You Can Beat These Expectations

Imagine you could buy shares of a well-managed company with a diverse business model after it had been cut in half. Then imagine that said company grew its net income at a better-than-13% annual clip for a period of seven years.

You'd be sitting pretty, right?

Wrong!
Microsoft (NASDAQ:MSFT) did exactly that. Seven years ago, after an extreme price cut courtesy of the larger tech-bubble meltdown, Microsoft was sitting around an adjusted $28 a share. After seven years of double-digit annual earnings growth, it's now at $25. That's an annual stock return of negative 1%.

Ouch. The culprit, as you may imagine, was the very lofty growth rate baked into the stock.

To a large degree, investing is an expectations game. Let's look at a few of the recent headlines for further evidence:

• "Citigroup (NYSE:C) posts $2.5B loss, but beats expectations," Associated Press.
• "Google's (NASDAQ:GOOG) Net Income Climbs Less Than Expected; Shares Tumble," Wall Street Journal.
• "Microsoft's Profit, Sales Jump But Outlook Fails to Impress," Wall Street Journal.

So let's review: Citigroup lost the equivalent of Aruba's GDP, and its assets declined by $99 billion since the first quarter. By contrast, Microsoft has its fastest annual revenue growth since 1999, and Google reported a revenue increase of 39% year over year. But Citigroup's shares rose 7.7% following the announcement, while Microsoft and Google lost 6.0% and 9.8%, respectively?

What's going on here?
It wasn't contrarian investors making the shares zig when you might have expected them to zag. Instead, the odd behavior owed to market analysts -- and their estimations of what each company should have made.

Analysts expected Citi to lose $0.66 per share, but it only lost $0.54. Google earned $4.63 per share, while the average analyst's estimate was $4.74 per share.

Now, these differences are by no means insignificant -- with hundreds of millions of shares outstanding, an $0.11 or $0.12 difference per share means tens of millions of dollars. But when a company has a $100 billion market cap, $30 million is pocket change.

But let's back up. Microsoft's market cap lost nearly $20 billion in one day -- at least in part because it missed analyst expectations by a penny per share.

Make it stop
Of course, shares don't go rise or fall simply because analysts think the earnings reports should have been a little bit better. Nope, their ups and downs stem from three primary reasons:

1. The earnings expectations are already priced into the stock.
2. New guidance creates new expectations, which then have to be priced into the stock.
3. Analysts revise their price targets based on new information about the company, the industry, or the economy.

That first reason explains why Microsoft's share price has been essentially the same for seven years -- expectations for growth were already built in, and they're just now being realized.

Its share price dropped after its earnings report because it missed expectations by a penny per share. However, analysts also dropped their price targets because of questions about Microsoft's product cycle and the uncertainty surrounding its bid for Yahoo!

In other words, Citigroup, Google, and Microsoft are being watched very, very closely -- each is covered by between 15 and 34 different analysts who are well-educated, well-informed, and paid to do little else but follow those specific companies' every move.

And with that kind of coverage, shares tend to be pretty efficiently priced, adjusting quickly to any changes in expectations.

That's not the case with small companies
It may seem obvious, but if a company isn't being followed by analysts -- or is followed by very few -- fewer expectations are priced in. That makes a particular security (or group of securities) less efficiently priced, which presents an interesting opportunity for you.

Let's look at an example. The following companies are all small caps with double-digit projected growth rates over the next five years:

Over the long run, small caps like those above tend to be less efficiently priced. Of course, that efficiency cuts both ways -- they can be priced too optimistically, or too pessimistically.

The Foolish bottom line
Analysts are very good at their jobs, but as my colleague Bill Barker points out, their jobs may not be what you think they are. They follow the money, and the money -- for their clients -- is in large caps.

At Motley Fool Hidden Gems, we like to search the small-cap value pond because companies therein tend to be obscure, ignored, and mispriced. They may not be known now, but the market's best stocks have been companies with those characteristics.

To see which small caps we think are mispriced -- including our five favorite small companies for new money -- you can join Hidden Gems with a 30-day free trial. Our picks are beating the market by 19 percentage points -- and there's no obligation to subscribe. Click here to get started.

At the time of publication, Julie Clarenbach owned none of the companies mentioned here. Google is a Motley Fool Rule Breakers recommendation. Microsoft is an Inside Value selection. American Oriental Bioengineering and II-VI are Hidden Gems choices. The Motley Fool's disclosure policy likes to keep dancing all night long.