Why we steer clear of hockey-stick forecasts
At Montgomery, our investment approach is strongly evidence based. We look for quality businesses with a history of positive earnings, and we steer away from those with negative earnings even when there is a ‘great turnaround story’ to tell. It means we sometimes miss out on making super-normal gains. But, more often, it means we avoid being disappointed when a hockey-stick forecast falls flat.
In managing our various funds we make use of machine learning techniques to distinguish between promising investments and not-so-promising investments. The simple but powerful idea behind this approach is to analyse a large database of past investment opportunities and find the characteristics that separate the two groups in a statistically meaningful way. In other words, we gather lots of data and we listen hard to what it has to say.
There are some interesting things that come out of this analysis. In some cases, the data lines up well with accepted investment wisdom; in others it provides a contradictory view. Either way, it’s good to have the facts in front of you when thinking about whether a particular investment attribute is relevant or not.
One of the simple and less controversial points that comes out of this analysis is that good investments tend to have positive earnings. Put differently, if a business reported negative earnings in the most recent financial year, and even more so it reported negative cash from operations, then the odds are against it being a good investment in future.
The analysis doesn’t tell us why this would be the case, which leaves us free to speculate on why this anomaly should exist. If I was to speculate – and I am – I would say that this reflects a tendency for analysts and investors to readily buy in to stories about future potential. In almost every case, a loss-making business will have a story describing how its fortunes will improve dramatically in the years ahead. There may be few objective facts to support this view, but there will almost always be a good story.
While some of these stories will certainly come true, I think the natural tendency is to give them undue credit. Some will no doubt be spectacular successes, but the statistical evidence shows that these success stories will be outweighed by the many disappointments.
The lesson to take away is simple: a loss-making business that offers a set of hockey-stick forecasts should be viewed with scepticism. These forecasts are much easier to generate than actual results.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
