It is commonplace for investors to rely on forecasts when deciding how to allocate capital. For example, they may use economic forecasts to determine whether the prospects for specific industries or certain stocks are favorable. Similarly, they may judge a stock’s capital growth potential based on its earnings per share forecast for the coming quarters.
However, many investors fail to check whether the source of the forecasts they use has a strong track record of being correct. Indeed, even investors who make their own forecasts may rarely look back to see whether their predictions were accurate. This could mean they are using projections that are unlikely to be correct and do not add value to their investment process. Worse still, they could be wasting time on forecasts when there are superior options available.
Using historical data
In my view, using historical data to allocate capital is a more prudent approach than relying on forecasts. For example, a company’s financial position can be accurately assessed by considering figures such as its debt-to-equity ratio, interest coverage and cash flow. Together, they can provide guidance on how it may perform in more challenging operating conditions that are likely to occur at some point in the future.
Similarly, past profitability over a sustained period and measures such as return on invested capital can help investors to determine the size of a company’s competitive advantage. This may provide guidance on how a company could perform across a variety of economic conditions and in relation to its industry peers.
Indeed, Oaktree Capital founder Howard Marks (Trades, Portfolio) has previously discussed his reservations about the use of forecasts. He said:
“Many more investors assume they have knowledge of the future direction of economies and markets – and act that way – than actually do. They take aggressive actions predicated on knowing what’s coming, and that rarely produces the desired results. Investing on the basis of strongly held but incorrect forecasts is a source of significant potential loss.”
Time lag
Of course, historical facts and figures are immediately out of date once published. Moreover, operating conditions can be dramatically different in the future than they have been in the past. This could mean that even the most profitable businesses fail to deliver performances that are in line with their historical levels. As a result, using historical data will not paint a perfectly accurate picture of how a company, or its shares, will likely perform.
However, relying on historical facts and figures provides an opportunity to make an informed judgment on the key elements that most value investors are likely to seek when purchasing a stock. Namely, the size of its economic moat, the success of its strategy and its financial strength. Together, they may have a significant impact on how it performs across a variety of market and economic conditions that cannot be accurately predicted by any investor over any time period.
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