What is a skill great investors must possess? What quality is necessary, if not sufficient, to elevate one’s investing?
I think forecasting is one.
Great investors are often great forecasters. The giants of the game are able to parse possibilities as a chef parses produce in the market.
They clutch a possibility, inspect it, prod at it, test it…and discard it if need be. All in the pursuit of best aligning their investment theses with the future.
Investing, the past, and seeing the future
We are told ad nauseam that past performance is no guarantee of future performance.
But future performance is where the gains lie.
So if you can’t turn to the past to see the future, forecasting becomes even more important.
To keenly assess what’s coming — to glimpse a stock’s prospects — is what sets the best practitioners apart.
You can be an Excel wizard, spinning webs of financial analysis, and still possess a mediocre track record.
Or you can be a CFO’s worst nightmare, poring over financial statements with an adept eye and performing poorly with your investments.
Take the discounted cash flow (DCF) method of valuing a stock.
The DCF method is one of the most dominant ways to appraise a stock’s worth — taught in business and finance schools all over.
But even DCF’s biggest exponents warn the method has a glaring issue: input.
Consider McKinsey’s respected Valuation textbook on the matter:
‘A valuation based on discounted cash flow is only as good as the model’s forecasts.’
Garbage in, garbage out.
Some think the work lies in executing and running complex valuation calculations.
But the real work comes before: the work to generate sound assumptions and reasonable forecasts.
A model is useless without sound data.
But how do you get sound data about the future? How do you come to reasonable assumptions about matters one, three, or five years down the line?
Superforecasting: a skill in its own right
What does it take to make a good forecast?
A great place to start is by consulting the work of political science professor Philip Tetlock.
Tetlock is the author of the seminal Expert Political Judgment: How Good Is It? and the popular Superforecasting: The Art and Science of Prediction.
Tetlock’s research revealed that good forecasts are rare and often illude the very experts we think would be best placed to make them.
Subject matter expertise does not by necessity lend itself to superior estimates of the future.
In fact, Tetlock found it could hinder them. Experts can double down on bad forecasts by using their wide knowledge of a given field to continue arguing for lousy estimates.
Forecasting, Tetlock found, was a skill in its own right, not a by-product of expertise:
‘What my research had shown was that the average expert had done little better than guessing on many of the political and economic questions I had posed…
‘The average expert was roughly as accurate as a dart-throwing chimpanzee.’
What sets good forecasters apart is not necessarily their knowledge but their thinking. How they think matters more than what they know.
Investment strategist Michael Mauboussin reiterated that point by noting that superforecasters are ‘actively open-minded, intellectually humble, numerate, thoughtful updaters, and hard working’.
They are not defined by encyclopaedic knowledge in X or a PhD in Y. They excel in their pattern of thought, not in its content.
Tetlock distilled the characteristics of a superforecaster to the following bumper sticker:
‘Beliefs are hypotheses to be tested, not treasures to be guarded.’
Superforecasting example: inside view versus outside view
One way to improve your forecasts is to toggle between what Daniel Kahneman — author of Thinking, Fast and Slow — dubbed the inside and outside views.
The inside view is a perspective on the particulars of a case.
Most of us only ever consider the inside view when judging a situation.
The outside view places the particulars among the general trend and considers the base rate.
Kahneman had a neat illustration of this in Thinking, Fast and Slow (emphasis added):
‘An individual has been described by a neighbor as follows: “Steve is very shy and withdrawn, invariably helpful but with little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure and a passion for detail.”
‘Is Steve more likely to be a librarian or a farmer?
‘The resemblance of Steve’s personality to that of a stereotypical librarian strikes everyone immediately, but equally relevant statistical considerations are almost always ignored. Did it occur to you that there are more than 20 male farmers for each male librarian in the United States? Because there are so many more farmers, it is almost certain that more “meek and tidy” souls will be found on tractors than at library information desks. However, we found that participants in our experiments ignored the relevant statistical facts and relied exclusively on resemblance [inside view].’
Considering base rates is a great way to improve your forecasts.
Tetlock has a nice demonstration of taking the outside view in Superforecasting (emphasis added):
‘If Bill Flack were asked whether, in the next twelve months, there would be an armed clash between China and Vietnam over some border dispute, he wouldn’t immediately delve into the particulars of that border dispute and the current state of China-Vietnam relations. He would instead look at how often there have been armed clashes in the past. “Say we get hostile conduct between China and Vietnam every five years,” Bill says. “I’ll use a five-year recurrence model to predict the future.” In any given year, then, the outside view would suggest to Bill there is a 20% chance of a clash. Having established that, Bill would look at the situation today and adjust that number up or down.’
Interestingly, McKinsey’s Valuation book hints at the importance of taking the outside view in the following passage (emphasis added):
‘Yet, all too often, we get caught up in the details of a company’s financial statements and forget the economic fundamentals: A company’s valuation is driven by ROIC and growth. Thus, when you perform a valuation, it is critical to evaluate how your forecasts of ROIC and growth relate to the economics of the industry and how your results compare with the historical performance of companies that came before.’
It is not sufficient to focus on the details of your watchlist stock alone.
You must also consider the base rates: the historical performance of similar firms and the mean economics of the stock’s industry.
The inside view may show you a business with great management, solid growth, effective marketing, and happy customers.
But the outside view may show an industry with slim margins, high exit rates, low barriers to entry, and dwindling ROE.
Remember farmer Steve: he was more likely to be a ‘meek and tidy’ soul driving a tractor than a librarian.
So ask yourself whether a stock you’re interested in is more likely to be a statistical anomaly or another affirmation of the mean.
Until next week,
For Money Morning