Notes on the Importance of Managing Shareholder Expectations

In the baseball industry, when scouts evaluate a baseball player, they tend to describe the current talent as their "floor" and their future talent as their "ceiling." When a player hits a lot of home runs or if a pitcher collects an abundance of strikeouts in a given year, their projected ceiling goes up in the eyes of scouts. Therefore, the player needs to continue to improve not just at the same rate year after year, but the improvement needs to be exceptional, as the expectations of the scouts will continue to rise. If the player does not meet the scout's expectations, they could be in danger of their future value decreasing. 

Now that is an overly-simplistic description of how the evaluation process works in baseball, however, it’s a good analogy to explain the dynamics of the relationship between companies and shareholders. When a company beats expectations, and the market believes the improvement is sustainable, the company's stock price will go up - or in baseball terms, the companies ceiling is higher. This is because shareholders buy more of the stock because they want to capitalize on the company's future value, not the current value. However, because shareholders believe that there is serious future value to capitalize on, like the baseball prospects, the managers of the company itself will have to add more value than they did the year before. 

Another good analogy to explain this is using the functionality of the treadmill. In this analogy, the company's growth equates to the treadmill's speed. The more growth the managers add, the more speed is added to the treadmill, forcing the managers to 'run' faster, which I think we can all agree is only sustainable to a certain degree. If you don't understand, try walking on a treadmill at 3 mph and then immediately jumping it to 12 mph. This is the exact relationship between growth and shareholder expectations. This is why companies with low expectations of success among shareholders at the beginning of a period may have an easier time outperforming the stock market. Low expectations are easier to beat. Also, at some point, it can become almost impossible for managers to deliver on increasing expectations without miscalculating and floundering. 

This is why the most talented managers try to manage shareholders' expectations. They do this by delivering only reasonable TSR (total shareholder return) and communicating plausible & modest projections. Even the best managers in the world can't beat excessively high expectations. These managers are aware of the dangers associated with those kinds of expectations. This is also why you see legendary investors such as Warren Buffet and Charlie Munger value companies who show slow growth over time and talk about the importance of managing expectations. Companies that focus on both of those tend to avoid volatility, making them a better long-term investment. 

There can be many vulnerabilities attached to companies with excessively high expectations. For example, in their quest to achieve their projected TSR, managers could resort to bad behavior or misguided actions such as continuing to push for unrealistic earnings growth or pursuing risky acquisitions. 

Peloton is the most recent example of this behavior. Peloton was focusing on growth when they should have been focusing on improving their ROIC, Cash Flows, and managing investors' expectations during the frenzy of the WFH trend that increased their sales.

Instead, they decided to give in to the confirmation bias that they did something operationally to improve this rapid growth instead of realizing that this was just a result of luck from closed gyms during COVID-19. This resulted in Peloton predicting excessive growth YoY, irresponsible spending, and executing acquisitions that they could not afford or operationally handle. As a result, Peloton has recently halted production of their products and has hired Mckinsey to review their cost structure. Perhaps the managers should have taken note from Apple where the CEO, Tim Cook, does an excellent job managing their projections which allows them to consistently beat shareholder expectations.

I like the treadmill analogy because it's dynamic enough to show that in some cases, a good investment and a good company may not be the same thing. Good companies may not be suitable investments because the upside may already be built into the share price. On the other hand, savvy investors usually prefer weaker-performing companies because they have more upside potential. As a result, the expectations expressed in their lower share price are easier to value especially when you start to do your research and take a hard look at the management's decision-making and metrics such as ROIC and Cash Flow over time, highlighting the effectiveness of the manager's decisions.