Blog 1 - FORECASTING GROWTH PART I: THE SIREN SONG OF GROWTH
Please find key excerpts of fantastic series of articles (Total 5 post in that series) written on forecasting growth by Ensemble Capital. We have combined our learnings from all the 5 blogs in the series. Ensemble Capital is a registered investment advisor located in Burlingame, CA, midway between San Francisco and Silicon Valley. (Emphasis Ours)
The chart shows that investors as a group tend to be far too optimistic about growth, except for just as the economy is coming out of a recession, at which point investors end up being unhelpfully pessimistic.
Value investing absolutely requires forecasting the future just as much as growth investing does. The difference is that traditional value investing implicitly assumes that the future will be similar to the past, which is still very much a forecast.
Methods to forecast
1- Base rates ->
Let’s say you are asked to guess whether it is more likely to rain in Seattle or in Las Vegas on a random day in the future. Even the most general sense of American weather patterns would say that it is more likely to rain in Seattle. The “base rate” of the frequency of rain is higher in Seattle than in Las Vegas. If you take the time to look up this base rate, you’ll find that it rains in Seattle on about 42% of all days, while it rains in Las Vegas about 7% of the time.
BUT WHAT IF the sky was full of dark clouds in Las Vegas, but clear and blue in Seattle, which city would you say is more likely to get rain tomorrow?
In forecasting, the “inside view” refers to the information you have about the specific forecast being made. In this case, the inside view is the information about the conditions of the sky in each city. The “outside view” refers to the base rate data about the historical experience of a relevant reference class, or in this case, the frequency with which it rains in each city.
Most people, when faced with a conflict between inside view and outside view information, go with what the inside view information suggests.
Nobel prize winning psychologist Daniel Kahneman explains overweighting this information and neglecting the outside view information of base rates is a primary reason most people are so bad at forecasting.
As you can see in the chart, when a company is growing quickly it typically does continue to grow relatively quickly for three to five years. While very low growth companies tend to continue to report slow growth for three to five years or a bit longer. But by about year five most companies, regardless of any prior display of high-flying growth, have seen their growth revert to a more average level.
Sometimes you feel strongly about the evidence supporting your inside view that a company can grow at 20% for 5-10 years, but you need to recognize that your forecast implies that the company in question will not just do well but will produce best in reference class type results. So, you can use the base rate of growth from the reference class to “tie yourself to the shore” as you go exploring in the abyss
2 - Mistakes with Base Rates
Mckinsey curve above included all the public companies since 1963. A lot has changed since 1963. In this chart, you can see that technology adoption rates have persistently sped up over time.
The nature of the US economy has changed over the last 60 years as well. The source of growth of the US economy has pivoted sharply. Rather than a majority of corporate growth investments being made in tangible assets, such as machinery, equipment, and factories, most growth investments today are made in intangible assets such as research and development, branding, and training of a company’s human capital.
This shift in the economy is so large and so important that it triggered Warren Buffett to declare in 2017. “I believe that probably the five largest American companies by market cap…they have a market value of over two-and-a-half trillion dollars…and if you take those five companies, essentially you could run them with no equity capital at all. None.” -Warren Buffett, 2017 ANNUAL MEETING.
Intangible asset-based businesses have grown materially faster than tangible asset-based businesses. It may be a heroic assumption to think that a manufacturing business needing to build and buy factories and equipment can grow at nearly 10% continuously for a decade. But this same outlook would be just an average outlook for a health care company built on intellectual property with little need for acquiring large amounts of tangible assets to fuel their growth.
While base rates are extremely valuable and a key input into how we forecast growth, it is important that they be used with care. The more complete and long-term a reference class is, the more likely it is free of NOISE or bias. But the less likely its base rate is applicable to making any one company forecast. The narrower and more recent a reference class is, the less likely it is free of noise but the more likely its base rate is applicable to making any one company forecast.
An example will help make this clear. When thinking about the future growth rate of Google in our portfolio, considering the growth rate of oil companies and banks in the 1970s is probably irrelevant. On the other hand, if you created a reference class of advertising supported search engines with over $100 billion of revenue, your sample set would only include the last few years of Google’s own history and, thus, be no more useful to making forecasts than simply extrapolating from Google’s own historical results.