Can you benefit from forecasts and extrapolations?

We have two classes of forecasters: 

• Those who don’t know – and 
• those who don’t know they don’t know.

Many believe that the future is unknowable.

Some favorite quotes on this subject. (The first one may be the greatest ever):

No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future.
Ian E. Wilson (former Chairman of GE)

Those who have knowledge don’t predict; those who predict don’t have knowledge.
Lao Tzu

People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome.
George Orwell

Forecasts create the mirage that the future is knowable.
Peter Bernstein

I never think of the future – it comes soon enough.
Albert Einstein

The future you shall know when it has come; before then forget it.
Aeschylus

Forecasts usually tell us more of the forecaster than of the future.
Warren Buffett



There actually are things we know about the macro future. 

However, this is an extreme oversimplification and not entirely correct. There actually are things we know about the macro future. The trouble is that, mostly, they’re things everyone knows. 

Examples include

• the fact that U.S. GDP grows about 2% per year on average; 
• heating oil consumption increases in winter; and 
• a great deal of shopping is moving on-line. 

But since everyone knows these things, they’re unlikely to be much help in the pursuit of above average returns. 

The things most people expect to happen – consensus forecasts – are by definition incorporated into asset prices at any point in time. 




Most forecasts – and especially macro forecasts – are extrapolations of recent trends and current levels.

Since the future is usually a lot like the past, most forecasts – and especially macro forecasts – are
extrapolations of recent trends and current levels, and they’re built into prices.

Since extrapolation is appropriate most of the time, most people’s forecasts are roughly correct.

But because they’re already reflected in security prices, most extrapolations aren’t a source of above average returns.




The forecasts that produce great profits.

The forecasts that produce great profits are the ones that presciently foresee radical deviations from the past. 

But that kind of forecast is, first, very hard to make and, second, rarely right. 

Thus most forecasts of deviation from trend also aren’t a source of above average returns.




Summary

So let me recap:
(a) only correct forecasts of a very different future are valuable,
(b) it’s hard to make forecasts like that,
(c) such unconventional predictions are rarely right, 
(d) thus it’s hard to be an above average forecaster, and
(e) it’s only above average forecasts that lead to above average returns.



So there’s a conundrum:

• Investing is the art of positioning capital so as to profit from future developments.
• Most professional investors strive for above average returns (i.e., they want to beat the market and earn their fees).
• However, according to the above logic, macro forecasts shouldn’t be expected to lead to above average returns.
• Yet very few people are content to invest while practicing agnosticism with regard to the macro future. They may on some level understand the difficulty entailed in forecasting, but their reluctance to admit their ignorance of the future (especially to themselves) usually overcomes that understanding with ease.
• And so they keep trying to predict future events – and the investment industry produces a large volume of forecasts.

Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

https://www.oaktreecapital.com/docs/default-source/memos/uncertainty.pdf

Forecasting Performance

Typically, forecasting involves making projections of cash flows to some point where the company has a steady state going forward  



The point when the Steady State going forward is reached

This steady state going forward is characterized by two properties

• the company grows at a constant rate with a constant reinvestment ratio, and 
• the company earns a constant rate of return on existing capital and new capital invested.

The Explicit Forecast Period

The horizon to the steady state, called the explicit forecast period, is usually 10 to 15 years.

This explicit forecast period should be divided into

• a first forecast period of five to seven years, where the statements will include many details,and,
• the remaining years' forecasts where the statements are simpler with less detail, which avoids the error of false precision.

Such forecasts require assumptions concerning a host of variables, including the return earned on invested capital and whether the company can stay competitive.



Steps in the Forecasting Process

There are six steps in the forecasting process.

1. Prepare and analyze historical financial statements and data.
2. Build the revenue forecast consistent with historical economy-wide evidence on growth.
3. Forecast the income statement using the appropriate economic drivers.
4. Forecast the balance sheet entries.
5. Forecast the investor funds into the balance sheet.
6. Calculate ROIC and FCF.

Additional issues include

• determining the effect of inflation,
• nonfinancial drivers, and 
• which costs are fixed and which are variable.

Charlie Munger - Projections do more harm than good

Reading Tea Leaves

" I have no use whatsoever for projections or forecasts.  They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be.  We never look at projections but we care very much about, and look very deeply, at track records.  If a company has a lousy track record but a very bright future, we will miss the opportunity,"  explained Warren Buffett.

Charlie Munger, added that in his opinion projections do more harm than good.  "They are put together by people who have an interest in a particular outcome, have a subconscious bias, and its apparent precision makes it fallacious.  They remind me of Mark Twain's saying, 'A mine is a hole in the ground owned by a liar.'  Projections in America are often a lie, although not an intentional one, but the worst kind because the forecaster often believes them himself."

Here is how Graham and Dodd looked at projections.  "While a trend shown in the past is a fact, a 'future trend' is only an assumption.  The past, or even careful projections, can be seen as only a 'rough index' to the future."

More than five decades have passed since those words were said, and Buffett still agrees.

Buffett (1994): Don't get bogged down by near term outlook and strong earnings growth; look for the best risk adjusted returns on a long-term basis

Warren Buffett highlighted, in his 1994 letter to shareholders, the futility in trying to make economic prediction while investing. Let us go further down the same letter and see what other investment wisdom the master has to offer.

