Even in the best-performing companies’ investors have the tendency to keep extending their expectations. Companies have the habit of giving future guidance. They guide us on how their profits and sales will grow. Investors layer their judgements on such guidance and start comparing the actual performance based on their expectations.
In exceptional companies’ expectations could be higher than the guidance and the company could well exceed that expectation. In such cases, investors start believing that the company displays the capacity to grow much faster and exceed expectations repeatedly. This makes investors stretch their expectations without a reasonable connection to the company’s guidance and expectations start running ahead of what the company can deliver. In such situations, stock prices run ahead of the guidance, expectations set and the actual performance. In other words, investors start expanding the multiples of the company beyond what is reasonable.
At some point, this chain of events will snap. When that happens, companies start correcting despite having their best phase of business performance. Investors are to be blamed for this. The way in which investors set and manage expectations causes the valuations of the company to run ahead of time.
Such dream runs in valuations tend to also end exactly when the performance of the company is exceptional. Stock valuations start receding and prices begin correcting. This trend will happen in the best of businesses and well-moated companies. In smaller companies and illiquid stocks, this trend will be triggered by sharp selling from large investors. It is a time for investors to exercise caution when they spot this trend in setting expectations and valuations.