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

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.

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