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Rupert Hargreaves
Rupert Hargreaves
Articles (978)  | Author's Website |

Charlie Munger: Extrapolating the Past Is 'Massively Stupid'

Investors should be wary of using past performance as an indicator of future returns

November 08, 2019 | About:

We are constantly told that with investing, past performance should not act as a guide to future achievement, but that doesn't stop investors and analysts across Wall Street extrapolating a stock's past performance into the future.

Investing is all about picking companies that will be successful 5-10 years from now, while at the same time avoiding companies that were successful in the past but are struggling to adapt to the changing environment.

Falling behind

You could argue that this is one of the reasons why value investing has struggled over the past few decades. Value investors become fixated on a company's past performance rather than its position in the future economy, which leads them to buy companies facing structural decline.

Historically, this hasn't been so much of a problem because, for much of the 20th century, technology didn't change drastically. However, since 1990, the internet has revolutionized the global economy to such a scale that economists are now calling it the fourth industrial revolution.

That's where value investors have been caught out. There's no evidence to support this hypothesis. It is just something that I've been thinking about recently.

Falling into the trap of extrapolating the past is something every modern investor should try to avoid. Mindlessly projecting that a company's earnings will expand at a rate of, say, 20% indefinitely, is not only lazy - it can be downright foolish.

Charlie Munger (Trades, Portfolio) has even gone so far as to say that this approach is not just "slightly stupid," but "massively stupid," during the 2001 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting of shareholders.

Don't extrapolate the past

Warren Buffett (Trades, Portfolio) was responding to a question from an audience member who asked The Oracle of Omaha for his thoughts on Berkshire's growth trajectory for the next few years. After a couple of years of achieving 15% per annum earnings growth, the shareholder wanted to know if the group could keep this rate of growth up.

Buffett got right to the point in his response. "I think the probability of us achieving 15% growth in earnings over an extended period of years is so close to zero, it's not worth calculating," he declared.

After briefly explaining why these expectations were wildly unrealistic, he handed the microphone over to Munger, who added:

I certainly agree that the chances of this 15% per annum progress extrapolated way forward is virtually impossible. I think, generally, the shareholding class in America should reduce its expectations a lot.

Following these comments, Buffett went on to explain that in general, Wall Street makes more money by offering overly optimistic expectations than it would be reducing expectations, because that's what investors want to hear. It is much easier to sell a stock that has predicted earnings growth of 10% per annum for the next 10 years, rather than a business that is not expected to grow at all.

However, these extrapolations miss a key part of investing, the margin of safety. This term, coined by Benjamin Graham almost 100 years ago, is still missing from Wall Street's vocabulary.

The margin of safety

Nothing is stopping a company from growing earnings at 15% per annum indefinitely, but the chances of being able to do this are quite small. It is much more likely that the company will fail to meet this lofty target than achieve it.

With that being the case, investors should approach a business with the expectation that it will miss growth targets because that's what the probabilities suggest, and value the enterprise accordingly. That's the margin of safety principle in action. If the company then outperforms expectations, shareholders will be well rewarded.

Of course, the actual growth rates and appropriate margin of safety that needs to be used will vary from business to business, but the principle remains the same. It is better to be on the right side of the trade and have a pleasant surprise than it is to be on the wrong side of the deal and suffer losses.

Disclosure: The author owns shares in Berkshire Hathaway.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website

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