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Oct 26, 2010, 02.40 PM IST | Source: Forbes India

The futility of forecasting in the stock market

Most stock market forecasts are hopeless. The investor is better off betting on the fundamentals rather than market direction

The futility of forecasting in the stock market

The professional investor desperately craves to know the future. The true mission is to read tomorrow’s newspaper today. Brokers, fully aware of this innate desire, are quick to sell gullible investors placebos — stock recommendations, earnings estimates, market forecasts, price targets — of minimal value.

Forecasting earnings, prices or the direction of the stock market with precision in the short-term is hopeless. Irving Fisher’s prescient comments just before the Great Depression in 1929 remain unsurpassed for being totally off the mark! But the story remains the same whether it was the dot-com bubble, the financial melt-down of 2008 or the Asian crisis in 1997-98.

What of the poor fund manager who needs to out-perform every month just to keep his job? As investors pile into a rising market and the avalanche of money builds, his best attempts to stay rational and focus on the long haul are destroyed. The need to invest first and investigate later is forced on him. Rather than be caught lagging behind his peers, he is better off watching Bloomberg like a hawk for every twitch in stock prices and making bets on quarterly earnings! The resultant herd mentality presents true opportunity for the more placid but truly consilient investor.

Corporate CEOs and CFOs have figured out that the majority of investors will pay disproportionate multiples in their quest for a semblance of predictable, growing earnings. Not surprisingly, accounting rules are tweaked for advantage to ensure that investor expectations are met. In a brutal economic environment, ‘Big Bath’ accounting or re-structuring charges come to the fore with the intent of obfuscating declining margins, sagging revenues and loss of competitive standing. The truly enlightened CFOs have raised their game one notch higher. They coax analysts into lowering their estimates ahead of reported results to ensure they do not “disappoint” investors. Subsequently, they come out with stronger than expected financial numbers which causes the share price to surge northwards! “Earnings guidance” is the last frontier for wily managers to manipulate the psyche of the investor.

As Alfred North Whitehead, eminent English philosopher and co-author of Principia Mathematica said, “It requires a very unusual mind to make an analysis of the obvious.” Mr. Bernanke’s efforts at throwing money at the kitchen sink are leading to wholly unintended gains for emerging market equities. Prima facie, there are no signs that he is likely to have a change of heart in the next couple of months. But for this fact, it would have been sensible to consider selling most stocks since they are certainly expensive.

Realistically speaking, “quantitative easing” is a huge fly in the ointment. Rather than bet on market direction, better to stick with the fundamentals. Two stocks that merit serious consideration are Tata Sponge Iron (Rs. 380) and Taj GVK Hotels (Rs. 160) — unsung worthies that exemplify the best practices of the Tata stable. Barring a couple of mediocre performances in 2006 and 2007, Tata Sponge has turned out exceptional financial results. Quite apart from the fact that it has zero financial leverage, 25 percent+ ROE and a meaningful dividend yield, the stock trades at under 6 times current year earnings. Though Taj GVK is markedly more expensive (a PE of 20 times FY2011), it has a track record of consistently outstanding capital allocation, low debt and focussed growth. Most importantly, the company is recovering strongly from what was arguably a period of extended difficulty for the entire hotel industry.

Mario Gabelli put it perfectly in saying, “Buy what is, not what will be.” Relying on worthless forecasts of an essentially unpredictable future is akin to gambling on events outside your control. Nothing adds more risk to an otherwise prudent investment approach.

Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein.

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