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The next best thing to Time-Machine in investing....

Apr 9, 2015

In this issue:
» Has the Fed been fooling us for the past 6 years?
» Can stocks trade at price to earnings multiple of 10,000x?
» Moody's upgrades India
» ...and more!

The legendary Peter Lynch once opined that if you can follow only one thing, follow the earnings. Because sooner or later earnings make or break an investment in equities.

Quite true indeed. If valuations are reasonable and everything else remaining constant, a company that grows its earnings 3 times in 5 years will also see it stock price go up by the same amount. Consequently, if you want to predict stock prices, try predicting the earnings first.

This is easier said than done though. For forecasting requires a skill set we can break our heads with but still not come anywhere close to doing a decent job of it. As a matter of fact, even specialists who are asked to make predictions about their own industries end up with foot in the mouth at times. We hope you all remember what Microsoft CEO Steve Ballmer had to say about iPhones when they were first launched in 2007? He simply shrugged them off saying there's no chance the iPhone is going to get significant market share!

Then there's Irving Fisher, arguably the best economist of his generation. But how wrong was he when he predicted in 1929 that the US stock market has reached permanently new highs! Within 3 days of his prediction, the US stocks started what is widely accepted as one of their worst slides ever!

There are of course plenty more bold predictions gone horribly wrong. However, the biggest bomb by far was yet to come. It was finally planted under the forecasting industry in 1987 by a gentleman who answers to the name of Philip Tetlock. Incidentally, the bomb didn't explode for close to two decades. But when the results of his study were finally out, it created an explosion so big, it shook the very foundations of the forecasting industry.

After studying 28,000 predictions from close to 284 experts, the key finding for Tetlock was that experts are terrible forecasters. Worse still, the average expert did only slightly better than random guessing.

Does this hold good for equity research analysts also? Absolutely. It will be a huge stretch of imagination to believe that equity research analysts who make earnings forecasts are better at predictions than experts from other disciplines. This is certainly not the case. And therefore while their research models have gotten more sophisticated over the years, their track record in terms of forecasting earnings remains as bad as ever!

Looks like the anti-forecasting brigade does have a strong case to make for itself. And we would sort of tend to agree with them. Rather than investing with the assumption that we can predict the future, it is always better to start with the opposite point of view. In other words, start with the assumption that in investing as in many other disciplines that requires human interactions; it is next to impossible to predict what future has in store for us.

And mind you, we have some great company if we start thinking this way. Despite all the wisdom and knowledge at their disposal, even the likes of Buffett and Munger approach every potential investment opportunity with the assumption that the future is impossible to predict.

And when you make this assumption, your mind immediately works towards creating as many safety levers as possible. This is to ensure that the losses are minimised in case the predictions go wrong. In investing, this would mean staying within one's circle of competence and always remaining conservative when forecasting future earnings. Last but not the least, insisting on a margin of safety when valuing a stock.

No, this may not help in accurately predicting the future. But it will ensure you always remain a step ahead. A step ahead of most of the investors out there who either due to their arrogance or greed assume the future to turn out exactly the way they had anticipated. And in the process, end up betting way too much or take bets where the risk-reward equation is not in their favour.

To conclude, all of us would certainly love to have the equivalent of a time machine so that we can make our investments by first travelling into the future and coming back. However, till the time science resolves this mystery, it is always better to assume that the future is more uncertain than we make it out to be. And therefore have safety levers in place like the ones we highlighted.

Do you think building few safety mechanisms help when it comes to long term investing? Let us know your comments or share your views in the Equitymaster Club.

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  Chart of the day
As highlighted earlier, valuations play a very important role in any buy/sell decision. And one of the most common metric used to gauge valuations is the P/E ratio. It tells us how expensive/cheap a company is relative to its earnings.

Today's chart redefines the term expensive in the P/E parlance. It shows a list of stocks trading at astronomical P/Es you may have never heard of. As seen, Mangalam Industrial Finance is the most expensive stock trading at a P/E of 88,073 times! Even the least expensive stock in the list is trading at a multiple of 12,060 times.

