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Lower expectations make the returns that much sweeter Add to ...

It's summer blockbuster time for the movie industry, the time of year when throngs of people line up to see the latest big-budget, big-hype films.

If you're like me, you've probably had the experience of going to one of these overhyped movies and walking away less than thrilled. The movie might not have been bad – in fact, it might have been quite good. But once the buzz surrounding a film reaches a certain level, it's hard to live up to the hype.

Expectations play a big role in determining how you respond to a movie. They also play a large role in how and why value investing works.

That's what Joel Greenblatt, the hedge fund guru, recently discussed in an interview with Barron’s. “The way we make money as a group,” he said, “is that we don’t pay a lot for anything, and most of the stocks we buy have low expectations. So if the future is a little better or a lot better than the low expectations – it doesn't have to be great – you have the chance for asymmetric returns on the upside.”

Mr. Greenblatt is by no means the first to embrace such an approach. Benjamin Graham, the father of value investing, recognized more than half a century ago that expectations were a big factor in stock returns.

The “margin of safety” concept that guided his investment philosophy was based on the idea that stocks with high valuations (i.e., high expectations) would be hit much harder if something went wrong than would stocks with low valuations (i.e., low expectations).

History does indeed show that value stocks, which usually have low expectations, outperform growth stocks as a group over the long haul.

From 1927 through 2009, U.S. large-cap growth stocks averaged a 9.08-per-cent annual compound return, according to Kenneth French of Dartmouth College, while small-cap growth stocks averaged 9.23 per cent. Large-cap value plays, however, averaged 11.21 per cent. And well ahead of the pack were small-cap value stocks, which returned an average of 14.17 per cent a year.

Overreacting and Surprises

Perhaps more than any of the gurus I follow, Canada-born David Dreman puts great emphasis on investor expectations, and their impact on investment strategy. Mr. Dreman believes two key things: that investors tend to overreact to surprises (like firms beating or falling short of analysts’ earnings projections), and that surprises occurred often in the stock market.

“Negative surprises are like water off a duck’s back for [stocks with the lowest valuations],” he has written. “Investors have low expectations for what they consider lacklustre or bad stocks, and when they do disappoint, few eyebrows are raised.”

For the stocks considered the “best,” however, investors pay top dollar and expect nothing but great results. With expectations sky-high, good surprises don’t give the stock all that much of a boost. But, when negative surprises arrive, “the results are devastating,” Mr. Dreman says.



Of course, sometimes expectations are low for good reason – a company is a dog, and everyone knows it. That's why you should look not only for attractively valued shares, but also for companies that meet a variety of quality tests. Return on equity, free cash flow and debt levels are all variables you can use to identify good, solid businesses.

Right now, I see a lot of quality in the U.S. and Canadian markets. And despite the two-year bull run, I also see a lot of lingering fears and low expectations, which are holding down the valuations of some quality investments. The lingering euro zone debt crisis, the continued fallout from the earthquake and tsunami in Japan, and fears about what will happen when the Federal Reserve’s latest round of quantitative easing ends are just some of the fears weighing on investors right now.

All of those issues are legitimate and must be dealt with. But while these problems inspire fear, they also lower expectations for many quality companies – and investors’ tendency to be myopic often leads those expectations to become unrealistically low. For disciplined investors, that signals opportunity.

 

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