The Hindu Business Line : The Sisyphean task of forecasting

We've reached that time of year when all experts are busy dishing out forecasts for the next year and the media is happily lapping all this up bringing them to investors who firm up their action plan for the 12 months ahead.

Equity markets, interest rates, currencies, commodities and other asset classes are under close scrutiny as experts analyse past trends and make forecasts based on their world-view.

Forecasting is important not just in financial markets but also in most spheres of life. The other night at a gathering, I sat next to a supply chain manager of a fast moving consumer goods giant and the discussion inevitably tilted towards the complexities of forecasting and its importance in today's dynamic, ever-evolving, just-in-time world.

However, for the purpose at hand, let's focus on the art of financial forecasting and its importance in equity valuation.

Essence of equity investment

If we believe valuation to be the essence of equity investment, then financial forecasting is the lifeline for arriving at a sensible and precise estimate of business valuation. Valuation is all about finding the true value of a business. That depends on how the business is expected to shape up.

This brings us to the archetypal arena of financial forecasting, as that is the route to quantifying expectations from the underlying business. There are two essential questions that face you at this stage: which valuation model to use and how to forecast financials.

I think the latter is much more important than the former. If you look around, you'll be greeted by a variety of valuation models — discounted cash flows, relative valuation, multiples, sum-of-parts, real options.

In my view these models are mere black boxes. What is crucial is to have the right inputs, that is, forecasted financials, for these models so that they churn out a meaningful output, that is value of the business. Garbage in, garbage out works here as well as it does in the IT domain and hence the importance of forecasted numbers.

That brings us to the enigma that financial forecasts are. One common refrain to forecasting is that it is the art of saying what will happen, and then explaining why it did not, given that very few forecasts are ever bang-on. I can assure you that it is not much fun being a forecaster, whether of the weather, the economy or the stock market.

When you get it right, no one seems to notice; but get it wrong, you face ridicule or slander and, worse, people remember. Think of all the expert forecasts you've heard on the various business TV channels and I'm sure the more memorable ones are those that were totally wrong. Probably the most (in)famous of them all was the consensus over ahead of the last parliamentary elections about the results and the final verdict. That is what makes this business of forecasting enigmatic as well as hazardous.

One useful mantra that I've seen some professional forecasters follow, including equity analysts, is this — if you have to forecast, do it often. There surely is safety in numbers.

Popular perception is that if you really understand something, you should be able to predict what's going to happen next. In any form of social gathering, people just have to realise what my profession is before they start asking for opinion on stocks or general market directions. Even more so they're eager to tell me about their friend or a fund manager or a broker they know or have heard of (!) who has an unblemished track record in predicting stock and index movements consistently.

Accurate forecast impossible

My take on this is simple: When someone tells me they can predict with a great deal of accuracy what the stock market is going to do next, my first reaction is that the person may well be a fraud.

When someone tells me they don't have a clue, I tell myself, now there's a real expert! I tend to agree with Sir John Templeton when he says, "If you have all the answers, you don't even understand the questions."

Being an expert means understanding most of the questions and after considering impact of various factors, arriving at a probabilistic outlook for what the future is likely to hold in store. Improving forecasts beyond that, in my view, may just be a Sisyphean task.

An important consideration is that these forecasts are no good even for experts themselves if they don't have the courage of changing their views as soon as any fresh data point emerges that contradicts their stance.

Often, people form opinions on stocks and markets and then do not want to change those even in the fact of contradicting evidence. That is a sure-fire way of losing money in the market - ask any novice or beginner and they would have firsthand experience.

Accepting mistakes

On the other hand, George Soros is a great example for reneging on his views - if you've read his books and writings, you'd realise the number of times his forecasts have gone wrong but the point is, he has still managed to make tonnes of money in the markets. It is due to the fact that he is not afraid to revise his forecast if required and change his stance in the market. Like him, each of us has to decide: is it more important to make money or to be right?

I'm a firm believer that there's no perfect solution to many of our forecasting problems. As underlying relationships constantly change, forecasts based on past experiences are of limited use. I'm not going to hold my breath waiting for a forecasting methodology that does a good job at predicting what the future holds in store for us.

Make the best of the knowledge that you have, consider as many factors as maybe relevant for the task at hand and develop a worldview based on your experiences. Then be on the lookout for any evidence or new factors that may require you to change your forecast. This is truly an ongoing process and will always be. Happy investing!!

(The author is with Emerging Markets Group of Franklin Templeton Investments. The views are personal.)

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