Value Investing

Howard Marks: “Extreme Predictions Are Rarely Right, But They’re The Ones That Make You Big Money”

One of the best resources for investors are Howard Marks’ annual memos. They provide a number of valuable investing insights for investors. One such example can be found in the 1993 missive titled – The Value of Predictions, or Where’d All This Rain Come From?. In this memo Marks discusses a number of aspects of market forecasting. With particular emphasis on the difficulty of forecasting, the timing of forecasts, and more importantly how accurate forecasting doesn’t necessarily correlate to significant change in a company’s share price.

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The key to forecasting, Marks says, is:

“Extreme predictions are rarely right, but they’re the ones that make you big money”.

Here’s an excerpt from that memo:

At least twenty-five years ago, it was noted that stock price movements were highly correlated with changes in earnings. So people concluded that accurate forecasts of earnings were the key to making money in stocks.

It has since been realized, however, that it’s not earnings changes that cause stock price changes, but earnings changes which come as a surprise. Look in the newspaper. Some days, a company announces a doubling of earnings and its stock price jumps. Other earnings doublings don’t even cause a ripple — or they prompt a decline. The key question is not “What was the change?” but rather “Was it anticipated?” Was the change accurately predicted by the consensus and thus factored into the stock price? If so, the announcement should cause little reaction. If not, the announcement should cause the stock price to rise if the surprise is pleasant or fall if it is not.

This raises an important Catch 22. Everyone’s forecasts are, on average, consensus forecasts. If your prediction is consensus too, it won’t produce above-average performance even if it’s right. Superior performance comes from accurate non consensus forecasts. But because most forecasters aren’t terrible, the actual results fall near the consensus most of the time — and non-consensus forecasts are usually wrong. The payoff table in terms of performance looks like this:

The problem is that extraordinary performance comes only from correct nonconsensus forecasts, but non-consensus forecasts are hard to make, hard to make correctly and hard to act on.

When interest rates stood at 8% in 1978, most people thought they’d stay there. The interest rate bears predicted 9%, and the bulls predicted 7%. Most of the time, rates would have been in that range, and no one would have made much money.

The big profits went to those who predicted 15% long bond yields. But where were those people? Extreme predictions are rarely right, but they’re the ones that make you big money.

You can read the entire 1993 memo here.

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Article by Johnny Hopkins, The Acquirer's Multiple