Only Time Will Tell
No-one can accurately predict what the future will hold, argues Mark Wharrier, who outlines our open-minded approach to forecasting.
Reading time: 5 minutes.
Why, as humans, do we crave certainty if the one thing we can be certain of is that the future is unknown? We look at the link between behavioural science and financial markets and why an open-minded approach is our preference.
According to the esteemed economic historian — and student of the Great Depression — J.K. Galbraith, “the only function of economic forecasting is to make astrology look respectable”. Forecasts are unavoidable. There is something deep in the human condition that craves certainty about the future, even if the future is inherently unpredictable. At a more practical level, forecasting is sensible when planning for diﬀerent outcomes, be it budgeting, risk management or simply whether an umbrella will be required for the day ahead. However, forecasts can contribute to a false sense of security and camouflage risks, particularly those forecasts using sophisticated modelling and delivered by an erudite presenter with clarity and conviction. Perhaps one of the underrated contributors to the Financial Crisis was the humble Microsoft Excel spreadsheet, which gave the illusion that complex debt structures and economic models could be predicted with granularity for years ahead, therefore justifying even more risk. Sadly, judgement and experience slowly gave way to extrapolation.
It’s fair to say forecasting enjoys mixed reviews amongst professional investors. Investing in any company involves a thesis which rests on an assessment of future cash ﬂows and, consequently, an implicit forecast of all the wider variables which drive the trajectory of earnings. A whole industry has emerged over the years to feed the insatiable demand for forecasting these variables. However, much of this commentary and instant analysis is to exploit short term price volatility; you must trawl through waves of verbiage and data to find real nuggets of value for the longer term investor.
A key element of successful longer-term forecasting is maintaining objectivity and not being tempted to bend the changing facts to fit the original thesis. This is sometimes challenging given the blizzard of data and information available on a continuous media loop. The sheer volume of information now available on the fundamentals can sometimes give the illusion that there is an explanation for everything. The reality is more complex and nuanced. Share prices and asset classes are ultimately driven by fundamentals over time, but there are periods where the two become detached. We have seen too many examples in recent history; the 1999 tech bubble or the lead into the 2008 crash are two of the most dramatic examples of where the focus on near-term forecast accuracy obscured more fundamental and, with hindsight, obvious truths. Being accurate on a precise forecast isn’t much use if the company isn’t going to be here in a few years’ time.
The bias for forecasts to focus on near-term accuracy rather than the bigger picture is driven by a variety of factors, which frequently revolve around the career risk of deviating from the consensus. Behavioural science can also provide some clues. The Nobel Laureate Daniel Kahneman, in his seminal book Thinking Fast and Slow drew attention to two modes of human thought. ‘System one’ thought is fast and generates instinctive responses, while ‘system two’ thought is slower, deliberate and grounded in rational logic. Both approaches have their role in life. System one is important for simple questions and immediate actions, such as responding to traffic when driving a car. System two thinking is more appropriate for complex decision-making where multiple variables can determine different outcomes over time. System one thinking is all too apparent in financial markets.
However, in equity investing the forecasting horizon is everything. Too often the chain linking of short-term performance in response to new data creates share price momentum which can be self-reinforcing. Momentum can give the illusion of dependability, durability and safety, but over time share prices can become detached from fundamentals, both on the upside and the downside. Forecasts can be anchored by recent events. Then something changes: perhaps a private equity bid at a significant premium to the current market value, or a sharp fall in a share price in response to market expectations which had exceeded management’s ability to deliver. We frequently see both scenarios in the UK equity market.
While recalibrating forecasts to new market data is a healthy discipline, forecasting those qualities which are difficult to measure can be more rewarding for equity investors. Our approach to income investing is to seek those companies that can sustain a healthy return on assets, which in turn drives sustainable dividend growth. Rather than forecast the return on capital that we can see, the key is to forecast the durability of those intangible qualities of the business which are responsible for the premium return. These can be a long list of qualities, such as customer relationships, a reputation for reliability, the network effect of a customer base, the competitive advantage of scale or the scope to grow a new market or gain market share through innovation. Examples include the technical product knowledge that Electrocomponents provides to make its customers’ lives easier, or the essential nature of commodity pricing data that Euromoney delivers to its clients through Fastmarkets. These intangible factors are sometimes difficult to measure and tend to be of less interest to the consumer of short-term datapoints, but forecasting their long-term evolution can be rewarding.
The drumbeat of the falling discount rate to unprecedented levels has unwittingly increased the burden on forecasts. The higher a valuation multiple, the more sensitive the share price is to the forecasts implicit in both that discount rate and company cash ﬂows. However, longer-term forecasts tend not to reflect the complexity of the world or the wide range of macro outcomes in the years ahead. The ownership structure of the equity market, with the dominance of index and factor orientated strategies, also tends to extrapolate the recent past. Entertaining a broader range of outcomes and qualitative factors may be less comfortable for those craving certainty, but it enables us to identify asymmetry as not all forecast error is equally rewarded by the market.
While there may be reassurance in following paths which are well trodden and consensual, these are not always right. An open-minded approach to forecasting, encompassing objectivity and a broad range of risked possibilities, is at the heart of Majedie’s approach — one we feel is right for the road ahead.