Low Expectations, Blockbuster Returns

06/08/2011 11:49 am EST

Focus: STOCKS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

Unloved value stocks are a patient investor’s best bets, while the negativity now in the market is a promising contrarian indicator, writes John Reese of the Validea Hot List.

Joel Greenblatt—the hedge fund guru upon whose writings I base one of my best-performing strategies—recently discussed the nuts and bolts of value investing in an interview with Barron's.

"The way we make money as a group," Greenblatt explained, "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.

“And, hopefully, you don't lose much on the ones that don't do better than the low expectations, because you didn't pay much for them in the first place."

While Greenblatt has used this mindset to great success, he's not the first to embrace it. Benjamin Graham, the man known as 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 Graham’s 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).

The Wall Street Journal's Jason Zweig, who provided commentary in Graham's revised version of The Intelligent Investor, had this to say in discussing expectations and margin of safety: "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."

NEXT: History Favors Value

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History Favors Value
History does indeed show that value stocks—which usually have low expectations—as a group have outperformed growth stocks, which usually have higher expectations, over the long haul.

  • From 1927 through 2009, US large-cap growth stocks averaged a 9.08% annual compound return, according to the data of Dartmouth college professor and noted stock researcher Kenneth French. Small-cap growth stocks, meanwhile, averaged 9.23%.
  • On the value side, large-cap value plays averaged 11.21%, and well ahead of the pack were small-cap value stocks, which returned an average of 14.17% per year.

(For the breakpoint between small and large stocks, French and colleague Eugene Fama use the mean market equity of New York Stock Exchange stocks. Growth stocks are defined as those in the bottom 30% of the market, based on book/market ratios; value stocks are those in the top 30%.)

Perhaps more than any of the gurus I follow, David Dreman put great emphasis on investor expectations and their impact on investment strategy. Dreman believed that investors' penchant for overreaction often makes popular stocks overpriced and unpopular stocks underpriced.

Because of that, popular stocks have a long way to fall if they don't meet expectations, and little room to climb in the event they meet or exceed expectations. Because unpopular stocks are often already undervalued, however, they have a lot of room to climb if the company meets or exceeds expectations, and not much room to fall if the company disappoints.

"Negative surprises are like water off a duck's back for [stocks with the lowest valuations]," Dreman wrote in Contrarian Investment Strategies. "Investors have low expectations for what they consider lackluster or bad stocks, and when they do disappoint, few eyebrows are raised.

“Consider the 'best' companies, however. Investors expect only glowing prospects for these stocks. After all, they confidently—overconfidently—believe that they can divine the future of a 'good' stock with precision. These stocks are not supposed to disappoint; people pay top dollar for them for exactly this reason. So when the negative surprise arrives, the results are devastating."

Dreman believed, moreover, that surprises occurred a lot in the stock market, in part because analysts so often miss the mark with their earnings estimates.

"There is only a 1 in 130 chance that the analysts' consensus forecast will be within 5% for any four consecutive quarters," he wrote. "To put this in perspective, your odds are ten times greater of being the big winner of the New York Lottery than of pinpointing earnings five years ahead.

"Because of the frequent surprises in the market, focusing on unloved stocks could net you big rewards over the long run," his extensive research on historical stock returns found.

Contrarian gurus beat the market because they do what few investors can do: buy solid stocks when expectations are very low, which they always are as bear markets wear on. Similarly, those investors who jump onto hot stocks with high expectations—or who jump into the market when broader expectations for stocks are high—usually end up getting hit hard.

Drowning in Gloom and Doom
This is why I actually find the copious amount of negative news stories swirling around the stock market to be a good sign.

Recently, for example, the top stories on CNBC.com included:

  • one about banking giant UBS (UBS) "falling apart";
  • one on the Federal Deposit Insurance Corp. chief saying a US debt default would be "calamitous";
  • and one on how foreclosures are becoming a bigger part of the US housing market.

That's not to mention the lingering Eurozone debt crisis, the continued fallout from the Japan earthquake and tsunami, and fears about what will happen when the Federal Reserve's latest round of quantitative easing ends.

To be sure, all of those issues are legitimate and must be dealt with. But while these problems may inspire fear, they also lower expectations—and investors' tendency to be myopic often leads those expectations to become unrealistically low. For disciplined investors, that signals opportunity.

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