Can the future be predicted with any degree of certainty?
Wall Street’s view of the longer future is notoriously fallible, and this necessarily applies to that important part of its investigations which is directed toward the forecasting of the course of profits…
-The Intelligent Investor, by Benjamin Graham
Often, traditional Wall Street research is superficial and provides misleading information to investors. As any participant in the marketplace can observe when earnings are announced, the actual company report is generally different than that predicted by a group of equity analysts.
Companies and analysts alike can’t possibly predict the future of earnings due to the uncertain nature of the economy and marketplace.
The notion of accurately forecasting events over the next 90 to 365 days or more is fanciful at best, yet research analysts continue to provide earnings forecasts, often to the penny, for periods of up to three years or longer.
The table below shows the percent of ‘Above, In-Line, Below’ of earnings estimates for different industries for quarter one of 2018. Clearly Wall Street analysts have a bias to overestimate actual earnings, but more important is the relative infrequency with which the earnings forecasts are ‘In-Line’ with actual reported earnings (yellow slice).
This bias is confirmed when comparing the ratio of ‘Buy, Hold, Sell’ ratings across the same group of stocks as evidenced below:
Company management are more and more inclined to omit earnings guidance altogether for legal reasons stemming from the inherent uncertainty and the liability associated with trying to predict the future of their own operating results, including revenues, gross margins, capital expenses, net income or EPS.
If those in the best position to make an informed projection are unwilling to do so, given they have access to vital material non-public information and detailed operational and financial data, how could an outside analyst possibly hope to render an accurate forecast?
In addition, as fewer and fewer analysts are writing research on companies, it has become common for companies to have just a single analyst providing coverage. Thus the earnings forecast that is reported with the headline news becomes a consensus of one.
To further illustrate the point, let’s use the most watched economic indicator in the world as a parallel for analyst forecasting, the US Federal Reserve overnight interest rate (Fed Funds rate). Every six weeks, sixteen members of the Federal Reserve’s Open Market Committee gather to ponder the condition of the economy and assess whether or not to cut, hold, or raise the Fed Funds rate. When asked to project a one year, two year or longer-term interest rate, the forecasts of this elite group vary far more widely than one would expect given they come from some of the most informed economists and bankers in the world.
The following are their actual forecasts provided during the June 13, 2018 Federal Open Market Committee (FOMC) meeting:
Over the next two years, looking out to 2020, the members’ views range from a low rate of 1.75% to a high of 4.25% – a statistically meaningful difference, and a set of opinions that imply a very different economic outlook1.
This is really quite remarkable. For years the FOMC’s elite have maintained an aura akin to the Wizard of Oz. Yet despite evidence to the contrary, we still look to their forecasts to get us back to Kansas.
Looking back twelve months to the June 2017 FOMC meeting, the group offered forecasts for one year, bringing us to the present.
The range for today as projected just one year ago was between 1.00% and 3.25%. The actual rate today is 2.00%. Of the sixteen members making a one year-projection, nine were off the mark, several by a wide margin2.
We offer this example to those who would find a degree of certainty or assume a level of confidence based on a forecast. Arguably some of the smartest analysts in the world who immerse themselves in forecasting the economic outlook, meeting every six weeks to update their views, cannot predict the future.
For good reason (or common sense), public companies are adopting a policy of not offering financial forecasts or other types of guidance. We suspect there will be a time in the future when it’s perfectly acceptable to ignore this practice altogether.
Most investors prefer certainty. No certainty exists in the world of investing.
So how do investors distill information in the marketplace into actionable ideas for sound investments?
It takes a good deal of time and effort to employ a thoughtful study of a company, which will necessarily include financial statements, competitive positioning, senior management and related economic incentives, and the cyclical nature of the company’s interests. It is important as well to have an understanding of the economy and forces which are driving it now or may be in the future.
After ascertaining that the company is sound, it is next a question of price. If the company can be purchased at a discount, and exhibits a likelihood of continuing to implement a sound business plan, then that is the only type of forecast on which we can rely.
Simply put by Benjamin Graham:
The rate of return sought should be dependent on the amount of intelligent effort the investor is willing and able to bring to bear on his task. The maximum return would be realized by the alert and enterprising investor who exercises maximum intelligence and skill.
-The Intelligent Investor
1 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180613.pdf
2 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20170614.pdf