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Smart Investor: don't let predictions cloud investment decisions

Predictions about the future of a company should always take a back seat to the hard facts of past performance.

 
Smart Investor: don't let predictions cloud investment decisions

Predictions about the future of a company should always take a back seat to the hard facts of past performance.

Attempting to predict the future has fascinated man since the dawn of time. The apocalyptic predictions of Nostradamus, tarot readings given in dusty streets, and the mythology of palmistry all have the power to shape lives. I vividly recall a computer programme sold in the 90s that claimed to be able to predict next week’s lottery numbers – I kid you not!

Visionary leadership

So what does this have to do with investing in shares or any other asset class?

In fact it has a lot to do with investing, because so many people who work in the financial services industry, as well as company management, are remarkably keen to tell private investors what they think will happen in future.

In the case of management this often takes the form of some kind of statement that accompanies a company report, while financial services professionals will often say which direction they ‘see’ things moving in future.

Unreliable narrators

Focusing on company management for now, it has become quite clear to me over the years that managers typically have very little idea about how the company will fare in the medium to long run. Granted, they may be able to say why sales and profit have risen or fallen in the past – but statements about the future are nothing more than guesswork.

Of course, company managers may come across well and appear to know how their company will perform in future, just as a palm-reader will look you in the eye when they tell you about the great riches to be won on a day ending in the letter ‘y’.

Unfair? Let’s rewind to 2007 and specifically to the HBOS annual report. Having just made a net profit of over £4 billion, HBOS CEO Andy Hornby included the following in his review on page 15 of the annual report:

'We expect house price growth to be flat in 2008. Sound fundamentals underpin the housing market, in particular, record levels of employment and a continuing shortage of new properties. We expect financial markets to be difficult in 2008 but our combination of balance sheet strength, diversified business mix and stringent cost control, together with relative margin stability, leaves us well positioned to take opportunities presented in these markets and deliver good growth in shareholder value over the next few years.'

HBOS went on to make a loss of £7.5 billion in 2008, while house prices fell from an average of £195,333 in December 2007 to an average of £158,437 in December 2008, according to the Halifax house price index. This shows that the CEO’s confidence was grossly misplaced.

The kingdom of the blind

Of course, I could have picked any of a wide range of senior managers who did not see the credit crunch coming. I could quote politicians, central bankers, financial-services professionals and many others who did not predict the coming storm. HBOS should not be viewed in isolation, it merely offers an exaggerated example.

Another more recent example is Thomas Cook (TCG.L). In its September 2010 annual report, former CEO Manny Fontenla-Novoa stated the following on page 11: 'We are confident that the actions we have now taken to reinforce the UK business, together with continued progress on our strategic initiatives, leave us well positioned to make progress in the current year.'

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8 comments so far. Why not have your say?

Fenchurch

Oct 03, 2011 at 06:58

I think that it would have been a brave company that reported problems up ahead in 2006 , some commentators did though. Best to do it all together - the herd mentality.

Also it seems to me that these problems are very protracted leadingto the fundamentals being a bit behind the economic reality , or more than normally so. I think that this can lead to 'value traps' which turn a sound company into one that is less sound.

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Matt Freeman

Oct 03, 2011 at 08:40

Everyone watching everyone else and suddenly theyre off ! only Gods knows where. We know from history these bubbles always end in tears. The market takes on a momentum of its own fuelled by greed irrational exuberance and other human emotions . Everyone piles in ,housewives banktsers truckdrivers etc . Thats the time to go away to the country and lie low and away from the madness of crowds. When you come back things will be calm again and theyre will be many bargains to be had if you have some available cash . Remember ! this will pass in a little while and things will settle down until again we feel the need for some madness . I always look at the market and think of it like a woman . Sometimes she is happy sometimes sad and othertimes goes crazy but Im dammed if I understand her .

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Stephanie Dewar

Oct 03, 2011 at 10:16

Matt Freeman, you're a clever man. Damned if we understand ourselves - it's hormones of course. I'm a housewife, and an accountant, and yes, time to wait right now, 'cos every time you buy anything it's down the day after. When the market steadies I'm in tthere and buying, agreeing with ,you know, THAT rogue trader the other day, the one who either has guts or a just a death wish.. We all know Greece is going to default, the euro is probably doomed and all the EC does is inhibit business. We blame the banks for our problems, but let's face it people were greedy enough to borrow massively, not on their incomes but on the wobbly possibility of future equity in their homes. Banks are merely scapegoats, they then passed that debt around each other. Estate agents hyped up homes that weren't fit for purpose - if you can fit a double bed in a room it's a double room! And Gordon Brown made the situation far worse by not building 'social housing' during the Labour years , as well as wrapping Britain up in so much red tape that business was gagged. Come on - shake it all up and start again!

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Hotrod

Oct 03, 2011 at 11:39

The author forgot to mention that company reports and directors statements usually terminate with a disclaimer onlong the lines of: "Past performance is not necessarily a guide to the future, share values can go down as well as up, blah, blah, blah.

My response is two fold: First I compare what the directors have actually said, with trends which have been set by past performance. I then try to deduce what has NOT been said, and what should have been said. e.g. a company may have been trading profitably for a number of years but has now reached a stage where major investments in new plant and equipment is necessary. Many directors have cultivated the happy knack of talking up their companies healthy cashflow, but at the same time playing down the fact that profitability will be restricted due to ongoing costs of replacing machinery etc.

My second response is to study what the company actually does: How does its "USP" (unique selling point) fit within the scale of developments by its competitors.

This approach gives me some idea of how well a company will perform in the future.

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Mahendra Patel

Oct 03, 2011 at 18:18

Very difficult to predict the future. Remember G. E. C(Latter became Marconi). was regarded bluest of blue chip quoted co. Mismangement liquidated the company and its huge pile of cash.

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Bryan Jefferson

Oct 03, 2011 at 21:26

Can't help wondering about someone who calls himself 'Hotrod' and uses abbreviations like 'USP'. Must be a wannabe apprentice I guess?

Certainly not a down to earth person like Matt or Stephanie. When reading these blogs it's best to take notice of what the Matts and Stephanies of this world say and ignore the Hotrods.

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Hotrod

Oct 04, 2011 at 06:45

@ Bryan Jefferson (BF Who ever he is)

Thank you for your compliments, I was merely making a comment regarding my methods of evaluating a company with regards to progressive forward looking statements by directors.

I tried to say something that was pertinent, as I was under the impression that the main gist of this article (and most of the articles written by Smart Investor for that matter) refers to company evaluation, and not market evaluation.

Mark's and Stephanie's contributions, illuminating in their own way regarding aspects of the human psyche, did not, (for me personally) shed any light on the subject.

As we all know stockmarkets around the world are in turmoil, people seem to be running around like headless chickens.

In order to keep mine on my shoulders, I think it is important to never forget the basic principles of business.

Which are:- A realistic business plan, a cashflow projection, and a unique selling point. Some good examples would be Apple, Amazon, and Google.

Unfortunately, for all of us, politians don't think that way.

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John Thorley

Oct 04, 2011 at 13:24

The time to invest is when all the director's reports are trying to explain away why the results of the past year were so bad. Only then is the bad news potentially actually in the past. While they are projecting forward with unfounded optimism they are probably over valued and about to crash.

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