By: Frank Armstrong, CFP, AIF
In our previous article we discussed the underlying theory that propels growth stock investing as a philosophy. Now let’s look at the practical problems that investors have when they try to implement.
The dividend discount method gives growth stock investing a pseudo-science basis conferring a completely undeserved credibility on the process. What looks like a perfectly rational methodology raises far more questions than it answers. If the whole process sounds like hocus pocus, you are absolutely right.
In his attempt to outperform the market by identifying companies that will grow faster than the market as a whole, the growth stock investor must make accurate forecasts in at least four dimensions. The process to pick these winners is called fundamental analysis. Either investors do it themselves, or they are guided by the opinions of outside “experts”. Wall Street brokerage houses employ an army of analysts whose opinions are widely followed and relied on by investors.
But, no matter who is doing it, the process is fraught with peril. In the end, relying on a forecast or prediction to spot a mis-priced security is a big bet against the market. As we all should know, it’s hard to beat Mother Market.
To begin with, forecasting profits is a joke. I don’t care how much data you have, and how sophisticated your methods, forecasting future conditions is problematic at best. Notwithstanding the efforts of armies of analysts, we have recently seen some of the most widely held public companies shock Wall Street overnight. For example, JDS Uniphase, Lucent, and Cisco. Where were all those bright analysts while those horror stories developed? If Wall Street can’t forecast these highly visible market leaders from day to day or quarter to quarter, who really believes that they can predict a five or ten year window? Please!
Of course, the further out you go in your forecast, the higher the probability of gross error. These errors increase exponentially, but a growth stock investor must still select a time frame as the basis of his valuation. The only forecast you should be willing to believe is that the world is going to be a vastly different place five years from now. Even with perfect knowledge of a company’s operations today, the odds of any company five-year profit forecast being even close are microscopically small.
In theory, the process might work if we could gauge the probable error of our forecasts and account for it with the appropriate discount rate. Alas, there is no indication that anybody is able to do that either. In practice, discount rates are selected by the herd depending on how bullish they feel that particular moment.
Hidden agendas and conflicts of interest
Even if you give the analysts credit for ability and smarts, there is a big problem with integrity. Wall Street derives huge profits from public offerings. Without rosy forecasts, who is going to buy that stuff? Not only must a forecast be positive, it must be good enough to attract the attention of investors with multiple other stories to evaluate. The tendency for upward bias is overwhelming. Just a little hint of objectivity, and companies will switch underwriters. To a Wall Street underwriter, any profit that the end investor realizes is merely a happy coincidence. Nobody on Wall Street is blind to those facts of life.
The primary function of many analysts is to justify buy/sell recommendations for the house. These commentaries either boost underwriting efforts or contribute to a general high level of trading that profits the brokerage business. The fact that investors lost money as a result of these irresponsible and self-serving forecasts is irrelevant. The house made money and lots of it. What’s five trillion dollars amongst friends, anyway?
In times of great confidence, growth rate assumptions, time horizons, and discount factors are pushed to extremes. Valuations can become absurd. As in the case of the Tech Wreck, eventually such delusional behavior is justly recognized and appropriately rewarded.
The recent mass hysteria found tech stock analysts tripping over themselves to make optimistically absurd forecasts. The lemmings were engaging in one-upsman- ship. It wasn’t unusual to hear confident predictions of growth rates, which if attained, would have consumed all the world’s available capital! Many of these estimated far exceeded the actual growth rate experienced by any single large company in the world’s history!
The SEC has recently become interested in activities of analysts. A strongly worded report warned investors to use a liberal grain of salt on any recommendations, and pointing out the numerous conflicts of interest. See: http://www.sec.gov/investor/pubs/analysts.htm. Meanwhile, the lawsuits against brokerage houses and their analysts are piling up in the aftermath of the Tech Meltdown.
On Wall Street, memory is short. Instead of being banished forever for their sins and stupidity, those same guys are still making the financial show circuit. Just as if they had some credibility! And investors eat it up! What am I missing here?
So much for fundamental analysis
Given the difficulty of making accurate profit forecasts, choosing the appropriate time horizon, selecting a reasonable discount rate, and guessing the terminal period P/Es–all at the same time–it shouldn’t surprise you that growth stock investing is inherently high risk.
There is no credible evidence suggesting that anyone can consistently forecast even one of these variables! Keep that in mind next time you hear some cocky analyst on Wall Street Week! The evidence will show that their opinions are worth far less than zero.
Coming up: The proof is in the pudding
How profitable is growth stock investing? How does it compare to alternative strategies? We will look at the long term results.