Conservative Forecasts - Masters Thoughts

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Forecasting, or more importantly, accurate Forecasting is an art which has long been considered akin to crystal ball gazing. Many think they can do it well, but when you really get down to it you'll often find that those self professed 'seers' are no better at it than anyone else.

Our opinions on the worth of certain investments are also affected by the intellectual biases we have been talking about in recent blogs. Basically, if you want an investment that you really like to perform, then naturally, your belief is that it will. And if you are attempting to forecast that business' future results, invariably it will have significant upside potential.

In realistic terms, the value of an investment is determined by the future cash flows a business will generate, not what it has earned in the past.  Given no-one knows what's going to happen in the future, determining a company's worth requires making an estimate of what those future cashflows may be. This of course, is where it gets hard.

Given the number one rule of investing is not losing money, the Investment Masters manage this difficulty by focusing on buying stocks with a 'margin of safety'.  Should future events unfold in a manner you weren't expecting, a margin of safety will help minimise the downside.

"Investing is inherently about predicting the future. But predictions can never reach 100% accuracy; they can only fall between zero and something approaching 100%. So when we make a judgement, we need a large buffer. This is called margin of safety.  Because there is no way to ever be sure, you must always remember the margin of safety no matter how many other things you grasp" Li Li

“The best investments have a considerable margin of safety. This is Benjamin Graham’s concept of buying at a sufficient discount that even bad luck or the vissitudes of the business cycle won’t derail an investment. As when you build a bridge that can hold 30-ton trucks but only drive ten-ton trucks across it, you would never want your investment fortunes to be dependent on everything going perfectly, every assumption proving accurate, every break going your way.” Seth Klarman

To build this margin of safety, you'll find the Investment Masters take a conservative approach to forecasting future earnings. Simply assuming a company can grow earnings at high rates into the future, and then relying on a valuation based on those optimistic forecasts, exposes the investor to undue capital risk should those optimistic forecasts not be met.

“How do value investors deal with analytical necessity to predict the unpredictable?  The only answer is conservatism.  Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb.  Virtually everything must go right, or losses may be sustained.  Conservative forecasts can be more easily met or even exceeded.  Investors are well advised to make only conservative projections and then invest only at a substantial discount from valuations derived there from.” Seth Klarman

“Typically, when I’m making investments, I’m not making them with assumptions in terms of futures, which are anything more than conservative. I am not banking on massive amounts of demand or any growth rates. I want to make them in a manner where, in virtually any circumstance that I can think of, the odds are heavily in our favour.” Mohnish Pabrai

“.. take all of the variables and calculate ‘em reasonably conservatively .. don’t focus too much on extreme conservatism on each variable in terms of the discount rate and the growth rate and so on; but try to be as realistic as you can on these numbers, with any errors being on the conservative side.  And then when you get all through, you apply the margin of safetyWarren Buffett

“Over the years, we have always positioned ourselves so that if we err, it will generally be on the side of excessive conservatism”  Frank Martin

“When weighing whether or not to purchase a security, we usually make assumptions that hopefully will prove conservative”  Ed Wachenheim

“Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount.  We try, therefore, to keep our estimates conservative.” Warren Buffett

“We strive to be conservative and realistic in assessing opportunities, paying close attention to our own limitations” Allan Mecham

“We only want to buy when we can pay less than 60% of a conservative appraisal of a company’s value .…. trying to create a big margin of safetyMason Hawkins

It's important to recognise that very few companies are actually able to grow at very high rates over the long term.  Not only that, it's also very difficult to estimate which companies will be the fast growers ahead of time. While analysts and investors sometimes have a tendency to project double-digit growth for years into the future, in reality this rarely eventuates. Companies become too large and succumb to the 'law of large numbers': competition is attracted by the high growth rates, or they get disrupted by new technology. The Investment Masters recognise few companies can grow at double-digit rates over the medium to long term.

