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When it comes to predictions, even Amazon’s founder can be out by miles

17/02/2017

Juan Torres Rodriguez

Juan Torres Rodriguez

Research Analyst, Equity Value

Investors may obsess about a business’s ‘headline’ numbers, such as revenue or growth, but that does not mean anyone is any good at predicting how these might turn out.

 

 

If, over the years, we have given the impression it is difficult to make consistently accurate forecasts about investment or finance or indeed anything else, we apologise. The idea we have been trying to get across, here on The Value Perspective, is it is impossible. People may obsess about a business’s ‘headline’ numbers, such as revenue or earnings growth, but that does not mean anyone is any good at predicting how these might turn out.

The nature of their job often means company analysts receive a lot of our flak – as they recently did in Don't follow the share price in the context of setting share price targets – so let’s even things up with a story we came across recently about one of the most successful businessmen in the world. It is taken from The Everything Store, by Brad Stone, which tells the story of Amazon and its founder Jeff Bezos.

In the first year or so of its existence, Amazon was funded through family money but, in the summer of 1995, Bezos began looking for external investors. As he presented to them, Bezos sketched out Amazon’s future, predicting the company would see annual net sales of $74m (£59.2m) by the year 2000 or, if things went really well, $114m. As it happens, things went so well that year the company saw net sales of $1.64bn.

At the same time, Bezos predicted Amazon would be moderately profitable by 2000 and, while he was out by a similarly large margin, this time it was in the other direction – that year the company made a net loss of $1.4bn. Clearly any of those external investors who stuck with Bezos and Amazon over the longer term will not have been too unhappy but it is another illustration of why investors should treat predictions with caution.

Value investors certainly do and they tend to be especially wary of paying for growth – a commodity they view as highly speculative. Furthermore, when investors focus excessively on headline numbers such as growth, they are unlikely to be thinking hard enough about other aspects of a company’s balance sheet – for example, the capital a business has to invest to deliver the predicted growth that has caught everyone’s eye.

It is the level of return a company generates on the capital it has invested that ultimately matters and the associated metric – return on invested capital – is one we look at very closely, here on The Value Perspective, when we are weighing up our understanding of a potential investment. There is an interesting story that helps illustrate why – albeit one that requires us to bash one more company analyst.

It is actually a case study I used to refer to when training up junior staff at my previous job and what makes it so interesting is the analyst got so much right. Having made various predictions about the outlook for Brazilian cosmetics manufacturer Natura back in May 2010, it transpired he had gone spookily close on the company’s revenues and broad earnings – and not just for the year ahead but for each of the next three years.

Where the analyst missed – and missed big – however, was on how much capital the company would need to invest in order to deliver the kind of growth he had so accurately predicted. The further into the future the analyst went, the more he missed by, which rather undermined all his previous good work – in reality, as the company’s ROIC declined, so did its share price.

As with news stories, headlines are helpful but you can learn much more from what you find underneath them.

Author

Juan Torres Rodriguez

Juan Torres Rodriguez

Research Analyst, Equity Value

I joined Schroders in January 2017 as a member of the Global Value Investment team. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet I was a member of the Customs Solution Group at HOLT Credit Suisse.  

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