Wednesday, February 3, 2010

Value of Predictions

I am currently on a month long vacation in India, and I meet people in various different lines of business on a daily basis. One of the most common topic of discussion is the growth in the Indian economy and investing in India. I do not disagree that India is going to grow at rapid pace in the next 10-20 years. However, being a value investor, I do not invest based on market forecasts, for lack of margin of safety. I found it extremely challenging trying to explain the rationale for this point of view, so I will do so here.

My thoughts on this subject are mainly influenced by Howard Mark's memo Value of Predictions. It is not useful to just make correct forecasts, but also be able to monetize it.

Expected Value of Forecast = Value of Correct Forecast x Probability of Being Correct.

Being "right" does not lead to superior performance if the consensus forecast is also correct. For example, if the consensus forecast for GDP growth in India is 9%, stocks will come to reflect that expectation. If you conclude that GDP in India will grow at 9% and that motivates you to buy stocks, the stocks you buy will already anticipate this growth. If actual GDP growth in India happens to be 9%, then stock prices will probably not jump - because reaction to this news already took place when the consensus was formed in the past. Instead, you will earn risk-adjusted returns for equities over the holding period.

Everyone's forecasts are, on average, consensus forecasts. If your prediction is consensus too, it won't produce above-average returns even if it's right. Superior performance comes from accurate non-consensus forecasts. But, because most forecasters aren't terrible, they fall near the consensus most of the time - and non-consensus forecasts are usually wrong. Furthermore, accurate non-consensus forecasts are hard to make, and even if you can make them accurately, they are hard to act on.

When interest rates stood at 8% in 1978, most people thought they'd stay there. The interest rate bears predicted 9%, and the bulls predicted 7%. Most of the time, rates would have been in that range, and no one would have made much money.The big profits went to those who predicted 15% long bond yields. But where were those people? Extreme predictions are rarely right, but they're the ones that make you big money.

Not only must a profitable forecast have the event or direction right, but it must be correct at timing as well. Such a forecast is much further away from the conventional wisdom. Holding onto such a position for a long period of time is difficult since it poses career risk (read previous post Market Inefficiency).

Besides, forecasting costs money. Every time you are wrong, you are going to under-perform a buy and hold strategy that emphasizes investing with a margin of safety (read my previous post Two Rules of Investing).

Lastly, you should always be asking why a non-consensus forecast is being shared with you. Groucho Marx said "I wouldn't join any club that would have me as a member." Another formulation may be "I would never act on any forecast that someone would share with me."

All of this does not mean that one should not invest in India. It just means that you are better off not investing in India (or anywhere else) based on macro-forecasts. Instead, invest in businesses that have a strong competitive position, run by competent, honest, and shareholder friendly management, and are selling at discounts from their intrinsic value. I personally find it easier to find such businesses in markets I am familiar with (US and developed nations in Europe) that have a good exposure to emerging markets than in emerging markets themselves (Nestle, Heineken, Diageo, Kone, Unilever, Phillip Morris. Disclosure: Author owns common stock of each of these companies).

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