Columbia University Press sent me a copy of Expectation Investing by Michael Mauboussin and Alfred Rappaport to read and review. So thank you very much.
Q3 2021 hedge fund letters, conferences and more
Expectations Investing: Reading Stock Prices for Better Returns by Michael Mauboussin, Alfred Rappaport
This book is a special one. It’s not a new book. It’s a classic that just celebrated it’s 20 anniversary. This edition has been revised for modern time. It takes into account changes to accounting, the rise of intangibles investments, the shift to passive investing, among other things. Even a great home need a fresh coat of paint.
If you have been in the investmentverse, Michael Mauboussin and Alfred Rappaport don’t need an introduction. They are both pillars in investment research. I consider myself privilege to review their work.
Mr. Mauboussin is known for his top-notch research and knowledge. He is a researcher at Morgan Stanley Investment Management. He’s very generous with sharing his knowledge. He’s active on Twitter (in a good positive way). His work is always on some “must read” investment list.
Al Rappaport is professor emeritus at Kellogg School of Management and one of the most respected experts on markets. He’s known as the economist who developed the concept of shareholder value in the 1980s and he wrote a book on the topic: Creating Shareholder Value: A Guide for Managers and Investors. According to Wikipedia Al would be 89 years old today. I don’t know what he’s up to now but he left us with a high-quality body of work to learn from. Here’s an article he wrote for the Harvard Business Review, Ten Ways to Create Shareholder Value, that includes a subtext on Berkshire Hathaway by M. Mauboussin.
Most financial textbooks share three things in common: massive, boring and expensive. Not this one. Expectation Investing is 272 pages of wisdom. You can get a copy from Columbia University and Amazon for less than $30. There’s a Howard Mark quote on the cover that says: “…a gradual-level course in intelligent investing”. A graduate level class in finance cost more than $30. And it’s not just that. You can actually make a lot more money if you apply their method properly. This is great value, especially if you include inflation.
Sometimes it is good to go back to basics. Investors who seek market-beating returns need to find stocks with meaningful differences between their price and value. The problem is that price is known but value is not. It takes the textbook material out for a spin in the real world. I wish that was the book I had to read in school.
While reading the book I got reminded by what one of my professor said during a 4th economic class. He said something like “here’s what you learned the last 3 years, and now I’m going to show you why it doesn’t work”. Expecting Investing has that feel, “here’s what you have been thought, and here’s a better way.” It take the classic financial textbook stuff and reverse it on its head.
For example, a popular tool to value a company is the discounted cash flow model (DCF). You begin with a cash flow forecast to estimate value. The book suggests to inverse the common practice. It’s basically a inverted DCF. You start with the price and work you way back. The idea is that stock prices are a treasure of information about market’s expectations of a company’s future performance. So you’re basically asking, “What is the market saying at this share price? You can have investment success if you manage to estimate the level of expected performance embedded in the current stock price.
Another example: When it comes to forecast period, most valuation texts advocate arbitrary five or ten year periods. Other says you should use a business cycle. Why? Well we all kind of accepted that’s the way because that what everybody does, so who I am to question big expensive books. Expectation Investing suggests that the forecast period is the time that market expects a company to generate returns on incremental investment that exceeds its cost of capital. Why didn’t I think of that first? Thank you for the dose of common sense.
I can go on and on but the point is that the book’s insights are powerful and will make you think. You will have many takeaways.
This is book is for people who are serious about valuation work. Valuation is a subjective art, not a science. I mean it’s much easier to slap a multiple to earnings and call it a day. We know that value equals the present value of a company’s future cash flows. Few investors disagree with this in theory, but many are wary of analytical models that value, or “discount”, future cash flows because they find them too speculative. Include me in that group. That’s why I find the inverted DCF and the “expectation infrastructure” attractive.
If you are a student of “the game of investing”, this is a book for you. If you are going to invest time in reading this book, be prepared for an adventure in high-level investing. It will certainly offer a deeper understanding of a different investing approach. The combination of Michael Mauboussin and Alfred Rappaport’s insights will make you a better investor if you’re inclined. You learn how to read stock prices. If you can them effectively, you can apply your strengths and take advantage of opportunities the market gives you. It will make you a more complete investor.
Critics
I’m not really in a position to critique guys like Mauboussin and Rappaport. This is a great piece of work but everything is not perfect. Here’s a couple things I though of:
- If you are new to investing, don’t start here. I’m not saying not to read it. Read it. But you might not grasp everything on the first read. It definitely help to have some background in investing and valuation.
- Not easy to put into practice. Let’s call it a work in progress.
- There’s too much reason in the method suggested. It’s too logical for this world. If you are in the portfolio management business, you know timing is not on your side. That’s why most portfolio managers are closet indexers or engage in momentum trading. Unfortunately such a get strategy is not applied broadly. But that’s not the authors’ fault. And if you are a long-term investor, this is an edge you can have.
Article by Brian Langis
