We have discussed the pros and cons of extrapolating trends when it comes to the investment process. In his investing classic, Security Analysis, Benjamin Graham addresses this issue. Amazing how the words written originally in 1934 have impact today. The following is an excerpt from his work;
{“In recent years increasing importance has been laid upon the trend of earnings. Needless to say, a record of increasing profits is a favorable sign. Financial theory has gone further, however, and has sought to estimate future earnings by projecting the past trend into the future and then used this projection as a basis for valuing the business. Because figures are used in this process, people mistakenly believe that it is “mathematically sound”. But while the trend shown in the past is a fact, a “future trend” is only an assumption. The factors that we mentioned previously as militating against the maintenance of abnormal prosperity or depression are equally opposed to the indefinite continuance of an upward or downward trend. By the time the trend has become clearly noticeable, conditions may well be ripe for change”}.
Few words could not make the point better. Our reliance on the false extrapolation gives us the comfort of certainty, yet provides no tangible contribution to our analysis.
Graham goes on to explain;
{“It may be objected that as far as the future is concerned it is just as logical to expect a past trend to be maintained as to expect a past average to be repeated. This is probably true, but it does not follow that the trend is more useful to analysis than the individual or average figures of the past. For security analysis does not assume that a past average will be repeated, but only that it supplies a rough index to what may be expected of the future. A trend, however, cannot be used as a rough index; it represents a definite prediction of either better or poorer results, and it must be either right or wrong.”}
Once again, we come upon a very important distinction. Graham’s commentary doesn’t rule out the significance of historical results or how it might be applied to our own investment process. But it does draw the distinction against the use of this data as a forecasting tool. I have written in past articles about the pitfalls of prediction and forecasting. It is fascinating how often forecasting is thrown at the public every day. While even today there will be someone forecasting inflation, deflation, economic depression, etc. It seems so counterintuitive that the best investors in the world uniformly discourage predicting, yet we consistently fall into this trap.
Proper evaluation of a company’s current condition is the only answer to this potential dilemma – much easier said than done. But a well established investment process of discipline will make this task much easier.
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