When making forecasts, it’s better to look ahead and not behind
Habit is a fundamental part of our everyday lives. Most of us take the same route to work each day, eat at our favourite restaurants, and shop at the same stores. The alternative – devising new routines each day – is too mentally taxing. Taking the easy way out is fine for everyday decision-making. But, when it comes to investing, it‘s a high-risk approach.
One particularly notable area in investing where cognitive errors can creep in is in making forecasts. Forecasting is a necessary component of investing, given that the value of a stock is derived by determining the present value of all future cash flows that the business will produce over its lifetime. The temptation of our brains to take the easy route when making forecasts can lead to what has been termed “recency bias”. This simply means that we give too great a weighting to recent events when making forecasts.
Consider the following table, which shows the revenue growth trajectory of Company A.
What will the revenue growth be in 2016?
Already you are probably feeling a strong, magnet-like pull toward the number “3%” for your answer. But why? Is this a sound and rational starting point?
In some ways, recent history is a useful baseline for making forecasts about the future, although only if we understand the drivers of that past growth and how likely these drivers are likely to sustain that level of growth in the future. In other words, it is necessary to analyse exactly why the business has been growing at 3% like clockwork each year.
Let’s say that Company A is in the business of selling uniforms to the Australian Army. It sells roughly the same volume of uniforms to the Army each year, but is also allowed to put through a 3% price increase each year. This contract might continue for an extended period and Company A might be the only company with the scale to produce the required volume of uniforms, in which case assuming 3% revenue growth for 2016 might be sensible.
However, investing through the rearview mirror and failing to analyse the future prospects for this business could lead to an investment mistake if the situation was vastly different. What if the competitive environment for producing military uniforms was highly competitive and Company A’s contract, which represents 100% of its revenues, was up for renewal in 2016? If Company A were to lose that contract, the revenue growth in 2016 could be -100%, rather than the sanguine +3% our minds automatically gravitate towards.
It’s crucial to always be mindful of the spectrum of outcomes that could transpire for a company under different scenarios. The greater the rigour with which the analysis is undertaken, the more informed this spectrum of outcomes is likely to be. To avoid the pitfalls of the recency bias, investors must always strive to turn their mind to “what could be”, rather than the much more easily observed “what has been”.