The Effect of Expectations

Value investing seems very simple – you buy a stock when it’s below its intrinsic value and sell it when it exceeds that intrinsic value. But in reality, making the right decisions is much more difficult, even if we could see the intrinsic value with mathematical precision and have better knowledge compared to the entire market.

A 5-lari painkiller actually works much better than a 50-tetri one (despite the content); wine served in a beautiful glass truly tastes better than in a regular one; something hot really feels hotter when we are warned in advance that it’s hot…

The placebo effect is still an unstudied phenomenon. It’s unclear how the brain manages to change real feelings and perceptions based on expectations. Pain relief is a research-backed fact, but how temperature self-regulation, sensory perception modification, and self-healing from illnesses happen is still the subject of study.

Due to the pre-formation of expectations, political parties are constantly polarized (not only here). They believe they stand on the side of truth against monsters. Fans always complain about unfair referee decisions because two fans from opposing teams genuinely see the same situation differently and with absolute conviction.

How is all of this related to investment decisions?

The influence of expectations on stock prices is such a complex and powerful phenomenon that the “intrinsic value of a stock” can lose its meaning even for years. The herd mentality drives the formation of expectations, and the price of a stock can float very high or very low for a long time. People filter information based on their expectations, reading and understanding only what they expect, while the truth remains hidden in the shadow of illusions.

What does this phenomenon give us in the context of investment decisions?

When should you sell a stock?

The first conclusion I’ve come to is that if I’ve bought a good company’s stock at a good price, it doesn’t matter how much it appreciates – I will never sell it. Or, more precisely, I won’t sell it unless I have a better alternative at hand, because if I do, the stock may never return to its fair level, and I could miss out on a great opportunity.

When should you buy a stock?

There are two approaches here:

1. Find a stock that is significantly undervalued, has good growth potential, and buy it cheap (for example, I recently bought Intel’s stock at $19 because it had even fallen below its book value).
2. Buy a good company at a fair price. (For me, a good company means one with a 15%+ net margin and 25%+ ROIC).

In the past, value investors leaned towards the first approach, but now they have shifted more towards the second. I think experience has shown that the influence of illusions on reality is very long-lasting.

Here’s how I explain it:

When a stock’s price suddenly falls, it continues to drop for a long time. Initially, there’s a historical perception that the company is “efficient” and the price will return to a “logical” level. Therefore, the price doesn’t fall to the bottom all at once… It happens slowly, as investors gradually come to terms with the loss.

Then expectations gradually form that the company has “fallen apart” and will never be good again. As a result, the price falls below its intrinsic value. These expectations linger for a long time until the company manages to open Mister Market’s eyes by showing through a few “good” quarters that things aren’t as bad as they seemed. Hence, the return of the stock price to its intrinsic value is a long-term process.

As for buying a good company at a fair price, that’s a very difficult task. Good companies are usually not only valuable because they have good margins and competitive advantages, but also because they have a historical high growth rate. In such cases, market expectations for future growth are high, and therefore, the stock price is usually very high.

That’s why I think buying a stock at a fair price in high-growth companies is unrealistic. On the other hand, the good news is that it’s impossible to grow at a high rate forever. And if we wait for Mister Market’s boiling expectations to cool down after the growth rate of sales slows, we might be able to buy a good compounding machine.

Behavioral ideas from the book:

Predictably Irrational: The Hidden Forces That Shape Our Decisions by Dan Ariely.