Expectations Investing. (Director Library).
Published by Harvard Business School Press, Boston, Mass., 226 pages, $29.95
AL RAPPAPORT has written a new book, Expectations Investing: Reading Stock Prices for Better Returns, with Credit Suisse First Boston's equally accomplished (though in somewhat different realms) Michael J. Mauboussin. It belongs on your bookshelf.
Expectations Investing (El) builds on two ideas: first, that one can read investor expectations into stock prices; and second, that one can only beat the market by correctly anticipating changes to those price-implied expectations. While this sounds like, and is, an investing book, it has great power for the corporate executive and board member.
The authors point the reader at precisely where to look for -- and how to assay -- the relative significance of different revisions to expectations and thereby demystify the price-setting process. That they do so by breaking down the silos that typically gird finance, competitive analysis, investor relations, and behavioral science is unique; that they do it so well is truly distinctive.
Everyone on Wall Street (Mr. Mauboussin, for example) wants to find cheap stocks; every company wants to avoid being one. An incredibly large sum is spent to do both -- by Wall Street on the billions of dollars spent for investment research, trading and the like, and by companies to court Wall Street favor. A large body of knowledge suggests that markets are rather adept (in part due to that spending) at setting individual valuations where they belong, given the available information. But many of us sometimes have trouble hearing what the market is telling us, perhaps because we lack an objective way to decode those expectations and to challenge them in a constructive manner. Hence, strategic investor relations/value enhancement efforts can be impaired by subjectivity and false assumptions.
Shareholder value is about doing the things that investors esteem; remarkably, much confusion seems to yet prevail about precisely what investors revere. Just look at the quixotic fixation on quarterly earnings per share and on meeting or surpassing the "whisper" number, at the growing volume of market commentary by telegenic broadcasters consumed by anecdote, at the cumbersome and distracting practice of grouping companies within "growth," "income" or other investment "styles," and at the awkward and stilted prose that emerges when corporate communication becomes "corporate cosmetology."
No wonder corporate directors sometimes express frustration in their primary duty -- to be sure the right team is doing the right things to make shareholders richer -- when managers themselves may lack a "true north." EI argues that this complex company-investor interface is, contrary to popular opinion, remarkably coherent and implicitly harmonious because investors and managers in fact share a focus on the long (versus short) term, on economic (versus GAAP) profits, and on firms' real position in the product/service and capital markets -- despite all that "noise." Both sides have their eyes on the right balls; they just seem to be confused about each other's values, intent, and language.
Messrs. Rappaport and Mauboussin, the first with decades of corporate consulting experience, the second a well-regarded head of research, are ideal partners to give both sides a common language and methodology through which to express the values managers and investors share. The three-step El approach retains the discounted cash flow model so dear to Wall Street, but then estimates the cash flows, cost of capital, and forecast horizon that justify current stock price. Then, they urge the reader to:
* Determine consensus forecasts for those value drivers -- sales growth, operating margin, and incremental investment.
* Look at what management/you are telling investors about the drivers.
* Assess who is most likely closer to the truth after checking history.
* Treat outstanding employee stock options (ESOs) as debt, then estimate future grants and treat them as an expense (cutting operating margin).
* Finally, having estimated cost of capital and the market's free cash flow expectations, extend the forecast horizon in the discounted cash flow models as many years as it takes to arrive at today's stock price.
The balance of the book is about where to look for -- and how heavily to weight -- different changes in investor expectations and the possible valuation effects. They set out an "Expectations Infrastructure" and caution that sales growth is the "turbo trigger" from which margin improvement is gained (not, as many presume, cost reduction).
There's one thing the authors leave out (unintentionally, although Rappaport has for years conducted "market signals analyses" for clients that do this): the value of opinion research with price-setting investors. By marrying the rich quantitative yield from EI with the subjective, but nevertheless illuminating, insights gleaned from thoughtful conversations with investors, a fully realized valuation picture emerges. We've preached for such a holistic picture for two decades; experience has taught us that it enlivens and enriches the dialogue managements have with the market, and actually has a "haloing" effect that by itself acts to close value gaps when they truly exist. This is what investor relations is all about.
The writers devote a quarter of the book to "Reading Corporate Signals" -- assessing M&A, buybacks, and incentive compensation (see excerpt) in their EI framework. Investor relations officers typically put such decisions to music in the form of press releases and investor presentations; we often struggle to do so when asked to justify stock-for-stock acquisitions on goodwill avoidance and buybacks on mere "EPS accretion," dubious notions that EI disparages.
This is a valuable book and a novel one. It is valuable for many reasons, not least its insightful, articulate restatement of the valuation literature (to which both authors have made substantive contributions), and a novel one for the way it turns much valuation thinking on its head by tacitly challenging the investor and manager to rethink what truly drives valuation and to get on the same page about the process. That's a major advance, as we have come to expect from these two authors. (Note: More about EI can be found at www.expectationsinvesting.com.)
RELATED ARTICLE: A clear case for indexed options
Although CEOs consistently acknowledge the paramount importance of delivering superior returns to shareholders, we must recognize, as expectations investors, that standard stock-option plans do not distinguish between below-average and superior performance. In other words, boards are not setting the right level of required performance for incentive pay....
Can companies eliminate most of the limitations of standard stock-option grants? Yes. In fact, companies can design relatively straightforward option programs that reward exceptional performers with greater gains than they would achieve with standard options, while appropriately penalizing poor performers. Expectations investors should be alert to companies that adopt such a program and should advocate its implementation when possible.
An indexed-option program best aligns the interests of managers and shareholders seeking superior returns. With this kind of option, the exercise price that executives pay is tied either to an index of the company's competitors or to a broader market index. For example, if the chosen index increases by 20%, then the exercise price of the options increases by the same percentage. The indexed options in this case are worth exercising only if the company's shares rise more than 20%, outperforming the index.
Indexed options do not reward underperforming executives simply because the market is rising. Nor do they penalize superior performers because the market is steady or declining. If the index declines, then so does the exercise price, which keeps executives motivated even in a sustained bear market. Significantly, indexed options reward superior performance in all markets.
Despite their appeal and the support of notables such as Federal Reserve Chairman Alan Greenspan and a growing chorus of institutional investors, indexed options remain a rare species. CEOs shun them because they inject more risk into their compensation packages. Companies express additional concerns. For one thing, accounting rules penalize companies for using indexed options. Unlike standard options, companies must reflect the annual cost of indexed options on their income statement. For another thing, companies have to grant more indexed options than conventional options to provide a comparable initial value, and shareholders therefore suffer from "too much dilution."
Both concerns are misplaced. In the first case, the cost to shareholders is the same, whether a company charges option costs as an expense or whether it discloses the cost in a footnote to the financial statements.
The second concern, too, defies economic logic. Worries over dilution should not dwell on the number of options granted, but rather on the number that executives can exercise in the absence of superior performance. Because standard option plans can reward executives for below-average performance, they always pose a greater risk of economic dilution than do indexed-option plans.
From Expectations Investing by Alfred Rappaport and Michael J. Mauboussin, copyright (c)2001 by Alfred Rappaport and Michael J. Mauboussin, published by Harvard Business School Press.
Michael Seely is president of Investor Access Corp., the investor relations/value enhancement firm with offices in Stamford, Conn., and Dorset, Vt. (www.shvalue.com). He has worked with scores of companies to enhance their valuation and reputation. He is a director of the HSBC mutual funds and a frequent writer/speaker on finance and communications topics.
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|Publication:||Directors & Boards|
|Article Type:||Book Review|
|Date:||Jan 1, 2002|
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