Republished courtesy of the National Post
by Tom Bradley
I was looking at an analysis of the Canadian banks recently. It made for compelling reading. The banks are well capitalized. They continue to be highly profitable (the oligopoly is alive and well). And yet their valuations are below historical levels.
As for concerns about the financial health of their customers, the report said, “Canadian housing and consumer debt continues to spook global investors ... however, as long as employment is strong, incomes are growing, and increases in debt service ratios remain manageable these concerns are likely overblown.”
At this point, I stopped reading. Not because the banks aren’t a good buy, but because this analyst fell into the same trap that many investment professionals do. He addressed a concern about the future with data from the present.
How does telling me that “as long as the consumer is doing well, everything is good,” allay my fears about how the banks’ highly-levered clientele will impact future profits? It doesn’t. High debt levels are rarely a problem when times are good.
This kind of rationale is common in investment reports. For instance:
1. The employment outlook is excellent (future) because the economy is growing (present).
2. The market will continue to rise (future) because profits are strong (present).
3. The resource stock is a buy (future) because commodity prices are high (present).
4. Corporate bond spreads will remain narrow (future) because defaults are low (current).
In all these, the current data sounds comforting, but has little or no impact on future asset prices.
There’s another example I put in this category, although I struggle with it. We sometimes hear that there’s cash on the sidelines waiting to go into a certain type of investment or asset class. An abundance of cash chasing a limited number of assets causes prices to go up, but I wrestle with the reasoning because capital flows are fickle.
When conditions change, the inflow that everyone was counting on can disappear in a heartbeat. And when the tap turns off, investors are left feeling like Wile E. Coyote hanging in the air after going off the cliff.
The fickleness of capital flows is particularly apparent in cyclical industries and asset classes that are driven by investor sentiment such as gold and cryptocurrencies.
In pointing out this flawed reasoning, however, I’m not saying that current data can’t support a forecast. For example, I’ll positively adjust the outlook for a company that meets the following criteria: It is tightly run and has an excellent record of capital allocation; it is well financed and has no need for additional financing; and it has a clear competitive advantage with regard to products, distribution or cost structure.
And I’ll dial up my forecast if a company is operating in an industry that’s consolidating down to fewer, less-disruptive competitors.
I started by picking on an analyst, but it’s not just professionals who mix up the ‘present’ and ‘future.’ Individual investors are doing the same thing when they’re confounded by market moves that run counter to the latest economic statistic or political headline. A common refrain in recent years has been, “The world is a mess! Why is the market going up?”
As I’ve said many times in this space, stock prices aren’t a reflection of what’s happening now.
They’re an educated guess as to what’s going to happen in the future.
Be careful when the present is being used to predict what that will be.
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