Why forecasting sometimes can go awry... - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Why forecasting sometimes can go awry... 

A  A  A
In this issue:
» Impact of giving credit to the wrong guys
» Emerging market bonds could be in a bubble
» India faces a shortage of talent
» Are these 'safe' investments?
» ...and more!

Forecasting sales and earnings of companies can be a tricky business. The past performance, management's business objectives and an understanding of the industry that the company operates in are some of the factors that are considered while projecting for the next few years. But there needs to be a thought process in place in terms of how these variables will play out. And many a time this hardly happens. Analysts and investors alike are unduly euphoric towards certain events as they scramble to make forecasts when the variables remain uncertain.

Take the oil and gas industry for instance. A recent gas discovery made by Reliance Industries Ltd (RIL) led to a surge in its stock price. As reported in an article in DNA, earnings estimates for the company were upgraded based on this development. This is despite the fact that there was not much clarity on the size of the reserves, whether the cost of extraction of gas will be feasible in the current pricing environment and a host of other factors.

And it is not the oil & gas industry only where forecasting can go haywire. The pharma industry is a case in point as well. Factoring in potential revenues from drugs when there is no approval on hand yet and the regulatory environment remains uncertain is bound to result in an over bloated value being ascribed to a company.

Either way, we believe it is dangerous to invest in a stock based on certain events alone. It makes more sense to adopt a conservative stance and give value to the basic core business fundamentals of the company. If the fundamentals are weak, investing in the stock on the basis of one likely positive event is highly risky according to us. At the end of the day, the idea is to build wealth on the back of prudent long term investing focusing on the fundamentals of the business. The lure of short term gains dependent on certain events taking place will not add up to much in the longer run.

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01:26  Chart of the day
The performance of global stock markets including India has been quite volatile for the past several years. Besides the weak fundamentals in Europe and the US on account of the global financial crisis, Indian stock markets have been impacted by problems back home as well. Policy paralysis, economic slowdown and rampant corruption have been the major culprits. So when we asked participants in Equitymaster's Investor Survey 2013 to cite the main reason for the disappointing returns on their stock portfolio, we got some interesting results. Around 35% of the respondents attributed this poor performance to their greed for making quick returns. Blaming the global financial crisis came in second. This is encouraging because it means that investors realise the futility of looking for that quick buck and would most likely take that all important step towards prudent long term investing.

Data Source: Equitymaster's Investor Survey 2013

Anything that is plentiful attracts that much lower value as per us. Take water for example. In areas where it is abundant, people could routinely be seen wasting it. Something similar applies to the concept of credit as well. In times when it is cheap and plentiful, it is extended to even the weakest of companies. However, unlike water where its wastage may not come back to haunt us in a hurry, mistakes from extending credit to the wrong guys could end up pinching the banks much sooner. FT reports how banks who lent to Gulf's family businesses are experiencing this whole after effect of giving loans without much attention to due diligence. And it is the international banks that seem to be facing the maximum brunt. The local banks on the other hand, have kept on extending repayment deadlines, in an effort to postpone the obvious. However, it is important that the region's banks bit the bullet as early as possible and write off loans that have really no hope of being recovered. Else, they would end up throwing good money after bad and this will only exacerbate the problem in the future.

In physics, you may have studied that wind blows from high pressure areas to low pressure areas. The flow of money also appears to follow some laws akin to those of physics. The most fundamental aspect about money is that it constantly chases higher returns. As such, it often flows away from low return areas to high return areas. Of course, finance is not an exact science. And factors such as risk add a lot of complexity to the equation. However, broadly one can say that money will flow wherever it finds higher returns. But sometimes this can be dangerous. Let us explain how.

As you may know, interest rates in the developed economies are abysmally low. This pushes investors to scour newer markets where they can earn higher returns. No wonder that several new emerging markets have witnessed a booming bond market.

But as they say, too much of anything is not good. So is the case with this bond mania. We came across an interesting article in Moneynews that says that emerging market sovereign bonds could be in a bubble. For instance, central African nation Rwanda raised US$ 400 m bond issue last month. Investors rushed in to get a piece of this offering. The worrying part is that a large part of the proceeds are not going into productive assets. Instead, it would be used to build a new conference centre in Kigali, the country's capital. In our view, this is certainly a sign of excessive-risk taking. If this bubble bursts, it will be another jolt to the global economy.

Given India's massive population, it would be difficult to imagine a scenario of talent shortage. Especially when thousands of professionals enter the corporate world each year! But that does not seem to be the case. Human resource firm ManPowerGroup India released the results of the Annual Talent Shortage Survey recently. It suggests that nearly 61% of employers in India are finding it difficult to fill jobs. This is way higher than the global average of 35%.

The survey reveals that employers seem to be finding it most difficult to fill vacancies in areas such as accounting & finance, information technology and engineering. The situation in India seems to have worsened over time. In 2009, the same survey figure stood at much lower 20%. We cannot help but bring in the aspect of the demand-supply into this. This development would only lead to higher costs. Not to mention another key issue that companies are grappling with - talent retention.

Investing in the developed world has become quite a dilemma. As central banks in these countries seem determined to keep interest rates close to zero, investors have been scrambling to find asset classes yielding better returns. As a result, the so called 'safe' investments such as dividend stocks and real estate investment trusts (REITs) are finding a lot of takers. So much so that many are offering a premium to remain invested in them. But history has time and again shown that too much dependence on any one particular asset class only leads to trouble. So while dividend stocks and REITs might be the hot thing now, the trend can easily reverse when the US Fed decides to raise interest rates. This hardly makes these investments 'safe' if that happens. Hence, it becomes important for investors to understand that safety of an asset class cannot be judged on a relative basis. Moreover, it becomes important to sort out one's financial goals and risk appetite and invest accordingly rather than become party to a fad.

After opening the day on a positive note, the Indian stock markets slipped into the red and have been hovering around the dotted line. At the time of writing, the BSE-Sensex was trading marginally above the dotted line. Barring auto, banking and pharma stocks, majority of the stocks have been trading in the positive territory. Power, oil & gas and realty stocks are the biggest gainers today. The BSE-Midcap and BSE-Smallcap indices were up by upto 0.5% each. Stock markets in rest of Asia ended the day on a positive note with the Chinese and Japanese markets up by 1.2% each, while Hong Kong was up by 0.6%.

04:56  Today's investing mantra
"I've found that when the market's going down and you buy funds wisely, at some point in the future you will be happy. You won't get there by reading 'Now is the time to buy" - Peter Lynch
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2 Responses to "Why forecasting sometimes can go awry..."

Digambar Kulkarni

May 29, 2013

Performance of a company is a lot like a General leading an Army! There are several factors opposing him and a lot depends on his ability to appreciate and re-plan his operations, and his ability to execute the plan, from time to time. there are unexpected gains and losses also.

This is the fate of reputed, well trained armies, well equipped and led in war by very capable and experienced Generals.

The prediction of Targets comes right by fluke more than by analysis.



May 28, 2013

Whether for the long term or short term, whether using technical or fundamental, at the end of it all you are only forecasting. With TA you are forecasting price moves. With FA you are forecasting the future of ALL the variables. Seems to me that is more fraught with dangers of forecasting than even TA is ! So your statement that the idea is to build wealth on the back of prudent long term investing focusing on the fundamentals of the business"" is also not tenable because ultimately you forecasting the business future. Seems you just cannot escape forecasting. So why bother with analysing it or commenting on it?

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