When You Have No Idea What Happens Next
Asking an analyst for this year’s earnings forecasts may sound ridiculous now given the complete uncertainty around the lockdown and return to normalcy thereafter. But this piece is to show that the question is no less ridiculous even in normal times. Indeed, the Indian sell side community collectively has failed to come remotely close to the Nifty’s actual earnings every single time in the last five years. Morgan Housel articulates this aspect of investing which we frequently tend to grapple in our conversations with clients – when we go on and on about the long history of a portfolio company and the client asks ‘all that is fine, but tell me what will happen in the future as my returns depend on that, not the past. Show me your forecasts’. To which we promptly say we don’t have any.
“Studying history can feel like intellectual candy that offers no practical use to investors who are paid to foresee the future. But once you accept how fragile our assumptions of the future are, you realize that forecasts are the real fluff and history is where the meat is.
Think of all the 2020 market forecasts published in December. Oof. Authors of these reports – most of which have been quietly removed – might say, “I couldn’t have foreseen Covid-19 in December, and it upended my entire forecast.” To which my response would be, “Yes, that’s my point.” If you claim an ability to foresee events, you can’t use events you didn’t foresee as an excuse – especially when unforeseeable events move the needle most. When a company reports poor earnings it’s often said they missed analysts’ estimates. But earnings don’t miss estimates; estimates miss earnings.
Accepting that forecasts have little use doesn’t mean you become a blind fatalist. When you pay more attention to history than forecasts you pick up on the patterns that guide how people respond to unforeseen events, which – given how stable behavior is over time – is the next best thing to knowing what will happen next.
I don’t know when this recession will end, and I’m not interested in your forecast. But I am interested in the historical observation that progress happens too slowly for people to notice but setbacks happen too quickly to ignore, which causes most people to recognize when a recession ended only with considerable hindsight, which requires maintaining investing optimism even when the economy around you feels broken.”
But this doesn’t mean we don’t care about the future. After all the client is right – her returns will come from what will happen in future. Here as well, Morgan’s tip is to have expectations, not forecasts.
“If I say, “The next recession will begin in 2024,” I’ve made a forecast.
If I say, “Recessions occur roughly every 5-10 years,” I’ve expressed an expectation.
They seem similar, but they’re very different.
Forecasts rely on knowing when something will occur. Expectations are an acknowledgment of what’s likely to occur without professing insight into when it will happen.
Expectations are healthier than forecasts because they provide a vision of the future stripped of all false precision. If you know a recession will occur at some point, you won’t be that surprised whenever it arrives – which is a huge benefit. But if you assume you know exactly when it will occur you’ll be tempted into all kinds of dangerous behavior, leveraged with overconfidence. And you’ll be shocked when time passes and what you thought would occur hasn’t happened (yet).”
We expect our portfolio companies to compund their earnings at around 20% for the next 5-10yrs.