Earnings Forecasting

Lao Tzu – a 6th century BC philosopher, observed: Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.Yet, most of the investment industry seems to be  obsessed with trying to guess the future.

While in school, I often wondered why would anyone assume that it is possible to forecast with precision future cash flows and interest rates. It turns out, I am not the only one. Charlie Munger points out: “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you, but it doesn’t. They teach that in business schools, because well they have to do something.”

To come up with an earnings estimate, analysts need to forecast  economic growth, industry growth, interest rates, competitors’ moves, market share, sales, margins. There is so much room for mistakes. It is not surprising that analysts are often clueless about future cash flows and earnings estimates; therefore they rely on:

– perceived authority: the management of the company they follow is often regarded as the ultimate expert. After all, who else would know more about its company than management itself, right? The point is that management has monetary incentives not to be entirely honest.

-overconfidence: if an analyst has a good recent track record, many assume that it will continue forever.  Such behavior has the highest probability of failure. The scariest thing about it is that most people would follow blindly someone with a lot of confidence and little knowledge and ignore someone with little confidence and a lot of knowledge. Vanity is my favorite sin as they say in one of my favorite movies.

– follow the herd: put their estimates close to the already existing consensus. The thinking is: if I am wrong, I won’t be the only one. We will be wrong together. There is a feeling of higher security when you are moving with the herd. You tend to feel less invincible.

Taking the above sequence into account, it is understandable why so many companies beat market’s estimates so often and why a small surprise is nothing more than a well executed guidance by companies’ management. This is why, when a company misses it is a clear indication of: 1) lack of knowledge and professionalism of the management (not knowing your own company doesn’t speak too good about you) or 2) deteriorating conditions on a macro level. Both factors are hard to reverce in one quarter. The most useful information that earnings expectations provide is that they tend to exhibit trending behavior. Prices reflect changes in expectations. Expectations are impacted by interpretations of news, forecasts and emotions.

It is said that capital markets are forward looking mechanisms that constantly try to discount any available information, both public and private. The point is that market does not only try to discount objective news, but it also try to discount forecasts. We already know that forecasts are often based either on subjective opinions or on objective analysis of unknown or imprecise data. This explains why capital markets are often irrational (of course they can remain irrational longer than you can remain solvent). The beauty of capital markets is that they tend to trend and once a trend is in place it is hard to be reversed.

If forecasts are often so flawed why so many market decisions are impacted by them? Why do we still keep forecasting? One simple answer – there is a demand for forecasts. Investors are afraid of uncertainty and any look into the future makes them feel more comfortable. The point is that it also makes them less profitable. If someone believes that he knows the future, he would be more confident in his decisions, more likely to leverage and less careful in his risk management – a recipe for disaster.  A proper way to use forecasts is to treat them as cornerstones of  your conditional thinking. For example: if events A and B occur simultaneously, the historic probability of event C to occur is 80%. Based on that we prepare a plan of action.

I pay huge attention to catalysts that cause high volume, price range expansion. Earnings surprises, Earnings guidance, New contracts, New regulation are catalysts with the potential to start a major process of reprising (new trend or continuation of an existing trend). My logic is simple – when institutions buy, they leave traces. They are heavy, but slow buyers, therefore I have enough time to enter and exit as they build their position.  But I also understand that any new information should be interpreted only in the context of the current sentiment. When the return OF capital becomes more important than the return ON capital, emotions trump rationality and investors run for the shore of perceived safety (lately that shore has been UST, Gold, USD, JPY). No setup works all the time. The success rate of any setup is derivative of the current market environment. During severe market corrections earnings surprises and guidance don’t matter. Participants sell first and ask later. Correlation between stocks approximates 1.00.

I have a very simple philosophy – I want to be aggressively long when there is clear evidence that institutions are buying across the board. I want to be in cash or net short when there is evidence that institutions are selling.

Source: The little book of behavioral investing, James Montier