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How Should Investors Assess Deviations From Expectations?

A common phenomenon which occurs in investing is one where expectations set by analysts and pundits are out of synch from reality. Sometimes, the deviation may be slight, while at other times, the reality is totally divorced from projections. Understandably, investors might be feeling somewhat confused as to how and why this happens, and also how they should react to this.

Expectations are a form of prediction, and represents a collation of projections made by both sell-side analysts and informed investors. As expectations concern the unknowable future, it’s common for reality to deviate somewhat, but the question here would be the extent and nature of the difference. I will detail a few examples of such deviations and how investors should assess and react to them.

Minor deviations – no surprises

Most of the time, investors should expect minor deviations to crop up, and these are considered normal as projections are inherently inaccurate. I would consider a magnitude of 5% to at most 10% (in either direction) to be a minor deviation and within a tolerable range of error.

Most seasoned investors would also be armed with their own set of expectations for how the business would perform, based on their investment thesis for the company. It is useful to perform an internal check on one’s own projections to see how far off reality is, in order to test how well we understand the business.

Major deviations – unexpected events cropping up

Major deviations from expectations are usually a result of unexpected events cropping up, examples of which include a major impairment (of an asset or acquisition), higher than anticipated costs (due to cost overruns) or better than expected cost control (resulting in soaring margins). Such major deviations could be either positive or negative, and the key thing to take note of is not just the magnitude of the deviation, but also its nature.

Investors who are surprised by such deviations should keep in mind that business forecasts are prone to errors, and unless you are actually in the business and running it, there is always a chance to get blindsided by events which occur in an unexpected fashion. A diligent investor would drill down into the nature of the deviation in order to provide a coherent explanation as to why it happened. He can then decide on an appropriate course of action after ascertaining the facts.

The Foolish bottom line

The assessment of deviations from expectations is one method which investors may use to determine if their investment thesis is sound. Unless our expectations are wholly unrealistic, a major deviation should be properly investigated and justified by management.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.