What we do on daily basis is our habit. For example, we take the same route for work, eat in our favourite restaurants and shop from the same stores. The alternatives to our habits is too mentally taxing. We always look for easy way out in our day-to-day life decision making. But when it comes to investing, it’s a high risk approach.

Forecasting is a necessary component of investing, because value of stock is derived by determining the present value of all the future cash flows that the business will produce over its life time. We have seen a lot of cognitive errors creeping in while making forecast. The temptation of our brains to take the easy route when making a forecasts can lead to what has been termed “recency bias”. This simply means that we give too great a weighting to recent events when making forecasts.

Consider below the table which shows the revenue trajectory of company A.

Company A 2010 2011 2012 2013 2014 2015 2016
Revenue 100 103 106 109 113 116 ?
Year-over-year % growth   3% 3% 3% 3% 3% ?

 

What will the revenue growth be in 2016?

Already probably you are feeling a strong, magnet-like pull toward the number ”3%” for your answer. But why? Is this a sound and rational starting point?

In some ways, recent history is useful to draw a baseline for making forecast about the future, but only if we understand the drivers of past growth and how likely these drivers will sustain to those levels. In short, it is important to understand why this business is clocking 3% growth in the past years.

Let’s say that company A is in manufacturing of school uniforms for 90% of the schools in Mumbai. It sells roughly same volume of uniforms every year, but is allowed to raise its price by 3% every year. This contract might continue for extended period of time and company A might be the only company with the scale to manufacture the required volume of uniforms, in which case assuming 3% revenue growth in 2016 might be sensible.

However, investing looking through rearview mirror and failing to analyse future prospects for this business could lead to an investment mistake if situation was vastly different. What if the competitive advantage of manufacturing school uniforms of company A is in threat from other manufacturing company, especially when company A contracts are due for recontract this year? Importantly, when we know that 100% of revenues generated by company A is through these contracts. If company A loses the contracts then there is a good chance for them to lose 100% of their revenues in 2016 rather than sanguine 3% growth.

It is crucial to always know the spectrum of outcomes that could transpire for company in different scenarios. The quality of your decision depends on what quality of analysis is undertaken to find the spectrum of all the different outcomes. To avoid the pitfall of recency bias, investors must always turn their mind to “what could be”, rather than the more easily observed “what has been”.

Aziz Dodhiya is the chief investment officer for the Valueoperations funds which operates in the Indian market as an FPI (Foreign Portfolio Investor). We do not offer any personal advice to buy or sell any stocks and the views that are shared by Aziz might not incline to your personal investment strategy and this is the reason we tell you to take professional advice before going ahead with our views.