Legg Mason chief investment strategist Michael Mauboussin talks a lot about expectations. What his ideas show me is that there aren't "cheap" or "expensive" stocks. Instead, there are three types of stocks:

  1. Stocks that meet the market's expectations.
  2. Stocks that fall short of the market's expectations.
  3. Stocks that exceed the market's expectations.

Suffice it to say that we'd all like to fill our portfolios with stocks that exceed the expectations the market has priced into them.

This one goes to 11
Thus, it can be much more advantageous to hold Company A, which increases earnings 5%, instead of Company B, which increases earnings 25%, if the market expected 3% growth out of Company A and 30% growth from Company B. Heck, you'll even see a company that posts bad results enjoy a nice bump in its stock price if the results are better than the market expected.

Or consider these examples:


Three-Year EPS Growth*

Three-Year Return




Fannie Mae (NYSE:FNM)



Bed Bath & Beyond (NASDAQ:BBBY)






Scientific Games (NASDAQ:SGMS)



First American (NYSE:FAF)



*Annualized. Data courtesy of Capital IQ, a division of Standard & Poor's.

Why did impressive earnings growth translate into mediocre (or no) stock price growth for Amgen, Fannie Mae, and Bed Bath & Beyond? One answer, of course, is expectations. The market expected so much from these companies -- or in the case of Fannie, expected that the growth couldn't continue -- that they couldn't satisfy the market's demands. It clearly didn't expect quite as much from PPL, Scientific Games, and First American -- and these stocks have simply blown away the market's expectations.

The merits of stock price
So how does an investor determine what the market expects of a company? Easy. The market has priced its expectations into the company's stock. There are a lot of columns on Fool.com telling investors that price doesn't matter. And while that's true in some ways, it's also true that all of the information you need to know about expected growth rates, risks, and even share dilution is evidenced in the price. By working backward in a discounted cash flow model, you can read the market's mind.

Now, you just need to figure out whether the market is wrong.

Even better than the real thing
was, by some measures, an expensive stock when Fool co-founder Tom Gardner recommended it in Hidden Gems. With its robust price-to-earnings ratio north of 40 and a price-to-book ratio in the double digits, Ctrip looked pricey. But Tom thought differently. He determined that just 30% earnings growth would earn investors massive, market-beating 25% annualized returns. To date, the stock has already moved up 160%.

Why was Ctrip seemingly priced below what Tom expected of it? In one word: risk. Many investors still don't feel confident investing in China, for reasons both political and economic.

You can't value what you can't see
While the market misprices all kinds of companies, we focus on small caps at Hidden Gems partly because we believe that we can find many more small companies that will exceed what the market expects of them. That's because small caps trade fewer shares, are followed by fewer analysts, and receive less media coverage. Without information, the market simply can't assess small companies as efficiently as it can large companies.

That's where we step in -- and where we profit. If you'd like to join us at Hidden Gems as we uncover the very best small-cap opportunities, click here. Since the service's inception in 2003, our picks are beating the market by more than 36 percentage points on average, and our brand-new review issue was released at noon today.

This article was originally published on March 15, 2006. It has been updated.

Tim Hanson owns shares of First American. First American, Bed Bath & Beyond, and Fannie Mae are Inside Value recommendations. Bed Bath & Beyond is also a Stock Advisor pick. No Fool is too cool for disclosure.