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The hopes around a stock, or a baseball player, can sometimes be so high that disappointment is nearly inevitable. (Dave Tulis/AP)
The hopes around a stock, or a baseball player, can sometimes be so high that disappointment is nearly inevitable. (Dave Tulis/AP)

STRATEGY

Playing the expectations game: How investors can hit a home run Add to ...

John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the Omega Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.

With the Major League Baseball season now about three-quarters done, consider these two teams:

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Team 1: 54-64 record, 16 games out of first place, minus-39 run differential (meaning in total it has scored 39 fewer runs than opponents), 0.1 per cent chance of making the playoffs, has sold 65.3 per cent of seats at home games.

Team 2: 54-62 record, 16.5 games out of first place, minus-26 run differential, 0.9 per cent chance of making the playoffs, has sold 64.8 per cent of seats at home games (all stats according to ESPN.com, through Aug. 13).

At first glance, these two ball clubs seem to have had very similar, below-average seasons. In reality, the difference is huge, and it’s all about expectations. Team 1 is Toronto’s own Blue Jays, while Team 2 is the New York Mets.

Before the season, the Jays added a number of high-profile players – including ex-Mets and former All Stars R.A. Dickey and Jose Reyes – adding dramatically to their payroll. The Mets, meanwhile, cut their payroll sharply and trotted out a mostly no-name lineup.

Las Vegas odds makers had the Mets winning just 74 games, and the Jays winning 86.5; six of Sports Illustrated’s seven baseball “experts” had the Jays making the playoffs; none picked the Mets. The Blue Jays have thus been bashed by fans, the media and analysts this year, while the Mets have flown largely under the radar.

Two teams, similar results – and totally different reactions and perceptions.

This happens all the time in investing. In the final quarter of 2012, for example, Apple’s earnings fell 0.5 per cent, and sales increased more than 17 per cent. In the two days following the announcement, however, shares tumbled 14.4 per cent. Bank of America’s earnings, meanwhile, plummeted 80 per cent in its fourth quarter, with revenue down almost 10 per cent. Its shares? They slipped just 5.4 per cent, and quickly returned to pre-earnings-report levels.

The difference was that Apple’s incredible decade-plus run led investors to expect the world from the tech dynamo. Anything short of incredible growth was a huge disappointment. Bank of America, meanwhile, was a poster child of the 2008-09 financial crisis, its earnings decimated in recent years as it flirted with bankruptcy. Investors weren’t expecting much more than mere continued existence from it.

Many of history’s best investors have been well aware of the impact of expectations on stocks, and have used it to their advantage. Benjamin Graham, the father of value investing, recognized this more than half a century ago. The “margin of safety” concept that guided his investment philosophy was based on the idea that stocks with high expectations (i.e., high valuations) would be hit much harder if something went wrong than would stocks with low expectations.

Canadian-born David Dreman wrote extensively about this. “Negative surprises [like earnings disappointments] are like water off a duck’s back for [stocks with the lowest valuations],” he said in Contrarian Investment Strategies. “Investors have low expectations for what they consider lacklustre or bad stocks, and when they do disappoint, few eyebrows are raised.” For the highly valued stocks considered the “best,” however, when negative surprises arrive, “the results are devastating,” Mr. Dreman said.

Jason Zweig, a financial columnist and author, who wrote commentary as part of the most recent version of Mr. Graham’s The Intelligent Investor, agreed. “Recent history – and a mountain of financial research – have shown that the market is unkindest to rapidly growing companies that suddenly report a fall in earnings,” he wrote. “Great expectations lead to great disappointment if they are not met; a failure to meet moderate expectations leads to a much milder reaction. Thus, one of the biggest risks in owning growth stocks is not that their growth will stop, but merely that it will slow down. And in the long run, that is not merely a risk, but a virtual certainty.”

One place to look for ideas, therefore, is the list of most-shorted stocks. But you also need to identify the highly shorted stocks that are being maligned not because of serious long-term problems, but instead because of overwrought fears or short-term issues. I recently ran Globe Investor’s list of the most-shorted TSX shares (to July 31) through my guru-inspired strategies, which subjects stocks to a myriad of financial and fundamental tests. Here are three that look like good bets to surprise pessimistic investors.

BCE Inc.: The Montreal-based CTV parent ($32-billion market cap) has a solid 15.5-per-cent long-term earnings growth rate, (using an average of the three- , four- and five-year earnings per share growth rates), 12.6 price-earnings ratio, and 5.5 per cent dividend yield. All of which helps to explain why my Peter Lynch-based model likes the stock – even though fears that Verizon will enter Canada’s wireless market have investors shorting more than 23 million of its shares.

Encana Corp.: This natural gas producing large-cap ($13-billion) has suffered recently, thanks to global economic worries and some strategic mistakes. But my James O’Shaughnessy-based model thinks it’s a good value, even though investors are shorting more than 30 million of its shares. It likes Encana’s size, $4.76 in cash flow per share, and 4.5-per-cent dividend yield.

Royal Bank of Canada: With the 2008-09 financial crisis still lingering in investors’ minds, a number of financials are among the TSX’s most-shorted stocks, including RBC. But while more than 25 million of its shares are being shorted, my O’Shaughnessy model likes its size ($92-billion market cap), cash flow ($6.99 a share), and 4-per-cent dividend.

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