Aswath Demodaran, the legendary NYU finance professor, ponders why Baltimore Orioles’ fans are so excited their team has made the postseason, while New Yorkers are rather ho-hum about the Yankees’ seemingly perennial inclusion–and relates this to stock movements.His conclusion: what is true for baseball fans is true for the markets — responses are not dictated by performance, but rather, by performance relative to expectations.
This is common sense that is often ignored in investing.
Consider the following cases:
A) Sales of the new iPhone 5s are on pace to shatter smart phone records.
B) A Research in Motion earnings report showed a decrease in revenues by 35% and a $235 million loss in 2Q 2012.
Some might assume that Apple’s stock price would rise based on this news, and RIM’s would tumble.
However, a company’s absolute performance is often not the most important criterion in determining stock movement.
In the short term, market reactions are based upon performance relative to expectations.
Apple’s (APPL) stock has fallen from a high of 705.07 to a current price of 626.58. Some experts attribute it to less than stellar product offerings. Even though its most recent offerings are sold out in many stores, Apple’s showing just wasn’t impressive enough.
By contrast, RIM’s losses were lower than expected — causing the company’s stock to rise 18%.
The bar for Apple was set too high to jump over; RIM’s bar was too low to limbo under.
To manage expectations is to walk a fine line, without walking the plank. Investors require information, as specific as possible, to ensure an adequate market reaction. These adjustments will only be made if investors believe the company’s news is credible. Companies that best control expectations do so by managing them up when appropriate, rather than only understating revenues, growth, or other projections.
Read more at Professor Damodaran’s blog.