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Have you got too much faith in the forecast?

Have you got too much faith in the forecast?

Here’s a chart you may find interesting. It shows how the consensus broker forecast for BHP Billiton Limited (ASX: BHP) 2015 Earnings Per Share (EPS) has evolved over the last number of years, together with the BHP share price during that time.

Screen Shot 2015-05-04 at 3.02.38 pmSource: Bloomberg

What you will notice is that the consensus EPS traffic has been very much one-way for more than three years: with few exceptions, revisions to analyst forecasts have been monotonously down. What this seems to show is the analyst community as a whole being slow to recognize the changes that have taken place in commodities markets, and preferring to make countless incremental adjustments that turn out to be more an indicator of what has already happened, than a bona fide indicator of where things are going.

We don’t hold this against the analysts, because in our view it is extremely difficult to predict commodity prices with any accuracy, and it is a brave analyst who sticks their neck out. As investors, we can acknowledge our inability to forecast accurately instead try to invest in things we can better understand. It’s much harder for an analyst charged with covering BHP to declare “too hard”.

It’s also worth keeping in mind the incentives that analysts face. Making a bold prediction that falls well outside consensus means potentially risking one’s career with a spectacular error. Far safer to be just a little way outside consensus, and a little closer to the correct answer than others. For this reason, it makes sense that consensus forecasts would move a little like a caterpillar, with one analyst after another making measured adjustments to move consensus along, and no-one ever making a large break away from it.

The message in this is to be cautious about placing too much faith in forecasts, even where the rationale is well articulated by a smart person wearing a nice tie.

And if you have the luxury of playing the “too hard” card, be sure to use it, where appropriate.

Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. To learn more about our funds please click here.

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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.

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2 Comments

  1. Marita Concepcion
    :

    Thanks for sharing an insightful thoughts with us Tim; to think that perhaps, somehow, we might be having the same observation, and yet maybe a little bit skittish whether to bravely admit it or not, – hoping that things might turn around somehow… Unfortunately, it would be too late, even if it turns around in the last moment. *Sigh* It’s time to wave our hands in the air and bid farewell.

  2. I prefer to listen to investors who can articulate their methodologies succinctly, with valid reasoning and don’t wear nice ties.

    As an aside, I have notice most of the MIM team don’t wear one….(except for Ben) sorry Ben.

    I think your onto something Tim.

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