Why the fixation on forecasting is misguided

It's results season, a lot of activity but any value?

Every six months, the finance industry moves into a frenzy of pre, during and post-earnings analysis during the earnings results seasons of listed companies.

Models are updated, earnings hits and misses summarised, and management presentations held. Much of the attention is centred around whether earnings positively or negatively “surprised” the market.

Positive surprises are generally met with an appreciating share price, negative surprises the opposite.

It would appear that all you need to do to make money in the share market is predict which companies will positively surprise, and indeed, many participants appear to try.

However, the futility of trying to consistently predict the future is well documented.

Our emotional and behavioural biases coupled with the complexity of the world makes it virtually impossible.

In a highly respected essay, Seven Sins of Fund Management, written by James Montier of GMO when he was at Dresdner Kleinwort, forecasting was sin number one.

Montier noted: “An enormous amount of evidence suggests that investors are generally hopeless at forecasting. So, using forecasts as an integral part of the investment process is like tying one hand behind your back before you start.”

And even if you do get the odd one right a recent study in the CFA Financial Analysts Journal has found that it does not affect your returns much.

Feng Gu and Baruch Lev found that the gains from predicting corporate earnings, or consensus hits and misses “an activity at the core of most investment methodologies” have been shrinking fast over the past 30 years. And that any residual gain that is left can be replicated by a “dumb” momentum investment strategy.

While you obviously need to review the performance of companies that you are invested in, trying to forecast the next six months' earnings to the decimal point seems to us to be a waste of time.

More importantly, it leads to a focus on the short-term and a potential risk of not seeing the wood for the trees.

If you are focused on earnings and are worried the company will miss consensus earnings you might sell it, even if you see great long-term value.

Worse still is the potential effect of this activity on the companies themselves.

A survey of CFOs by John Graham, Campbell Harvey and Shiva Rajgopal, published in 2006, found a willingness to routinely sacrifice shareholder value to meet earnings expectations or to smooth reported earnings.

They note: “Indeed, we assert that the amount of value destroyed by firms striving to hit earnings targets exceeds the value lost in these high-profile fraud cases!” This is not the only study that has found this.

The fact is businesses are uncertain and volatile, especially over short periods. Anyone in business will tell you that.

Trying to forecast the next six months' earnings to the decimal point seems to us to be a waste of time.

And the problem with forecasting is it is essentially guesswork plus maths. While the maths bit is relatively robust, there are all sorts of problems around the guesswork.

Our guesses of the future are based on a massive but incomplete information set and are generally biased by recent events and can be subliminally anchored to completely irrelevant facts.

And even if you get past these issues, to think you can consistently out-forecast the market must surely make you guilty of Montier’s sin number two: “The Illusion of Knowledge.”

The recent earnings reporting season is not going to tell you much about the long-term prospects of the companies.

Outlook statements are likely to have been conservative due to the higher-than-normal level of uncertainty.

A good example is the NZX announcement. Despite a solid first half, NZX kept to its previous full year guidance, which implied a slow-down in the second half.

If activity remains buoyant there is a good chance of an upgrade, but there are some big variables, like funds under management, that could materially change the outlook if market volatility returns, not to mention the odd cyber-attack.

Trying to forecast earnings is perilous at the best of times, but it is particularly challenging in the current environment.

The global economy is being severely warped by two massive opposing forces. The Covid-19 related demand and supply shocks on one side, and the massive monetary and fiscal policy responses on the other.

In our opinion, focusing on the characteristics of a company that makes it a long-term winner is not only easier but more financially rewarding than dwelling too much on what the company earned over the last six months.

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