Why Shareholder Expectations Become a Treadmill  71 the new stock price,2 let alone improve it further: the speed of the treadmill quickens as performance improves. So a company with low expectations of success among shareholders at the beginning of a period may have an easier time outperforming the stock market simply because low expectations are easier to beat. The treadmill analogy is useful because it describes the difficulty of con- tinuing to outperform the stock market. At some point, it becomes almost impossible for management to deliver on accelerating expectations without faltering, just as anyone would eventually stumble on a treadmill that keeps moving faster. Consider the case of Terry Turnaround, a fictional character based on the experience of many CEOs. Terry has just been hired as the CEO of Prospectus, a company with below-average returns on capital and growth relative to com- petitors. Because of this past performance, the market doesn’t expect much, so the value of Prospectus is low relative to competitors. Terry hires a top-notch team and gets to work. After two years, Prospectus is gaining ground on its peers in margins and return on capital, and its market share is rising. Pro- spectus’s stock price rises twice as fast as its peers’ because the market wasn’t expecting the company’s turnaround. Terry and her team continue their hard work. After two more years, Pro- spectus has become the industry leader in operating performance, with the highest return on capital. Because of its low starting point, the company’s share price has risen at four times the rate of the industry average. Given Prospectus’s new trajectory and consistent performance, the market expects continued above-average returns on capital and revenue growth. As time goes by, Prospectus maintains its high return on capital and leading market share. But two years later, Terry notes with frustration that her com- pany’s shares are now doing no better than those of its peers, even though the company has outperformed rivals. At this point, Terry is trapped on the expec- tations treadmill: she and her team have done such a good job that the expecta- tion of continued high performance is already incorporated into the company’s share price. As long as Prospectus delivers results in line with the market’s ex- pectations, its share price performance will be no better or worse than average. This explains why extraordinary managers may deliver only ordinary TSR: even for the extraordinary manager, it can be extremely difficult to keep beating high expectations. It also explains why managers of compa- nies with low performance expectations might easily earn a high TSR, at 2 Theoretically, if a company’s performance exactly matches expectations, its TSR will equal the cost of equity. In practice, however, with continual changes in interest rates, inflation, and economic activity, comparison to the broader market is sometimes preferable. 72  The Alchemy of Stock Market Performance least for a short time. They can create a higher TSR by delivering perfor- mance that raises shareholder expectations to the level of expectations for their peers in the sector. The danger for companies whose shareholders already have high expec- tations is that in their quest to achieve above-peer TSR, they may resort to misguided actions, such as pushing for unrealistic earnings growth or pursu- ing big, risky acquisitions. Consider the electric power boom at the end of the 1990s and in the early 2000s. Deregulation led to high hopes for power- generation companies, so deregulated energy producers were spun off from their regulated parents at extremely high valuations. Mirant, for instance, was spun off from Southern Company in October 2000 with a combined equity and debt capitalization of almost $18 billion, a multiple of about 30 times earn- ings before interest, taxes, and amortization (EBITA)—quite extraordinary for a power-generation company. To justify its value, Mirant expanded aggres- sively, as did similar companies, investing in power plants in the Bahamas, Brazil, Chile, the United Kingdom, Germany, China, and the Philippines, as well as 14 U.S. states. The debt burden from these investments quickly became too much for Mirant to handle, and the company filed for bankruptcy in July 2003. The expectations treadmill pushed Mirant into taking enormous risks to justify its share price, and it paid the ultimate price. The expectations treadmill is the dynamic behind the adage that a good company and a good investment may not be the same. In the short term, good companies may not be good investments, because future great per- formance might already be built into the share price. Smart investors may prefer weaker-performing companies, because they have more upside po- tential, as the expectations expressed in their lower share prices are easier to beat. The Treadmill’s Real-World Effects Tyson Foods and J&J Snack Foods are two U.S. branded-food processors. Tyson is one of the largest in the world, with brands such as Hillshire Farm and Sara Lee. Its revenues in 2017 were $40 billion. J&J Snack Foods is smaller, at just over $1 billion of revenues in 2017, with brands such as Icee and Auntie Anne’s. Not surprisingly, given its smaller size and more snack-oriented products, J&J grew its revenues faster, at 6 percent per year from 2013 to 2017, while Tyson grew only 3 percent (Exhibit 5.1). J&J also outperformed on ROIC, with after-tax ROIC (before goodwill and intangi- bles) averaging about 24 percent over the period, compared with Tyson’s 19 percent. Yet Tyson’s shareholders earned almost twice the TSR: 27 percent versus 14 percent annualized.