LONDON, 28 June 2004 — Ask any investor: What factors are the most discouraging to his investment planning strategies, and he will cite “uncertainty” as the primary factor. This fact is not surprising, for uncertainty is the Achilles’ heel of strategic planning. Remember, no one can accurately predict the future. Yet some investors, and I know quite a few, have absolute faith in security analysts’ estimates of the long-term growth prospects of certain stocks and the duration of that growth.
From my point of view, predicting future trends is the most hazardous occupation. It requires not only the knowledge and skills of an economist, but also the perception of a psychologist. On top of that, it is extremely difficult to be objective; wild optimism and extreme pessimism constantly battle for top place. Having said that, what would you, the investor, really do to realize a sense of relative understanding and comfort with respect to future trends in your investments and with the general condition of the economy? The best that you could do is to project and anticipate “modest” growth rates.
The point to remember, however, is that no matter what formula you use for predicting the future of your investments, it always rests in part on unqualified premises and assumptions. Although many expert analysts claim to see into the future, they are just as fallible as the investors themselves.
I recall a meeting I recently had in London with an investment analyst and clients, when one of the clients expressed an opinion to which the analyst said: “Yes, you are correct.” Then the second client commented with a totally opposite presentation, and the analyst nodded and said: “You are correct.” I could not help it but to express my own confusion and said to the analyst: “ You told both gentlemen they were right, but their views are totally contradictory. They both can’t be correct.” It took him a moment to respond: “Yes, you are correct.”
Take a stock (or a company) that you have heard lots of good things about. You study the company’s prospects, and suppose you conclude that it can maintain a high growth rate for a long period. How long? Well, five years! Why not ten years?
You then calculate what the stock should be “worth” on the basis of the expected future growth rate of dividends, and the general level of interest rates, perhaps making an allowance for the riskiness of the shares. It turns out that the price the stock is worth is just slightly less than its present market price.
You now have two alternatives. You could regard the stock as overpriced and refuse to buy it, or you could say, “Perhaps this stock could remain a high growth rate for ten years, or even more.” Armed with this basic knowledge, you make your sound purchase. There is always some combination of growth period that will produce any specific price. In this sense it would be inconceivable, given human nature, to calculate the intrinsic value of a share. The point to always remember is that the mathematical calculation of the value formula is based on treacherous ground: Forecasting the future. Therefore the major fundamentals for these calculations are never known with certainty; they are only relatively crude estimates — perhaps one should say guesses — about what might happen in the future. And depending on what guesses you make, you can convince yourself to pay any price you want to for a stock.
There are two extreme views taken about the effectiveness of fundamental analysis. The view of many is that fundamental analysis is becoming more powerful and skilful all the time. The individual investor has scarcely a chance against the professional portfolio manager supported by a team of fundamental analysts. An opposite extreme view is taken by much of the academic community. My security analysis professor suggested years ago, that a blindfold monkey throwing darts at the Wall Street Journal can select stocks with much success. My own view on the matter is somewhat less extreme than that taken by the professor and other academics. Nevertheless, an understanding of the large body of research on these issues is essential for any intelligent investor.
Expectation of future earnings continues to be the most important single factor affecting stock prices. Consequently, earnings are the name of the game and always will be. To predict future trends, analysts generally start by looking at historical trends. The argument goes, “A proven score of past performance in earnings growth is a most reliable indicator of future earnings growth.” Calculations of past earnings growth are no help in predicting future growth. The period of the 1970-80 would not have helped at all in predicting what growth they would achieve in the 1980-90 period! I strongly believe that there is no reliable pattern that can be discerned from past records to aid the analysts in predicting future growth. A good analyst will argue, however, that there is much more to predicting than just examining the past records.
Bluntly stated, the careful estimates of those analysts (based on industry studies etc) do very little better than those that would be obtained by simple extrapolation of past trends. Indeed, if you used a simple forecasting method based on the assumption of continued progressive growth in a given company, your “naive” forecasting model will have smaller errors in predicting long-term earnings growth than by using the professional forecasts of the analysts.
Moreover, no analysts proved consistently superior to the others. Of course, in certain years some analysts did much better than average, but there has been no consistency in their pattern of performance.
In the final analysis, financial forecasting appears to be a respectable science, and this is a fact of life with which individual investors have to deal with.
(Habib F. Faris is Vice President at Clariden Bank, London.)
