Investment is a forecasting business.  And predicting the future is hard.   This is why it is so difficult to ‘beat the market.’

It is difficult to make predictions, especially about the future – Yogi Berra

The investment world features scientific-sounding metrics like the operating margin, return on capital employed, and earnings retention ratio.

Quality investors seek strong franchises with growth.  These characteristics generate earnings per share momentum and share price gains. History is used as a guide.

This sounds professional, diligent and with reasonable odds of success.

But we are missing the hardest part: forecasting.  We need to identify which companies will achieve the desired results.

One approach is to buy successful companies.  But past winners can turn into losers.

We can’t avoid the need to forecast the future.

Investing would be easy if we knew the future

What would happen if an investor knew the future? Not future share prices but company fundamentals (profits, cash flow, growth).

They can now invest only in companies that deliver strong cash generation and earnings per share growth. This will result in outperformance.

What about an investor with the same investment approach but who lacks knowledge of the future? Some of their stock ideas will work out and some won’t.

Performance depends on having a good ‘hit ratio’ - winners offsetting losers.  Outperformance is uncertain.

Why did the two investors produce different results?  Only one of them had to forecast the future.

Forecasting the future

We all know the investment outcomes we want.

Investors want companies that sustain high returns while delivering growth. This requires strong competitive moats with industry tailwinds. We want to own companies with pricing power.

The challenge is forecasting which companies will have these attributes in future.  An additional challenge is that the future can be random in nature.

Could we have forecast that Amazon would invent AWS?  Could we have forecast Tesla’s success? Some things may be impossible to predict.

The more random the future, the harder it is to predict.

Active versus passive investing

Passive investing doesn't forecast the future.  It owns the entire market, which allows it to capture the big winners. Active investing, by contrast, forecasts which stocks and sectors will do best.

A common misconception is that active investors inevitably do well by adopting a certain strategy e.g. quality investing.  This is untrue.  They still need to forecast which companies will generate the desired outcomes.

Fund analysts should evaluate whether active managers are executing well – something that is often overlooked.

Rightmove (RMV) case study

Rightmove (RMV) is an interesting case study. Its share price slumped after US giant CoStar bought UK rival, OnTheMarket. The stock was sold by one quality investor, Smithson/Fundsmith, and bought by another, Lindsell Train.

Smithson’s managers believed it was time to exit while Lindsell Train saw the share price weakness as an opportunity .  What matters is which fund manager correctly forecasts Rightmove's future.

Successful forecasting - fund manager execution - is what makes the difference.

Fundsmith versus Lindsell Train - Who will be proven right on Rightmove?

Source: Google Finance

Summary

Investment is viewed as an analytical business with scientific-sounding ratios that sort the wheat from the chaff.  But at its core, it is a forecasting business.  We need to predict which companies will deliver.

Investing is hard because forecasting makes ‘fools of us all.’