To the casual observer of the financial markets, it would appear that earnings estimates are the most important metric that investors consider. Think about it: what is the first thing that flashes across a Reuters terminal, or the chyron at the bottom of a newscast when a business files its quarterly statement? "Company A reports earnings per share of $1.25, beating consensus analyst expectations of $1.14."
Earnings are important, but what always strikes me as interesting is that people pay way more attention to how the company has performed relative to "analyst expectations," rather than in absolute terms. As investors, we seem to have collectively anointed this separate group of people (the people who project out earnings) whose job it is to set our expectations, which raises the question: are these people actually good at forecasting earnings?
Unsurprisingly, I’m not the first person to have this thought - back in 1995 at the Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual shareholder meeting, Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) both expressed skepticism at the idea that earnings projections are an accurate representation of economic reality.
Subconscious biases rule supreme
Munger said that while projections are logically required for the business of estimating future cash flows, the way they are carried out in practice probably causes more harm than good:
“Most of them are put together by people who have an interest in a particular outcome. The subconscious bias that goes into the process and its apparent precision make it fatuous and dishonorable. Mark Twain used to say “a mine is a hole in the ground owned by a liar” and a projection prepared in America by anyone earning a commission, or by an executive trying to justify a particular course of action will frequently be a lie - not a deliberate one, but one where the man has come to believe it himself, and that is the worst kind.”
Buffett went on to add that Berkshire Hathaway never looks at projections, because the fact that they are prepared with so much care is evidence that they are probably nudged in one direction or another. It’s very difficult to remain impartial and objective as a forecaster when you have a strong vested interest in a particular outcome.
This phenomenon can be clearly seen in today’s market in the related field of stock price targets. On numerous occasions, I have seen analysts revise their price targets for stocks upwards simply on the basis that the share price has recently risen. This is, of course, entirely circular thinking - if you perform an analysis based on fundamentals (which most analysts claim to do) and have a price target of $100, and the company’s share price rises to meet your target, you don’t then revise your target upwards to $120. The only reason to do so is to sustain momentum in the upwards price move, and at that point you are speculating, not investing. Munger and Buffett know the difference, and so should all responsible investors.
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Value Investor's Handbook: Warning Signs to Avoid, Part 2
- The Value Investor's Handbook: Two Warning Signs to Look Out For
- Bill Ackman: How to Invest in Technology Companies
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