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In Gold Cup week, why forecasts Might Bite or leave you Definitely Red

You should be as sceptical of forecasting and what businesses tell you as you would about taking a tip from The Value Perspective on the winner of the Gold Cup this Friday

16/03/2018

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

This week’s Cheltenham Festival offers a topical opportunity to repeat one of our favourite mantras, here on The Value Perspective – the future is uncertain and thus impossible to predict.

Take the shock withdrawal last week of Sizing John from Friday’s Gold Cup after he suffered a hairline fracture. In theory, the absence of last year’s winner should now make life easier for favourite Might Bite but the future is uncertain and …

Mergers and acquisitions

As a fresh way of illustrating just how impossible the future can be to predict – even for those supposedly as well-informed as they can be – let’s turn to the world of mergers and acquisitions.

The US has a reputation for not being shy about litigation and yet that does not stop companies there offering a hostage to fortune by making some quite specific pre-deal financial forecasts as to how the merged or acquired businesses will fare.

As such, if anyone wanted to do so, they could look at the prospectuses of deals that happened three or four years ago and compare the forecasts with what actual happened – and we wanted to do so.

Take the merger of Walgreens and Alliance Boots at the end of 2014, where the predicted sales, earnings before interest, taxes, depreciation and amortisation (EBITDA) and implied EBITDA margins at times proved seriously optimistic.

As you can see from the following table, the merging businesses overpredicted future sales numbers and were particularly awry on EBITDA – clearly not expecting the fall that actually occurred in 2017.

It may not come as a huge surprise, however, to see that the margins of error tended to become greater the further out into the future the forecasts went.

 

Walgreens & Alliance Boots – pre-merger forecasts and actual numbers

 

 

2015

2016

2017

Sales

Predicted

90.25

128.509

134.802

 

Actual

103.44

117.35

118.21

EBITDA

Predicted

6.134

8.919

9.726

 

Actual

6.58

8.09

7.31

Implied EBITDA margin

Predicted

6.8%

6.9%

7.2%

 

Actual

6.4%

6.9%

6.2%

Source: The Value Perspective

 

Since Walgreens had bought 45% of Alliance Boots in 2012, you might imagine it may have built up a good understanding of the business and would therefore have been able to offer more informed forecasts but this was not the case.

Equally, given the environment that has persisted for US retailers over the last decade, you might imagine the forecasts may have been a bit more conservative – but, again, no.

Not that such optimism is limited to the retail sector. The next table shows forecasts from the merger of American Airlines and US Airways that began in 2013 and completed in late 2015. As you can see, the accuracy of the sales figures increasingly drifts and curiously, while the EBITDAR predictions were close, the closer they were, the further out the margin forecasts became.

 

American Airlines & US Airways – pre-merger forecasts and actual numbers

 

 

2015

2016

2017

Sales

Predicted

42.987

45.582

47.319

 

Actual

42.625

40.99

40.1

EBITDAR*

Predicted

7.467

8.458

8.527

 

Actual

6.794

8.818

8.012

Implied EBITDAR* margin

Predicted

17%

19%

18%

 

Actual

15%

22%

20%

*The ‘R’ in ‘EBITDAR’ denotes ‘aircraft rent expenses’. Source: The Value Perspective

 

Here on The Value Perspective, we have always been sceptical of ‘expert’ forecasts – whether they come from the worlds of economics or politics, weather or sport or, of course, business – yet many investors still put a lot of faith in what companies say.

They should, however, be as sceptical of forecasting and what businesses tell them as they would about taking a tip from us on the winner of the Gold Cup this today.

Do either and, having scanned the form card, we would suggest your bank account will look Definitely Red.

Author

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst. 

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