Stephen Hawking can teach you a lot about investing. And I'm not talking about an astrophysics lecture.
In an interview with The New York Times, Hawking was asked how, paralyzed and unable to talk after being diagnosed with a motor neuron disease in his early 20s, he has remained happy. He replied: "My expectations were reduced to zero when I was twenty-one. Everything since then has been a bonus."
If that line doesn't ram the incredible power of expectations into your brain, I'm not sure what will. This is actually a central principle in the field of positive psychology: The success of an experience is almost entirely determined by one's starting expectations.
Not to compare Hawking's tragedy with something as superficial as the stock market, but this is also a central principle of investing, even in a more literal sense. I started thinking more about this after watching a presentation by investor Vitaliy Katsenelson. Poring over 110 years of data, Katsenelson determined that investment returns are influenced less by the economy, earnings growth, or interest rates, as they are the market's expectations at the time you initiate your investment.
Start investing when the market expects the world, and valuations are high, and you'll probably lose money. Start investing when the market expects nothing, and valuations are low, and you'll be just fine. That's what Stephen Hawking can teach investors.
In value investing, this philosophy has been repeated ad nauseam. "Be fearful when others are greedy, and greedy when others are fearful," says Warren Buffett -- as we've all heard a gazillion times.
The idea is true, of course, and Berkshire Hathaway
Here are three examples.
Exhibit A: Cisco, circa 2000
At the peak of the dot-com bubble, Cisco Systems
To justify this silly valuation, Cisco would need to, at minimum, maintain the double-digit annual returns it achieved over the previous 18 years since its IPO, and keep those returns running consistently for decades into the future.
Unfortunately, Cisco's $600 billion market cap was so enormous that achieving that kind of growth was as close to mathematically impossible as it gets. Surveys showed that investors were expecting 15% to 25% returns. As Princeton professor Burton Malkiel noted, "If Cisco returned 15% per year for the next twenty-five years, and the national economy continued to grow at 6% over the same period, Cisco would have been bigger than the entire economy." And actually, in 2000 the Congressional Budget Office estimated that GDP growth would average just 4.8% over the following 20 years. Investors were just wholly delusional.
You know what happened next: Cisco stock fell nearly 90% after expectations shrank back in line with reality. In fact, several other tech-mania companies, including Oracle
Exhibit B: Chipotle, late 2007
I love Chipotle Mexican Grill
As I wrote at the time:
At nearly 100 times last year's earnings, Chipotle has the highest of expectations already baked into the stock price. Will earnings grow? Absolutely. Will stores expand? Unquestionably. Will it be reflected in the stock price? At these levels, that's not such a sure thing.
I further noted that with valuations this high, the favorable growth scenario outlined by management itself meant that Chipotle's stock would return a measly 5% annually over the coming three years. Those lowly returns left absolutely no room for error, with even the slightest hiccup leading to a possible share meltdown.
That's exactly what happened. Over the next year, shares crashed 60%, even while Chipotle's business grew mightily. Investors' expectations just came back down to earth.
Shares have since rebounded to about where they were in 2007 as growth ramps up. Even still, investors who were willing to stick out a 60% plunge have just now, three years later, broken even on a company that increased revenue by more than 60% during that period. That's the danger of investing when expectations are sky-high.
Exhibit C: Ambac, today
I don't want all of these examples to employ the benefit of hindsight, so here's a forward-looking one: Today, Ambac Financial
In this case, it's not just about high expectations that are dangerous; it's that investors have any expectations at all. It's been plainly clear for months now that Ambac's future almost certainly includes bankruptcy. Even management backs this view, admitting that the company is "pursuing a restructuring of its outstanding debt through a prepackaged bankruptcy proceeding."
What makes this situation unique is that even if Ambac does somehow manage to skirt bankruptcy, its ability to create value for its shareholders is sequestered by a recent asset seizure imposed by a Wisconsin insurance regulator. The handcuffs imposed by this regulator essentially prevent Ambac's operating subsidiaries from paying dividends to its parent company, which common shareholders own.
It's hard to imagine any sensible scenario in which Ambac's common stock is worth a penny. Yet the company still has a $150 million market cap. That, I believe, makes it a good short candidate -- investors' expectations just aren't realistic, even for this penny stock.
The Big Short
In all three of these scenarios, the short-selling thesis simply reflects of Stephen Hawking's comment that the final outcome of a situation can end up in your favor, provided you set your initial expectations at the right level. In this case, we're looking for companies where investors' expectations are so preposterous that the odds of success lean heavily in short sellers' favor.
Short selling isn't for everyone, but it can be incredibly lucrative if properly implemented. For more educational information on this subject, my Foolish colleague John Del Vecchio, CFA, a leading forensic accountant, offers a list of warning signs to look for in this free special report: "5 Red Flags -- How to Find the Big Short." Simply enter your email in the box below, and we'll send you the report, absolutely free.