Friday, December 20, 2013

Forecasters & Fortune Tellers

"We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children." - Warren Buffett in the 1992 Berkshire Hathaway (BRKaShareholder Letter

Well, with that Buffett quote in mind, this The Motley Fool article by Morgan Housel points out that it doesn't pay to ignore analyst ratings, it actually pays to do the exact opposite:

"...the 50 stocks with the lowest Wall Street analyst ratings at the end of 2011 outperformed the S&P 500 by seven percentage points in 2012. Think about that. Warren Buffett's goal was once to outperform the market by 10 percentage points a year. Doing the opposite of what Wall Street's smartest minds recommended last year got you two-thirds of the way there."

(More on going with "the opposite" approach later on in this post.)

The article also points out that essentially something very similar happened this past year:

Stocks with the Most Sell Ratings - January 2013

YTD Average Return: 75%
YTD Median Return: 52%

Stocks with the Most Buy Ratings - January 2013

YTD Average Return: 22%
YTD Median Return: 20%

Including dividends, the S&P 500 is up 27.4% over the same time frame.

Now, one year just isn't a long enough horizon to judge investment performance.

So, as a result, I'd generally say this means very little.

What makes this a bit more meaningful is when you consider that many analysts DO often set price targets that are over relatively short time frames like, for example, 12 months or so.
(Here are four examples of 12-month price targets by analysts on stocks of otherwise, at least for me, no particular significance.)

In other words, if an analyst is making a recommendation to buy or sell a stock because they believe it can now be bought with a margin of safety (i.e. a nice discount to per share intrinsic value exists) and will produce a good result, all risks considered, over 5-10 years or more then it would be unfair to focus on the 1-year performance.

Well, for a variety of reasons, analysts just generally don't deal with those kind of time horizons.

On the other hand, when you are setting 12-month price targets (or anything similar), highlighting these unimpressive results seems a whole lot more fair.

I have no idea if this awkward performance is an anomaly or a persistent pattern over time but, whether it is or not, trying to guess what the price action of something will be over such time horizons is essentially like flipping coins.

"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch

It's just not a good use of valuable time and energy in my view. I understand, at least in part, some of the incentives and cultural factors at work that lead to these attempts at predicting near term price moves.

More from the article:

"One of the most important lessons in all of finance is to understand the incentives of the guy sitting across the table from you. 

It sounds crazy, but a lot of professional stock analysts aren't terribly concerned with the accuracy of their picks."

Consider this carefully the next time, for whatever reason, an analyst opinion on a particular stock is highlighted by one of the major business media outlets.

What they are saying may be articulated extremely well and sound compelling.

It may even be informed by significant industry specific knowledge and insight.*

Unfortunately, for investors, that doesn't logically mean that their predictions will prove particularly useful or lucrative.

Toward the end of Morgan Housel's article, he makes the point that analysts tend to, in herds, project forward what recently happened. 
(i.e. When a stock rises predict it will keep rising, when a stock falls predict it will keep falling, etc.)

So I guess they're generally better historians than forecasters.


The Seinfeld episode where George Costan
za finally implements an effective strategy to overcome his innately terrible instincts comes to mind. The title of that episode happens to be "The Opposite".

"If every instinct you have is wrong, then the opposite would have to be right." - Jerry Seinfeld speaking to George in "The Opposite"

So maybe it's time for some on Wall Street to adopt George's strategy.

"A job with the New York Yankees! This has been the dream of my life ever since I was a child, and it's all happening because I'm completely ignoring every urge towards common sense and good judgment I've ever had." - George Costanza in "The Opposite"

Finally, I'd point out it's best to be at least a little bit wary of what is a special category of prognosticator; that'd be those who are primarily in the business of making attention grabbing -- occasionally extreme in nature -- predictions (and not necessarily limited to stock selection).

Sometimes, a little charisma (and maybe a charming accent) can make what's otherwise mostly useless -- or maybe even nonsensical -- seem informed, thoughtful, and intelligent.

Whether the predictions end up being frequently right or not ends up being mostly irrelevant.

Make enough predictions and at least a couple of them are bound to end up being correct.

Of course, better if the predictions are provocative in nature to maximize exposure.

Moderate forecasts just don't sell.

"...techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'". -Warren Buffett in the 1987 Berkshire Hathaway Shareholder Letter

The illusion of forecasting skill only then need be promoted in a clever way by the soothsayer. Unfortunately, if marketed well, the evidence seems to suggest there'll be no shortage of willful buyers.

So the fortune teller does not actually need a crystal ball.

In order to sell the illusion, what they say just has to be cloaked in complex sounding terminology, sound compelling, and, even if due mostly to pure chance, end up occasionally making what seems a brilliant prediction.**

That's not necessarily profitable for those who act in accordance with the next prognostication, but probably ends up being fruitful for the prophet.

Adam

Long position in BRKb established at much lower than recent prices

* Mutual funds, hedge funds, and other large institutional investors tend to be buyers of this kind of research. These entities are apparently more interested in their industry knowledge, less interested in their stock selection skills according to an Institutional Investor magazine survey. 
** Some seem to be very good at using language that makes it difficult to actually pin down what the prediction is.
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