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The Folly of Forecasting

“It’s tough to make predictions, especially about the future”
—Yogi Berra

Given it’s that time of year when Wall Street’s market strategists trot out their year ahead outlooks, we thought we might share our thoughts on the value of forecasting or perhaps the lack thereof. If the following sampling of prior year outlooks for CY2022 are any gauge, we doubt next year’s predictions are worth the paper they’re printed on.

“We forecast a total return of 11% by year-end 2022…for the MSCI AC World Index.”
—Credit Suisse (17 Nov 2021)

“We forecast the S&P 500 index will climb by 9% to 5100 at year-end 2022.”
—Goldman Sachs (16 Nov 2021)

“Next year, we expect S&P 500 to reach 5050…most of the equity upside should be realized between now and 1H22.”
—J.P. Morgan (30 Nov 2021)

Now to be fair, we recognize predicting the future is difficult, and we believe that’s especially so for macro forecasting where there are hundreds, if not thousands, of variables. Incorporating market and economic forecasts into top-down portfolio decision making commonly takes the form of adjusting sector and industries weightings. For instance, if one’s economic outlook is positive, you might choose to overweight cyclical stocks or higher beta groups, like many technology stocks in recent years. On the other hand, if your outlook is less sanguine, you might instead overweight defensives, like consumer staples and utilities. However, the odds of those decisions being additive to returns may be only slightly better than a coin flip. We choose not to play this macro game. Just like avoiding the casino where the odds are in the house’s favor, we believe we can find better odds elsewhere.  

Our focus is on bottom-up research—analyzing companies and industries. This includes studying competitive forces, scrutinizing financial statements and assessing incentives of corporate leaders, among others important factors. However, unlike many of our peers who are also bottom-up investors, we don’t play the quarterly earnings game—trying to time the market around company earnings events. The way to play this game is to identify situations where you believe the company will soundly beat the consensus EPS forecast. This approach has its merits, but it’s ultimately a short-term game, with more of a binary outcome. Business progress is rarely linear and often lumpy, so reducing one’s time horizon also reduces the probability of success.

Rather than forecasting, we lean into uncertainty. We aim to increase our odds of success. We do this in a few ways. First, we look for low-expectations situations. These are companies that may be underearning or out of favor with investors…for any number of reasons. We then estimate a normalized range of earnings power. By using ranges rather than specific numbers, we avoid false precision. As Warren Buffet has stated, “I would rather be vaguely right than precisely wrong.” Additionally, we use reasonable time horizons for business normalization since we find most of opportunities are realized over years, not months or quarters. If we find a company that returns to normal, we not only benefit from the growth in business value, but also the possibility of the re-rating of the stock to a higher multiple.

For example, if the company grows its earnings 50% over 5 years and re-rates from 12X to 15X, the equity investment generates an annualized 13.4% price return—8.4% from the earnings growth and 4.6% from the multiple expansion ((1.084 x 1.046) ^ (1/5)-1=13.4%). Adding an average dividend yield of 1.0%-2.0% and you have the makings of a solid double-digit annualized return.

We try to find as many of these types of opportunities as we can, ideally in different areas of the economy to construct a diversified portfolio of value-oriented companies that we believe are undervalued, in solid financial condition and have attractive business economics. Our effort is geared towards stacking the deck in our favor, i.e. we want the business on our side, the balance sheet on our side and valuation on our side. Experience has taught us that investing in companies with these characteristics tilts the risk/reward in our favor over the long term. We believe this is how we can add value and will leave the forecasting to the prognosticators and talking heads. There’s a belief in the industry that macro forecasting is an indispensable part of investing if you’re positioning capital to benefit from future events, but our experience has reinforced the wisdom of Warren Buffett’s statement that “forecasts usually tell us more of the forecaster than of the future.”