"In a finite world, high growth rates must self-destruct.  If the base from which the growth is taking place is tiny, this law may not operate for a time.  But when the base balloons, the party ends; a high growth rate eventually forges its own anchor." Warren Buffett

"As well as being difficult to manage and also attracting competition, high rates of growth are, in any case, unsustainable.  Eventually, even the most successful business models must face the law of large numbers - all markets are of finite size (even Coca-Cola's despite it's mid-90's slogan: "The closer we get to infinity, the better it looks!").   Empirically, very few companies can sustain anything like double-digit growth for a decade or more." Marathon Asset Management

"Once a fast grower gets too big, it faces the same dilemma as Gulliver and Lilliput.  There's simply no place for it to stretch out." Peter Lynch

"Since analysts consistently overestimate growth rates, disasters happen all the time.  A 20% growth rate is a nice round number, easy for an analyst to pencil in, and that gets people excited.  It should, because 20% growth over time would be spectacular.  And at some point impossible to sustain." Ralph Wanger

“It’s unrealistic to expect companies to grow at 15% for extended periods. Most great companies can’t do it.” Chris Davis

“The notion that any business can grow at 20% per year forever is a fallacy. It doesn’t happen. In fact, if you go back in time. Let’s say I go back 50 years and I look at the best businesses of the era 50 years back, the bluest of blue chips which were the Amex of the time. Most of them are not around today. They don’t even exist. They have gone bankrupt or they have been acquired or gone.  You cannot get long, long runs on most of these businesses” Mohnish Pabrai

"Examine the record of, say, the 200 highest earnings companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates.  You will find only a handful have.  I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings per-share over the next 20 years" Warren Buffett

"Over time, the growth rate of almost all technologies, products, and services slow because of saturation, obsolescence, or competition.  Many investors tend to project high growth rates far into the future without fully considering forces that eventually will lead to slower growth" Ed Wachenheim

Over time companies change and naturally, so industries also change. It's important therefore that when considering the future, we must ask ourselves what the economic and competitive landscape may look like.

"Everything is in a constant state of change, and the wise investor recognises that success is a process of continually seeking answers to new questions" Sir John Templeton

Simply predicting the future by looking into the past is one of the most dangerous pitfalls of investing. Even though this fact is largely known, many people still practice this approach. Because forecasting the future is so inaccurate, they feel the only safe way to predict what will happen is to look at past results. Successful investing requires that you think about the factors that will impact upon a business in the future. 

"The investor of today does not profit from yesterday's growth." Warren Buffett

“Typically, analysts evaluating the future prospects of a company look at its past. Where else can you look after all? And yet, even if they had a perfect snapshot of the past, they would be mistaken to assume that the conditions that held in the past will hold in the present or future” Leon Levy

"Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do"  Howard Marks

Over time I've witnessed many analysts change their earnings forecasts and tweak their price targets for companies by minuscule amounts. Yet, in the case of most companies, its almost impossible to predict future earnings with any level of precision. Rather than spending the time labouring over precise forecasts, time is better spent thinking about, and understanding the key quantitative and qualitative factors that are likely to impact on the business in the future.

“It is better to be approximately right, than precisely wrong” Warren Buffett

"The cost of obsessing on precision is to often miss the forest for the trees" Frank Martin

"Avoid over-relying on numbers and models. Investors often feel comfortable with numbers and models because they appear definitive. However, they can be misleading because they often are based on historical data that may not be repeatable or are based on assumptions that may not prove valid.  We need numbers and models, but their utility should be paired with judgment and common sense" Ed Wachenheim

Talking to customers, suppliers and competitors is likely to be more fruitful than burying yourself in a 5,000 line spreadsheet model.

"Reading the printed financial records about a company is never enough to justify an investment. One of the major steps in prudent investment must be to find out about a company's affairs from those who have some direct familiarity with them" Phil Fisher

One method I find useful in analysing a company is inverting the analytical process. Rather than forecasting how fast a company's earnings will grow, look to estimate the growth rates that are implied by the current share price. This can be done by building a basic discounted cash flow model of the company's earnings.  If you use the current EPS and a growth rate of 'n' for future years, you can calculate future annual EPS estimates and a terminal EPS estimate for the year beyond the forecast period [say 3-6 years]. You can then apply an appropriate PE ratio to the terminal EPS to calculate a notional terminal value. You can then discount the annual EPS estimates and the future terminal value back to the present value by using an appropriate discount rate.  If you solve for 'n' such that the present value of the cash flows is equal to the share price you get an indication of the growth rate implied in the stock price.  This can then be considered in terms of reasonableness.  

“Reverse engineering the expectations embedded in a stock price is usually more fruitful than trying to foretell the future.”  Marathon Asset Management

“If you are wedded to the use of discounted cash flow valuations, then you may well benefit from turning the process in its head.  Rather than trying to forecast the future, why not take the current market price and back out what it implies for future growth”  James Montier

Successful investment decisions are made through a combination of using conservative forecasts, thinking about the future and understanding that high-growth rates tend to be unsustainable in the medium to longer term. So how do your forecasts look?