European Equities

Forecasting: a fool’s game?

You’d be hard pressed to find an investor who is not familiar with the concept of behavioural finance.
February 2017

Sacha El Khoury

Vice President, Portfolio Manager, European Equities

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Risk Disclaimer 

Past performance should not be seen as an indication of future performance. The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

You’d be hard pressed to find an investor who is not familiar with the concept of behavioural finance. Yet, the impact of human behaviour on markets has arguably never been so strong.

Investors tend to be victims of their own behaviour

Quarterly earnings seem to be the main focus for investors these days as the average holding period for stocks has reached record lows1 and herding behaviour has pushed some areas of the market to unsustainable levels. The purpose of this note is not to delve into each and every bias in the repertoire (you’d be much better off reading James Montier2), but to zoom in on one in particular: anchoring.
 

The dangers and opportunities of anchoring around current trends

As Howard Marks3 puts it, “there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future”. Unfortunately, forecasting by way of extrapolation is still widely used by analysts to value companies. This practice is dangerous not only because it can ignore fundamental changes in industry dynamics, but because it also exacerbates the “market pendulum” which swings from one extreme to the other: euphoria to depression, over-priced to under-priced. What tends to happen is that, in periods of excessive optimism, expectations are high and prices will overshoot, making the descent into depression that much greater. In contrast, periods of excessive pessimism will drive expectations to unrealistic lows as analysts anchor around sensationalist negative news flow.

Risk Disclaimer 

Past performance should not be seen as an indication of future performance. The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

The market pendulum swings around with levels of expectations

1 The New York Stock Exchange (NYSE) average holding period is around 8 months, the shortest period since the 1920s. This reflects transactions driven by both individuals and institutional investors, although the latter now account for the largest share of investment activity.
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2 Strategist with Boston-based asset manager GMO and author of several books on behavioural investing
3 Howard Marks is the co-Chairman of Oaktree, and author of “The Most Important Thing”, a collection of his memos to investors.

Use our handy glossary to look up any technical jargon you are unfamiliar with.

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Recognising periods of excessive optimism and pessimism is important because it can present us, as active stock pickers, with valuable opportunities. Areas of the market that are over-looked or disliked by investors can quite often hide good quality assets whose depressed valuations offer excellent investment opportunities.
 

Luxury’s fall from grace

One such area of the market is the luxury sector where historically, cash rich companies wielded incredibly strong pricing power and exhibited high returns on capital which allowed them to command valuations that were almost as expensive as the leather bags they sell. The party ended abruptly in 2013 as China clamped down on corruption and a crackdown on ‘gifting’ wiped 30% off the market for luxury goods, some argue forever. Most luxury companies had gorged on a period of rapid retail expansion, and excessive Chinese spending. Throughout that period, forecasts anchored around the ever increasing double digit rates of growth, and so you can guess what happened next – companies that were held in high regard went from “hero to zero”.

Luxury peers vs market (normalised)

Source: Bloomberg, 30 January 2017

A good example is Swiss watch manufacturer, Swatch. In the course of 2016, the percentage of Swatch which was sold short (indicating negative sentiment on the company) was as high as 26.5% of free float and as of January 2017, it is still the fourth most shorted stock in the Stoxx 600. Over the last couple of years, the company lost almost 45% of its value from peak to trough. A violent swing by any account, especially for a company with a ’moat’ (competitive advantage) as wide as Swatch:

  • Swatch’s brands, ranging from budget Swatch to luxury Blancpain and Breguet, are highly regarded globally and command true pricing power,
  • The company has a virtual monopoly over the production of Swiss watch movements,
  • The business model is vertically integrated which gives it a unique competitive advantage,
  • Management, although secretive and uncommunicative, have proven to be excellent allocators of capital, and are truly aligned with shareholders,
  • The company sits on a strong net cash position exceeding CHF 1.3 billion, and inventory levels, although high, carry very little write-down risk.

 
Despite its long-term track record, competitive advantage and leading position in the industry, Swatch is currently not even priced to cover its cost of capital over the next five years. Expectations are anchored around the double digit declines in Swatch’s most profitable markets, Hong Kong and mainland China, and around the latest reported company results, which show depressed profitability. Essentially, expectations are so low that when Swatch warned on profits in the last two quarters, the stock went up. We believe that short-term noise
around China, Apple’s iWatch, inventories, exchange rate swings, is just that: short term. The competitive advantage around the business should enable it to get over the cyclical hump and go back to structurally higher levels of profitability. Currently, none of this is priced in, which provides a good margin of safety.
 

Concentrating on the fundamentals

To paraphrase Benjamin Graham, the proclaimed ‘father of value investing’, you do not need to know a person’s exact weight to establish whether they’re under or over weight. With this in mind, forecasting can be a futile (and time consuming) exercise that totally misses the point: the price you pay will ultimately determine the returns you make on an investment. This is why we always look for a margin of safety when we invest. So we’d rather be broadly right than precisely wrong, and spend more time on what really matters – ensuring we understand the business and test the moat sufficiently to make sure it can support growing cash flows and high returns into the future.

As bottom-up stock pickers, this is exactly what our process  is designed to do: strip out behavioural pitfalls and focus on finding value in quality companies run by effective management teams. This, we believe, will deliver superior performance to shareholders in the long term.

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