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Don't Believe Everything You Read


Talk about great expectations. A new book on investing is being endorsed by a veritable murderer's row of finance sluggers, from strategist Peter Bernstein and TIAA-CREF's resident rocket scientist, Martin Leibowitz, to that DiMaggio of money managers, Legg Mason's Bill Miller. Vanguard Group founder Jack Bogle even posted a five-star review at Amazon.com (AMZN). These guys all agree that Expectations Investing: Reading Stock Prices for Better Returns is a home run. And I'm here to tell you it ain't.

It's not because the authors, Northwestern University emeritus professor Alfred Rappaport and Credit Suisse First Boston strategist Michael Mauboussin, are bums. Rappaport's 1986 book, Creating Shareholder Value, has wielded vast influence on corporate decision-making, while Mauboussin's distinctive essays on applying scientific esoterica to the market enjoy an avid following on Wall Street. But with Expectations Investing and its companion Web site (table), something went awry.

Rappaport and Mauboussin see most investors as hopelessly lost in their quest for mispriced stocks, since they rely on such crude tools as price-earnings ratios. We would do better, they say, focusing on free cash flow. Fair enough, even if this is the Street's worst-kept secret. Then they suggest a twist: Instead of forecasting a company's cash flow and using it to find a fair stock price, why not examine today's stock price to see what it implies about investor expectations? If the stock suggests expectations for unreasonably high cash flows, sell it. If expectations seem too low, it's a buy.

To show how to do this, the book studies computer maker Gateway in April, 2000, at $52 a share. The math finds $52 is justified only by making such assumptions as 20% annual sales growth and 9% operating margins through 2006. There's nothing "revolutionary," as the authors boast, about working backwards. It just reverses what thoughtful investors do all the time (and what you can do for free at www.valuepro.net). They also played out more bullish and bearish scenarios, finding fair values from $18 to $76.

Yet no set of assumptions that they deemed reasonable in April, 2000, proved right. Gateway trades today under $6. Only those who foresaw shrinking sales and margins profited. It's the same old story: Working backward or forward, success rests on your assumptions.

The authors step into quicksand when they go beyond cash flow into something called "real-options value" analysis. Suppose cash-flow expectations do not justify a stock's price (think profitless Internet companies). Real-options analysis looks for extra value in a company's strategic options. Consider, as the authors did, Amazon.com in early 2000, at $64 a share. Even with generous assumptions, cash-flow analysis valued Amazon at $35. Could the extra $29 be in "real options" Amazon held to, say, expand into other lines? With lots of math, the book answers "no." To have exploited those imputed options, it says Amazon needed to put $28 billion into new projects in two years--a wacky prospect, since in the prior three years it had invested less than $2 billion. Amazon is now under $9, and any wisp of real-options value is long gone. Yet the book promotes this as a great way to gauge hard-to-value stocks.

SNAKE OIL. For all its elegance, the real-options formula strikes me as an elixir for anyone bent on rationalizing a crazy stock price. Instead of a sharp valuation tool, it's a prescription for snake oil. If humans are susceptible to hucksters promising cigarettes that "taste good," we are also capable of swallowing Amazon at $64, along with dreams it would be Earth's No. 1 store. Who knows exactly where Amazon's superb stock promotion ended and its real-options value began? No one.

While Expectations Investing often falls into such consultantspeak as "turbo trigger," it has strong parts on evaluating mergers and liabilities from employee stock options. Yet the book fails to deliver its promise of "the best available process to achieve superior returns." Investors, it notes, win by foreseeing changes in expectations. So if endorsements of this book prompt you to buy it, first take your expectations and revise them down, way down.

Corrections and Clarifications

The contents page entry for the Barker Portfolio (Oct. 29) should have listed Rappaport and Mauboussin as authors of Expectations Investing--not Bernstein and Leibowitz, who merely endorsed the book.

By Robert Barker


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