How To Make Investment Forecasts For Your Portfolio

Investment forecasts are notoriously inaccurate. A 2018 study by Morningstar indicated that 87% of consensus views for the five-year earnings per share growth rate for a particular company get the forecasts wrong by an amount greater than 5% annualized. Only 4% of analysts offer predictions of expected stock prices five years down the road within 20% of the figure’s accuracy.

That is well and good, but still, you have to do something intelligent with your surplus, so how should you move forward knowing that most predictions about the future are not particularly sturdy?

My thoughts on mitigating the uncertainty that surrounds any potential investment that you may make:

Try to arrange your affairs so that even if the future performance for a stock underperforms, you’ve locked in your riches on the buy side.

In my own experience, I remember purchasing shares of BP after the oil spill when the price was in the low $30s. My expectations for the subsequent after the oil spill in 2010 were far rosier than I initially anticipated. The litigation costs came in on the high side of my projections, the extended decline in the price of oil lasted longer than I expected, and the management wasn’t particularly brilliant over the past eight years. The earnings growth projections I scribbled in my notes were wrong–much loftier than the reality that followed.

And yet, even at the worst of it, when the stock was still trading in the low $30s six years later in 2017, I still achieved 5.5% annual returns because of the protection I got on the buy side.

Usually, I look for non-cyclical stocks to be trading at a P/E ratio that is lower than the ten year average. For cyclicals, I look for signals that the price of the stock does not match the earnings power (an obviously subjective criterion).

The flaw with investment forecasts is that they are usually too optimistic. The protection against undue optimism is an initial purchase price that can still provide adequate returns even if the actual business performance lags the projections.

Pay attention to the top-line growth.

I look at revenue growth through all business conditions to get a feel for the industry as a whole and a particular investment’s place within that industry. If revenues of a particular business barely trickle upward, the earnings growth is almost always going to disappoint the analyst consensus of earnings estimates.

That is how I was able to recognize that Procter & Gamble was going to struggle with long-term earnings growth, even though it is the bluest of blue-chips with a sterling record and an uninterrupted dividend history dating back to 1892. But the revenues stagnated, and then hemmed and haw-ed during each year from 2007 onward, and it provided a strong indicator that earnings growth wasn’t going to match the 6.5% annualized that the investor community anticipated at the start of 2008.

Meanwhile, the high double-digit earnings growth and future stock price projections for Visa have always been more credible to discern because the top-line growth, year after year, has been so impressive. Visa’s revenues have grown by 18% over the past decade, from $6 billion in 2008 to an estimated $20 billion by the end of 2018. Favorable forecasts are credible because the underlying economics of the credit processing industry are excellent, Visa has been partnering with potential disruptors, and year after year you receive perpetual confirmation of the business’ success story.

The first sign that a business is struggling is a few years of stagnating revenue. If an analyst predicts high earnings growth, and you don’t see revenues growing by at least a mid-single digit clip, you have found fertile soil for over-optimistic analyst projections.

The stocks that exceed expectations tend to retain lots of earnings while also growing the dividend.

If you see a blue-chip stock paying out over half of its earnings as dividends while analysts are projecting earnings per share growth of 8% or greater, it’s not going to happen. Philip Morris International, Reynolds American, and Altria are the only stocks I have ever studied that managed to pull that off.

On the other hand, if you see a record of steadily increasing dividends that are a small percentage of the overall annual profit amount, you can make an investment that incorporates a high-single digit or favorable forecast.

For example Becton Dickinson has grown its dividends by 9.5% annually for the past 25 years, and yet the current dividend is only a third of overall profits. When I see the analyst consensus for earnings per share growth of 10% annually now through 2023, that figure has a fair chance of being accurate because, although the business has a market cap worth tens of billions, the dividend is a manageable third of profits–giving Becton Dickinson a fair amount of retained earnings to invest in new business lines, make acquisitions, and repurchase stock.

Low dividend payout ratios and a great track record of top-line growth are the best indicators that an investment forecast will come true. This, along with protecting yourself against all possibilities of disappointment by getting a good purchase price on the buy side, is how I evaluate predictions about a stock’s future in light of the historical tendency for over-optimism of a stock’s future.