Imagine we have a friend
that makes a lot of
commitments but only does 53% of the things he said he will do over the
next year and only 7% of the ones he commits to over two years.
We are planning a camping trip this year and a school reunion in two
years. How many tasks would you trust your friend with?
Probably not many, if anything at all, or maybe things of little
importance.
At this point you are probably asking what this has got to do with
investing.
More than you think. It has got to do with forecasting and reliability. But more on that later.
First something on forecasting.
I came across an insightful blog post on forecasting by
Jonathan Davis.
Jonathan graciously
agreed for me to use the article in the guest post below. (Emphasis
mine)
Put
Not Your Trust in Forecasts
Friday,
January 22, 2010
Never invest on the basis
of forecasts. So says James Montier, recently anointed the dean of
behavioural finance in the UK.
Glance
at the index of Value Investing, his superb collection of essays on the
subject, and you will find that “forecast” appears more often than any
other, with the exception only of the holy of holies, Ben Graham
himself. References to the former are as consistently negative as those
to the latter are positive.
“The evidence
on the folly of forecasting is overwhelming” Montier concludes,
whether you are talking about economists or stockbroking analysts. “Frankly the
three blind mice have more credibility than any macro-forecaster at
seeing what is coming” is his verdict on economists.
As
for analysts, he notes that the average forecasting error in the US
analyst community between 2001 and 2006 was 47% over 12 months and 93%
over 24 months.
And what does Ben Graham
say? Simply this: “Forecasting
security prices in not properly a part of security analysis”.
Judging by the response to my last
column,
which described John Templeton’s approach to the forecasting business,
this is a view that many participants in the securities business share.
The only professionally acceptable response to any question on the
subject of analyst reports is to say “Well, I read them – but only for
the data, you understand, not for the recommendations”.
The only problem with all
this is that it
doesn’t seem to be true.
It would be nice to meet a few professional investors who don’t in
practice, either implicitly or explicitly, rely quite heavily on
forecasts to inform and justify their investment views. This has
prompted me over the years to formulate some other rules which I have
found helpful in distinguishing between useful and useless research.
Rule One
The first of these is
this: “Don’t
rely on what anyone says they are doing. Look at what they are actually
doing”.
Just as comment is free, but facts are sacred, so too market punditry
is cheap, but actual investment decisions are the only thing that
really matter. I recall a meeting of IFAs in March 2003 at which, on a
show of hands, a clear majority of those present disputed a claim by
Anthony Bolton that his then public bullishness on equities was a
contrarian call.
A second show of hands
then revealed that, although
being
bullish was what the majority professed to believe, only a tiny
minority of those present had actually positioned their clients’
portfolios to reflect that view.
While the audience was talking
about loading up on equities, Bolton was one of the few who had already
done so. A year later many in the audience were still struggling to
catch up with the renewed bull market that they had called, but
signally failed to act on.
Rule Two
A second valuable rule is
“Never
waste any time on investors who appear to be telling the markets what
to do”. Saying something will happen is a good way to generate a
headline, but a poor way to make money. Every investment call can at best be an
assessment of probabilities.
Those who proclaim that an outcome is a virtual certainty are either
deluded (if they believe their own pronouncements), charlatans (if they
don’t believe it, but go ahead and make it anyway) or professionals who
are paid to believe it (brokers and headline writers being good
examples). Those
who are
hesitant and make liberal use of phrases such as “my guess”, “the most
probable outcome” and so on are the ones talking the true language of
the market.
Rule Three
A third useful empirical
rule is “Don’t
use Japanese experience as proof of anything”.
Many of us have fallen at this hurdle over the years. Just as the great
equity bull market of the 1970s and 1980s powered on beyond any
possible rationalisation, so too the subsequent 20-year period has been
full of commensurate disappointments.
The
Japanese economic experience of the last 40 years serves only to
demonstrate that Japan, for reasons that are open to analysis, marches to different
rules from almost every other market, society and economy.
It is the exception to almost every rule in the book. Those who
currently claim that the US must inevitably follow Japan into 20 years
of debt deflation are breaking both the second and the third rule.
If forecasts are no use,
then what is the basis on which investors can or should make decisions?
Value
has to be part of it. Momentum is also a useful tool: wonderfully
consistent as long as it works and then periodically catastrophic when,
as invariably it does, it breaks down. Technical analysis, if used as a
guide to probabilities, has a place; ditto good fortune.
A good deal of the time however, including most likely the present,
markets can appear to be neither obviously dear nor cheap.
Who, though, one wonders, is buying Government bonds today out of
unalloyed conviction?
Jonathan Davis
http://www.independent-investor.com/
About
Jonathan Davis
I
have been analysing investment markets for more than 30 years,
initially as a journalist on The Times, The Economist and The
Independent, more recently as a columnist, author and investment
professional. I am Investment Director of Agrifirma Services Ltd and a
Non-Executive Director of Hargreaves Lansdown plc. Any personal views
expressed on this website, or in the newsletter, are entirely my own.
Getting back to our friend.
The commitments our friend keeps exactly matches the
forecasting ability of analysts. I know commitments and forecasts cannot directly be compared with each other but I wanted to somehow compare the results of both, to make it clear how unreliable forecasts are.
Not something that inspires confidence. Does it?
In James' own words: (Emphasis
mine)
"One
of the recurring themes of my research is that we just can't forecast.
There isn't a
shred of evidence to suggest that we can. This, of
course, doesn't stop everyone from trying."
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But as Jonathan says, everyone says that no-one
listens to
analysts but why is it when a stock misses expectations, it craters, or
when an investment bank issues a strong buy the stock price jumps.
I have gotten to the point there I ignore all
recommendations from investment banks.
But it is not always easy. It is as if humans have an innate weakness
for someone that says she knows something about the future. I have to
consciously make a point of ignoring forecasts.
Richard Beddard from The
Interactive Investor blog had an excellent review of James' book Value
Investing: Tools and Techniques for Intelligent Investment Jonathan
mentions above.
Your sceptical analyst ignoring forecasts.
Tim du Toit
P.S. A company the market forgot about
Last month while running my stock screeners to find attractively valued companies I stumbled onto something that will interest you.
As you know I look for the absolute cheapest companies in Europe, the UK and the USA, irrespective of size and market they are trading on.
This time however I discovered “a gem lying in plain sight”.
It’s a really large company (that you can buy nearly anywhere) that has gotten really cheap. But is so large and obvious that it is completely overlooked by the market.
Something like a diamond lying on the sidewalk, you do not believe that it is a diamond and thus ignore it as you walk by.
Another reason I like the company it that it recently got rid of quite a large millstone around its neck, another factor that should help it perform better in future.
I immediately analysed the company and recommended it to my subscribers.
To find out how you can also get ideas like this monthly click here.
