The legendary Peter Lynch once opined that if you can follow only one thing, follow the earnings. Because sooner or later earnings make or break an investment in equities.
Quite true indeed. If valuations are reasonable and everything else remaining constant, a company that grows its earnings 3 times in 5 years will also see it stock price go up by the same amount. Consequently, if you want to predict stock prices, try predicting the earnings first.
This is easier said than done though. For forecasting requires a skill set we can break our heads with but still not come anywhere close to doing a decent job of it. As a matter of fact, even specialists who are asked to make predictions about their own industries end up with foot in the mouth at times. We hope you all remember what Microsoft CEO Steve Ballmer had to say about iPhones when they were first launched in 2007? He simply shrugged them off saying there's no chance the iPhone is going to get significant market share!
Then there's Irving Fisher, arguably the best economist of his generation. But how wrong was he when he predicted in 1929 that the US stock market has reached permanently new highs! Within 3 days of his prediction, the US stocks started what is widely accepted as one of their worst slides ever!
There are of course plenty more bold predictions gone horribly wrong. However, the biggest bomb by far was yet to come. It was finally planted under the forecasting industry in 1987 by a gentleman who answers to the name of Philip Tetlock. Incidentally, the bomb didn't explode for close to two decades. But when the results of his study were finally out, it created an explosion so big, it shook the very foundations of the forecasting industry.
After studying 28,000 predictions from close to 284 experts, the key finding for Tetlock was that experts are terrible forecasters. Worse still, the average expert did only slightly better than random guessing.
Does this hold good for equity research analysts also? Absolutely. It will be a huge stretch of imagination to believe that equity research analysts who make earnings forecasts are better at predictions than experts from other disciplines. This is certainly not the case. And therefore while their research models have gotten more sophisticated over the years, their track record in terms of forecasting earnings remains as bad as ever!
Looks like the anti-forecasting brigade does have a strong case to make for itself. And we would sort of tend to agree with them. Rather than investing with the assumption that we can predict the future, it is always better to start with the opposite point of view. In other words, start with the assumption that in investing as in many other disciplines that requires human interactions; it is next to impossible to predict what future has in store for us.
And mind you, we have some great company if we start thinking this way. Despite all the wisdom and knowledge at their disposal, even the likes of Buffett and Munger approach every potential investment opportunity with the assumption that the future is impossible to predict.
And when you make this assumption, your mind immediately works towards creating as many safety levers as possible. This is to ensure that the losses are minimised in case the predictions go wrong. In investing, this would mean staying within one's circle of competence and always remaining conservative when forecasting future earnings. Last but not the least, insisting on a margin of safety when valuing a stock.
No, this may not help in accurately predicting the future. But it will ensure you always remain a step ahead. A step ahead of most of the investors out there who either due to their arrogance or greed assume the future to turn out exactly the way they had anticipated. And in the process, end up betting way too much or take bets where the risk-reward equation is not in their favour.
To conclude, all of us would certainly love to have the equivalent of a time machine so that we can make our investments by first travelling into the future and coming back. However, till the time science resolves this mystery, it is always better to assume that the future is more uncertain than we make it out to be. And therefore have safety levers in place like the ones we highlighted.
Quite true indeed. If valuations are reasonable and everything else remaining constant, a company that grows its earnings 3 times in 5 years will also see it stock price go up by the same amount. Consequently, if you want to predict stock prices, try predicting the earnings first.
This is easier said than done though. For forecasting requires a skill set we can break our heads with but still not come anywhere close to doing a decent job of it. As a matter of fact, even specialists who are asked to make predictions about their own industries end up with foot in the mouth at times. We hope you all remember what Microsoft CEO Steve Ballmer had to say about iPhones when they were first launched in 2007? He simply shrugged them off saying there's no chance the iPhone is going to get significant market share!
Then there's Irving Fisher, arguably the best economist of his generation. But how wrong was he when he predicted in 1929 that the US stock market has reached permanently new highs! Within 3 days of his prediction, the US stocks started what is widely accepted as one of their worst slides ever!
There are of course plenty more bold predictions gone horribly wrong. However, the biggest bomb by far was yet to come. It was finally planted under the forecasting industry in 1987 by a gentleman who answers to the name of Philip Tetlock. Incidentally, the bomb didn't explode for close to two decades. But when the results of his study were finally out, it created an explosion so big, it shook the very foundations of the forecasting industry.
After studying 28,000 predictions from close to 284 experts, the key finding for Tetlock was that experts are terrible forecasters. Worse still, the average expert did only slightly better than random guessing.
Does this hold good for equity research analysts also? Absolutely. It will be a huge stretch of imagination to believe that equity research analysts who make earnings forecasts are better at predictions than experts from other disciplines. This is certainly not the case. And therefore while their research models have gotten more sophisticated over the years, their track record in terms of forecasting earnings remains as bad as ever!
Looks like the anti-forecasting brigade does have a strong case to make for itself. And we would sort of tend to agree with them. Rather than investing with the assumption that we can predict the future, it is always better to start with the opposite point of view. In other words, start with the assumption that in investing as in many other disciplines that requires human interactions; it is next to impossible to predict what future has in store for us.
And mind you, we have some great company if we start thinking this way. Despite all the wisdom and knowledge at their disposal, even the likes of Buffett and Munger approach every potential investment opportunity with the assumption that the future is impossible to predict.
And when you make this assumption, your mind immediately works towards creating as many safety levers as possible. This is to ensure that the losses are minimised in case the predictions go wrong. In investing, this would mean staying within one's circle of competence and always remaining conservative when forecasting future earnings. Last but not the least, insisting on a margin of safety when valuing a stock.
No, this may not help in accurately predicting the future. But it will ensure you always remain a step ahead. A step ahead of most of the investors out there who either due to their arrogance or greed assume the future to turn out exactly the way they had anticipated. And in the process, end up betting way too much or take bets where the risk-reward equation is not in their favour.
To conclude, all of us would certainly love to have the equivalent of a time machine so that we can make our investments by first travelling into the future and coming back. However, till the time science resolves this mystery, it is always better to assume that the future is more uncertain than we make it out to be. And therefore have safety levers in place like the ones we highlighted.
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