Ignore forecasts (and guidance)

Think like a business owner, not a speculator.

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Last week in this space, I introduced a semi-regular series I'm unimaginatively calling 'Friday Fundamentals' – explanatory articles that help make sense of business, finance and the share market.

I didn't expect to be back here so soon, but this week I was pummelled by a whole lot of earnings season headlines, about companies missing, or beating, expectations.

And their close cousin, missing and beating 'guidance'.

These two things might explain short-term share price movements. Sometimes.

But they're examples of wrong-headed thinking, and things that investors really need to get out of their vocabulary.

First, let's get the order right.

Companies don't miss expectations. Expectations were wrong.

Similarly, companies don't miss guidance. Management's guidance about what to expect was wrong.

Am I splitting hairs, here? Not even a little bit.

When an analyst says they think Phillips Philately (ASX:STAMP) will do $100 million in profit, but it does $95 million, it's not the company that's wrong. The numbers are the numbers.

The company didn't 'miss expectations'. The analyst got his (or her) forecast wrong.

And if management had provided 'earnings guidance' for $90 million, the company doesn't 'miss guidance'… the guidance was inaccurate.

Why does it matter?

Well, because when you get sucked into comparing a company's numbers to some arbitrary best-guesses, rather than to last year's performance, or a competitor's results, you're playing the wrong game.

Were you really investing because you thought 'Gee, this business will beat analyst expectations / management guidance for an arbitrary 6 month period, and when it does, I'll sell and get rich?'

I mean, if that was literally the investment thesis, I guess you should act accordingly. But also, I think you should find an easier game to play!

The rest of us should be investing by saying 'You know, I think this company will be able to do well, over the long term, and my purchase price is attractive, based on that expectation'.

And if you did that? Then worrying about whether a company hit or missed some arbitrary short-term target is… as silly as it sounds.

I don't care what any analyst expects the next six months to look like. I've never done a 6- or 12-month forecast for a company I own shares in (or was considering buying). Ever.

And as for management 'guidance'?

Firstly, while some people like to believe that corporate CEOs have some sort of god-level ability, I don't reckon they're likely to be able to forecast the future with any more accuracy than the rest of us.

Sure, they know what their strategies are. But do they know what the economy will do? Interest rates? Their competitors? Their suppliers and customers? The price of their raw materials? Or any of another dozen things outside their control that might impact their ability to deliver a number.

But then… worse, once they give such 'guidance', these people – who usually aren't short of ego – will move heaven and earth to deliver on their promises. That's good, right?

No.

I've worked at quite a few businesses in my life. Some publicly-listed. And at almost all of them, a CEO has made a decision to sacrifice long term value so they can deliver on a short-term prediction.

Which is as silly, and damaging, as it sounds.

So, to the CEOs reading this: please stop giving guidance. It's useless to your long term shareholders, it incentivises short-term thinking among your owners, and leads to counterproductive behaviours from you and your team.

And investors: one of the most important things you need to know is what game you're playing. If, as I suggest, you intend to be a long term owner of the shares, you want to know the company is building long term value. How it performs, relative to even well-meaning short-term guesses is… all-but irrelevant.

In short, think like a business owner, not a speculator.

Have a great weekend.

Fool on!

Motley Fool contributor Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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