an entery price? (as in FB)


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Aswath Damodaran said...

Since I exited Apple to avoid this lunacy of quarter-to-quarter obsession with earnings and price reaction to non-news items, my entry point for Apple will be when that behavior subsides. That may take a shaking out in its stockholder base...

Anonymous said...



Indigo said...

I submit that - generally - markets react differently to good news and bad news affecting a stock.
Bad news makes a share price 'sink like a stone' immediately; while good news takes a while to get some purchase with investors: it takes some time for the market to absorb and accept good news as credible; so the share price gradually rises after the good news is received.
Anecdotal evidence vindicates this difference in approach to news. For example: some people ventured back into Uranium shares after the dust had settled on the Fukushima disaster - only to find that there had been a cover-up of the true scale of the calamity and the risks attending it.

Subu said...

Dear Prof Ashwath

///////Since I exited Apple to avoid this lunacy of quarter-to-quarter obsession with earnings and price reaction to non-news items, my entry point for Apple will be when that behavior subsides. That may take a shaking out in its stockholder base...

October 13, 2012 4:37 PM///////


being the extraordinary intelligence you are , don't you sometimes feel the urge to trade this lunacy ?

or do you just keep that urge under wraps ?


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Claudio Timber said...

I chose iphone because the rest are either crap or sort of. Blackberry is ugly looking, Samsung is too big in size, Nokia and the other... well..I negated them. So what is left is iphone. iPhone site

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Caloundra Bookkeeping said...

I am amaze how sports could tickle our emotions. Unconsciously, we are being driven out on how we react but watching sports is a good past time to do.

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