Saturday, November 23, 2013

Investing is an Expectations Game

A thing long expected takes the form of the unexpected when at last it comes. - Mark Twain
In such a low-interest rate environment, why would the market allow companies to trade with 8%+ free cash flow yields -- even after considering a reasonable equity risk premium?

The answer lies in market expectations. For firms with very low free cash flow yields, the market is expecting robust free cash flow growth in the coming years; conversely, for firms with high free cash flow yields, the market might be expecting some free cash flow contraction.

In this graphic, you could justifiably substitute "expectations" for "price".

Naturally, higher market expectations also carry greater risk for market disappointment, and vice versa. As we're evaluating companies for potential investment, this is an important relationship to bear in mind.

To illustrate, I considered the free cash flow yields of some of the largest S&P 500 stocks:

As the list illustrates, the market has relatively lower expectations for Apple than it does Home Depot and lower expectations for Wal-Mart than it does Tesla. This doesn't necessarily mean that Apple is a better investment than Tesla at the moment, but it does mean that, in terms of market expectations, Tesla has much less room to make a mistake than Apple does.

While some stocks with high market expectations -- the Teslas, Amazons, etc. -- could end up being great investments by doing even better than the market currently expects, I think that investors will do have better results, on average, by investing in companies with low market expectations.

Yes, those companies could also do worse than the market expects and fall further in price, but if we conclude that a company's competitive advantages remain intact, the financials are sound, and that they're led by capable management, then there are fairly decent odds that the market's low expectations are wrong.

Whether we're looking for long or short candidates, as investors we want to find where the market's expectations are meaningfully different from our own. Before you begin researching a new company or re-evaluating a current holding, then, it's helpful to determine the company's free cash flow yield to see where it sits on the market expectations spectrum and how your own expectations might differ.

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Good reads this week:
Quote of the week: 
This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them. - Howard Marks, "Everyone Knows"
Happy Thanksgiving!


(long CSCO)