One of the biggest qualities that separate the master from the rest of the investors is his knack of identifying on a consistent basis, investments that have the ability to provide the best risk adjusted returns on a long-term basis. In other words, the master does a very good job of arriving at an intrinsic value of a company based on which he takes his investment decisions. Indeed, if the key to successful long-term investing is not consistently identifying opportunities with the best risk adjusted returns than what it is.

However, not all investors and even the managers of companies are able to fully grasp this concept and get bogged down by near term outlook and strong earnings growth. This is nowhere more true than in the field of M&A where acquisitions are justified to the acquiring company's shareholders by stating that these are anti-dilutive to earnings and hence, are good for the company's long-term interest. The master feels that this is not the correct way of looking at things and this is what he has to say on the issue.

"In corporate transactions, it's equally silly for the would-be purchaser to focus on current earnings when the prospective acquiree has either different prospects, different amounts of non-operating assets, or a different capital structure. At Berkshire, we have rejected many merger and purchase opportunities that would have boosted current and near-term earnings but that would have reduced per-share intrinsic value. Our approach, rather, has been to follow Wayne Gretzky's advice: "Go to where the puck is going to be, not to where it is." As a result, our shareholders are now many billions of dollars richer than they would have been if we had used the standard catechism."

He goes on to say, "The sad fact is that most major acquisitions display an egregious imbalance:

• They are a bonanza for the shareholders of the acquiree; 
• they increase the income and status of the acquirer's management; and 
• they are a honey pot for the investment bankers and other professionals on both sides. 
• But, alas, they usually reduce the wealth of the acquirer's shareholders, often to a substantial extent. That happens because the acquirer typically gives up more intrinsic value than it receives."

Indeed, rather than giving in to their adventurous instincts, managers could do a world of good to their shareholders if they allocate their capital wisely and look for the best risk adjusted return from the excess cash they generate from their operations. If such opportunities turn out to be sparse, then they are better off returning the excess cash to shareholders by way of dividends or buybacks. However, unfortunately not all managers adhere to this routine and indulge in squandering shareholder wealth by making costly acquisitions where they end up giving more intrinsic value than they receive.

To read our previous discussion on Warren Buffett's letter to shareholders, please click here - Lessons from the master

http://www.equitymaster.com/detail.asp?date=2/7/2008&story=2

Learn from the Worst: The Futility of Forecasting

Having established that most investors - professionals and amateur - underperform the market, the obvious question is, why?

How can so many smart people fare so poorly?

Perhaps, the greatest reason, is the fact that we are human. The way we think, the way we perceive things and feel emotions - has become a major topic in the investing world in recent years. Behavioural finance and neuroeconomics examine how psychology and physiology affect the way we deal with our money. And in general, the findings show that we humans are investing in the stock market with the deck stacked against us.

Zweig authored a book on neureconomics titled Your Money and Your Brain. One of the main points Zweig stressed is that human beings are excellent at quickly recognizing patterns in their environment. Being able to do so has been a key to our species' survival, enabling our ancestors to evade capture, find shelter, and learn how to plant the right crops in the right places. Those are all good, and often essential, things to know.

When it comes to investing, this ability ends up being a liability. "Our incorrigible search for patterns leads us to assume that order exists where it often doesn't. Almost everyone has an opinion about whether the Dow will go up or down from here, or whether a particular stock will continue to rise. And everyone wants to believe that the financial future can be foretold." But the truth, is that it can't - at least not in the day to day, short-term way that most investors think it can.

Everyday on Wall Street, something happens that makes people think they should invest more money in the stock market, or, conversely, makes them pull money out of the market. Earnings reports, analysts' rating changes, a report about how retail sales were last month - all o fthese things can send the market into a sudden surge or a precipitous decline. The reason: People view each of these items as a harbinger of what is to come, both for the economy and the stock market.

On the surface, it may sound reasonable to try to weigh each of these factors when considering which way the market will go. But when we look deeper, this line of thinking has a couple of major problems.

• It discounts the incredible complexity of the stock market. There are so many factors that go into the market's day-to-day machinations; the earnings reports, analysts' ratings, and retail sales figures mentioned above are just the tip of the iceberg. Inflation readings, consumer spending reports, economic growth figures, fuel prices, recommendations of well-known pundits, news about a company's new products, the decisions of institutions to buy and sell because they have hit an internal taget or need to free up cash for redemptions - all of these and much, much more can also impact how stocks mvoe from day to day, or even hour to hour or minute to minute. One stock can even move simply because another stock in its industry reports its quarterly earnings. Very large, prominent companies such as Wal-Mart or IBM are considered bellwethers in their industries, for example, and a good or bad earnings report from them is often interpreted - sometimes inaccurately - as a sign of how the rest of companies in their industries will perform.

• When it comes to the monthly, quarterly, or annual economic and earnings reports, the market doesn't just move on the raw data in the reports; quite often, it moves more on how that data compares to what analysts had projected it to be . A company can post horrible earnings for a quarter, and its stock price migh rise because the results actually exceeded analysts' expectations. Or conversely, it can announce earnings growth of 200%, but fall if analysts were expecting 225% growth.

Here is one more wrench: the fact that good economic news doesn't even always portend stock gains, just as bad economic news doesn't always precede stock market declines. In fact, according to the Wall Street Journal, the market performed better during the recessions of 1980, 1981-1982, 1990-1991, and 2001 than it did in the six months leading up to them. And in the first three of those examples, stocks actually gained ground during the recession.