The most expensive stocks on P/E basis
MIF= Mangalam Industrial Finance, AM&M=Appu Marketing & manufacturing, Ojas= Ojas Asset reconstruction

What do such high P/E multiples indicate?

It is an indication that investor's are not valuing these companies based on their earnings capability but on other factors like land bank, replacement value etc. Or maybe the past year earnings were abnormally low for P/Es to appear so high. Even market manipulation cannot be ruled out in such a case which is generally a prime factor for wide divergence in prices and earnings. However, the fact that all these companies have market cap in excess of Rs 5 bn is an indication that manipulation wouldn't be that easy. Whatever the case, it's better if investors choose to stay away from such companies.

How much importance should we give to the US Fed's recent statement that higher interest rates are just around the corner? Well, if an article on is to be believed, absolutely none. It has argued that the Fed has been crying wolf for the last six years. In other words, since 2009, it has been making statements to the effect that higher interest rates could be upon as any time soon. And as we jolly well know, nothing of the sort has happened. Consequently, even the Fed's recent statement about interest rate hikes being imminent should be taken with a huge pinch of salt.

We would not beg to differ with this point of view. The thing is that the whole US recovery seems to us a result of the loose monetary policy. And therefore no sooner does the rug gets pulled, a severe slowdown can immediately take hold. This will therefore force the Fed to once again lower rates so that the economy can be pulled out of trouble. In other words, it looks like we have entered a period where the rates can be lower far longer than anyone can possibly imagine. And this may not be good news for stocks where prices already seem inflated in few pockets.

Buoyed by the steps taken by Indian policymakers, ratings agency Moody's has revised India's outlook to positive from stable. It believes that the Modi government is taking the right steps to boost economic growth. This coupled with the structural advantage that India has will enable itself to grow faster than its peers warranting a change in rating.

Let us now see how a change in rating outlook affects any economy. For one, it builds credibility thereby attracting foreign investors. Country ratings play a major role in attracting foreign capital. A better rating gives prospective investors a comfort about the country's economic strength. And an upgrade helps in that regards.

While this change in outlook would definitely help, India will have to pull up its socks so as to meet its fiscal targets if the rating is to be upgraded from here on. Unseasonal rains in some parts of India could play a spoil sport here by presenting agricultural shocks even if fiscal targets are met. This can impact the chances of a further upgrade. Thus, it remains to be seen how India's ratings move from here on over the next 12-18 months.

The Indian stock markets were trading in the green at the time of writing. While the BSE Sensex was up by 45 points, NSE-Nifty was up by 28 points. However, most Asian equity markets were trading in the red at the time of writing. European stock markets, however, opened the day in the positive.

 Today's investing mantra
"Forecasts usually tell us more of the forecaster than of the forecast" - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Jinesh Joshi and Rahul Shah.

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Equitymaster requests your view! Post a comment on "The next best thing to Time-Machine in investing....". Click here!

1 Responses to "The next best thing to Time-Machine in investing...."

RS Rathore

Apr 11, 2015

I don't know about others as to what they think about investing in the stock market, but I have made up my mind of my own to invest in two stocks in equity(BSE)for a period of at least 4 to 5 years after studying their business standard. Both should(will) fetch Laurels & Snowballs to me, but why should I disclose those two with EM or any one else ? !!

Equitymaster requests your view! Post a comment on "The next best thing to Time-Machine in investing....". Click here!
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Definitions of Terms Used:
  1. Buy recommendation: This means that the investor could consider buying the concerned stock at current market price keeping in mind the tenure and objective of the recommendation service.
  2. Hold recommendation: This means that the investor could consider holding on to the shares of the company until further update and not buy more of the stock at current market price.
  3. Buy at lower price: This means that the investor should wait for some correction in the market price so that the stock can be bought at more attractive valuations keeping in mind the tenure and the objective of the service.
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