Many a times when people ask me about how the markets would do, how a stock would perform, whether a sector will turn around, how the rupee will fare,what’s your take on the economy etc , I resort to a frank and an honest answer “Ask Bejan Daruwalla”. Forecasting the future really is the job of an astrologer. However in the investing world I have seen that analysts keep on forecasting in spite of our inability to predict the future. However still the forecasting industry is a highly paid industry and people go on forecasting and go on going wrong 90% of the time.
Most of the investing industry is obsessed with trying to guess the future. This is the result of how investors are taught to think about investing. Business schools teach us the discounted cash flow model: we are taught to forecast cash flows for a company 10 to 20 years in to the future and then discount them back to the present. I hope this was as easy as it sounds. It cannot be done as this is based on certain assumptions and these are subject to change over time. Moreover different people have different assumptions. People do it out of a habit or it has become a custom to do so to sound intelligent and smart. Certain behavioural traits also play an important role. In bullish times people are over optimistic and over confident and so would the assumptions be, which will change if there is subdued pessimism.
Normally the top down approach is followed. Forecast the economy, forecast the interest rates, forecast the sectors which will do well and within this environment forecast the stocks that will do well in that sector. Assume that someone is pretty good at this and is right on each forecast most of the time. If all the forecasts need to be correct then there is just a minimal chance of getting it right. After getting all these right the analyst still has a number of other forecasts to be made on individual companies: sales, different costs, power, raw material, wages, taxes and so on. Now how do you expect one to go right? No wonder they never hit the bulls eye.
Lets see the track record of all the forecasting by the analysts. The tech boom talked about the death of bricks and mortar and the birth of the new economy. The tech companies were forecasted to do very well. What happened? 2001 all the forecasts went for a toss. During that time the FMCG companies were the discarded lot and the analysts forecasted gloomy future for those stocks. Had you been using common sense and bought these FMCG companies because they were available at cheap valuations you would be immensely rich. Similarly 2005 to 2007 analysts forecasted bright future for the Real Estate, Infrastructure and Power Industry. None of those forecasts came true. When 2008 global crisis came, again it proved all the forecasts wrong. Surprisingly no one had forecasted the global crisis. Till last year everyone had a pessimistic outlook on our economy and the business environment and these forecasts have also gone wrong. Just recently analysts were bearish on Hindustan Lever and it surprised them with an 11% growth. Adani stocks have been zooming, had anyone forecasted? The forecasting record of the analyst’s have been dreadful and they don't have a clue about the future earnings. If you are going to read these broker reports, and hear the analysts on TV shows forecasting , please do it for entertainment rather than for investing.
If forecasts are really bad then why do people keep on producing them? Maybe it is the demand that creates the supply. We live in an irrational world and if investors really want meaningless information then someone will always provide it. And why do people use forecasts and why there exists a lucrative market for forecasts? The most important behavioural trait which creates a market for these forecasts is “Anchoring”. When given a number we tend to cling to it , even subconsciously. Forecasting is to markets what gravity is to earth. We may make fun of forecasts but at the same time we cannot function without them. Say for instance analysts consensus on a company like Infosys'. This anchor helps us to form an opinion about whether it is over valued or undervalued. Without forecasts the market would not be grounded to anything. But still I doubt if we really need forecasts to invest.
If we cant invest by forecasting how should we invest? Ben Graham pointed out very aptly “ Analysis should be penetrating, not prophetic.” That is the reason analysts are called analysts and not forecasters. Investors need to devote themselves to understanding businesses and their intrinsic worth rather than trying to waste time on forecasting the unknowable future. This is the “Bottom Up” approach to investing. It is all about buying a business and not a stock. The said business has to be run by a credible management, business that has a strong moat around it, that has least debt, that requires less amount of capital, that has a high ROI, that has pricing power, that has a competitive edge like strong brands, distribution network, patents etc. Above all, the business should be available at an attractive valuation.
The bottom up approach helps you to follow a well defined process and frees you from the various distractions of the markets like, timing the market, vagaries of weather, political changes, events beyond control and behavioural disorders. Stick to a well defined process and the results will follow. Be wise rather than smart.
