Meritage Periodical April 2025

Prompting critical thinking and conversations around issues in our industry.
Not intended as personal financial advice.

Implied Expectations Matter

During this period of historic market volatility, we and many of our clients have been keenly focused on downside risk. Year-to-date the stocks of many large, well-known companies are down by 20% or more. Why? The simple answer is uncertainty about the future, caused by the administration’s implementation of tariffs and other policies. However, we feel there’s a broader portfolio planning topic worth discussing. 

When we as investors purchase any stock, we are paying a price today for profits the company is expected to earn in the future. A classic way of analyzing this price is to compare it against the current earnings of the company. This common metric is a “price-to-earnings ratio,” or “P/E ratio.” On a company-by-company basis, P/E ratios vary dramatically. However, they always tell a story about the collective expectations for a company’s future. A stock with a higher-than-average P/E ratio indicates that investors believe the company is going to grow its earnings faster than the average company. In contrast, a company with a very low P/E ratio may indicate expectations of limited or negative growth. 

Warren Buffet is famous for saying, “In the short run, the market is a voting machine but in the long run it is a weighing machine.” Said differently, the market eventually gets prices right, but over relatively short periods of time collective expectations can be very wrong. These collective expectations lead to P/E ratios that are either far too high or far too low. Unfortunately, it’s human nature to be susceptible to the bandwagon effect, which leads us to treat stocks like a popularity contest and inflate P/E ratios. This is why many great companies have seen their stock price fall by over 20%--the expectations were simply too high. Everything had to go right to sustain that price. 

On the other side of the spectrum are companies with below average P/E ratios. While some have problems that can’t be fixed, there are others that are well-run companies which simply have lower growth expectations. During market downturns, the hidden value of investing in these low growth stocks often rises to the surface. They had low expectations built into their price anyway, so their outlook is not as dramatically changed by the news of the day. Said differently, low P/E ratios tend to provide investors with better downside protection. 

As in most aspects of life, if you are carrying around lofty expectations you are unlikely to have them fulfilled, and there is much room for disappointment. However, if you have realistic expectations, there is less room for disappointment and more room to be pleasantly surprised. In our experience, it has been amazing how much this lesson can transfer to picking stocks. 

We hope you find this perspective helpful, and as always if you have questions about your personal situation, please feel free to reach out.