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 (2000): The risks associated with the twin issues of CEO's lofty projections and sustainable long-term profit growth.

Warren Buffett talked about wealth transfers to greedy promoters during IPOs in the letter for the year 2000. Let us go further down the same letter and see what other investment wisdom the master has to offer.

The master's macro bet

Usually, Buffett refrains from making precise comments about the future especially at the macro level. But if he is willing to bet a large sum on the likeliness of an event happening, then indeed we must sit up and take notice. In the letter for the year 2000, the master has made one such prediction and was willing to bet a large sum on it. The prediction was about the magnitude of growth in profits that would take place among the 200 most profitable companies in the US at that time. Since the master does not believe in short term predictions, the time horizon that was assumed was ten years.

The CEO with a crystal ball

The letter for the year 2000 came out at a time when the practice of a CEO predicting the growth rate of his company publicly was becoming commonplace. Although Buffett did not have an issue with a CEO setting internal goals and even making public some broad assumptions with proper warnings thrown in, it did annoy him when CEOs started making lofty assumptions about future profit growth.

This is because the likelihood of the CEO meeting his aggressive targets year after year on a consistent basis and well into the future was very low and hence this amounted to misleading the investors. After having spent decades researching and analyzing companies, the master had come to the conclusion that there are indeed a very small number of large businesses that could grow its per share earnings by 15% annually over a period of 10 years. Infact, as mentioned in the above paragraph, the master was even willing a bet a large sum on it.

The reasons may not be difficult to find. In free markets, the intensity of competition is so high that it is very difficult for profitable players to maintain high growth rates for consistently long periods of time. Unless the business is endowed with some extremely strong competitive advantages, competition is likely to nibble away at its market share and cut into its profit margins, thus making high growth rates difficult.

Let us hear in the master's own words his take on the twin issues of

• CEO's lofty projections and 
• sustainable long-term profit growth.

The golden words

"Charlie and I think it is both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble."

He further adds, "It's fine for a CEO to have his own internal goals and, in our view, it's even appropriate for the CEO to publicly express some hopes about the future, if these expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court trouble."

The master reasons, "That's true because a growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here's a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years."

Adding further, the master says, "The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to "make the numbers." These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more "heroic." These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)"