Want Good Returns? Look to the Future

Tuesday, June 1, 2010

It’s easy to be mired down by today’s headlines. The negative news and uncertainties, even imponderables, can remove enthusiasm for keeping money “at risk” even though you know it’s the right thing to do – long term.

The solution? Focus on the future. Doing so puts your eye on the determinants of coming returns.

The bad news/good news today is that the stock market has lost some of its future-oriented valuations. “Bad” because many investors are remaining underweighted in US stocks. “Good” because US stock prices have become more attractive.

Before we can invest, however, we need to understand what’s driving the negativity and lower stock prices

There is discussion of a second recessionary dip, a second banking collapse and a second stock market crash. The belief is that the actions and accomplishments so far have been ineffective. All are seen as patches that don’t cure the serious ills that continue to undermine the economy, financial system and, hence, the stock market. However, such concerns are not supported by the data that, ever since we bottomed in March 2009, have been improving.

Added to these dismal discussions is the belief that stock investing should not be based on future forecasts. Led by Dr. Robert Shiller, economics professor at Yale, supporters of this theory point to the forecast errors made in the past, particularly in recent years. However, the conclusion is erroneous.

  1. Investing decisions are not mindlessly based on earnings estimates. Investors understand that projections are imprecise. Different analysts can come up with different forecasts, each with sound rationale. Knowledgeable investors understand this imperfection, but they nevertheless use them because…
  2. Tomorrow’s results will determine tomorrow’s values. Therefore, correctly anticipating those future results in advance produces superior returns. So, today’s prices typically reflect those “anticipations.”
  3. Looking to the future is not a simplistic earnings per share guesstimate. Analysts start by breaking a company down and then building it back up. They look at all the key drivers, such as research & development/products, marketing/sales, competition/market share, manufacturing/distribution, costs/pricing, finances/capital expenditures, etc. etc. Then portfolio managers use these forecast dynamics to understand the characteristics/personality of the company in which they may or may not invest. In addition, both analysts and portfolio managers talk with company management and others to better understand the company’s goals and strategies.
  4. Relying on past data to invest for the future means assuming conditions will be the same. Ceteris paribus (“all other things being equal”) may be an acceptable assumption for economics research, but it renders results invalid where the stock market is concerned. Even similar conditions can produce different outcomes because human emotions, beliefs and actions can differ widely.

So… Focus on the future. It will be the source of investment returns. Today’s US stock market, underweighted or avoided by many, offers good opportunities.

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John Tobey on Seeking Alpha

Seeking Alpha Certified

June 2010