What are the factors to consider when making accurate long-term forecasts about themes that are used in investment decisions? Frances Hudson takes a look.
Thematic approaches are well-suited to long-term investment thinking, as direction of travel along thematic lines can be more easily established than precise timing of when to buy or sell, while it is possible to look beyond immediate problems. There are various ways to identify themes, ranging from a focus on what is topical to broader, more general ideas. They can be linked to particular sectors, challenges or emerging trends. The ageing world, climate change, robotics, biotech, fintech, interconnectedness and the digital world would be likely current candidates, consistent with determining and seeking to invest in areas of rapid change.
However, this selection takes an inside view, risks anchoring on a narrow set of futures and, given the lack of perfect foresight, it is unlikely that the themes will evolve exactly as envisaged. For instance, two decades ago, the pervasive role of the internet was not envisaged, and talk focused on business-to-business development. Instead it has been business-to-consumer applications, particularly on-line shopping, that became spectacularly successful.
How do we get to an outside view? Taking a step back, the chart (on page 25 of the Autumn issue of Professional Investor) illustrates an alternative three-stage approach where the large circles represent major drivers and the smaller ones where they intersect are examples of proximate causes for the types of themes that can arise when drivers interact. Information relating to these themes can be drawn from multiple non-market sources, for instance, academia, social trends and business, as well as market sources. The indicators, such as risk premia and volatility, then provide a checklist for relating the themes to investment markets and a sense check for timing investment
Effective crystal balls are in scant supply in investment houses and longer time horizons seem to present particular challenges. However, it is not necessarily the case that the further into the future, the cloudier the picture becomes. Sometimes it is more about the methodology. Time frames matter in the choice of tools for assessing investment opportunities. Established analytical tools that concentrate on fundamentals, such as earnings, dividend yields and valuations in equity markets, or credit profiles in corporate bonds, or interest rate differentials, inflation and duration in government bonds, tend to work better in the medium term. They are only useful with respect to the longer term if backed up with a robust framework that not only recognises trends, but admits the potential for reversals.
On longer timeframes, we are dealing in the probable rather than the absolute, and multiple rather than binary potential outcomes. Treating all predictions as if they are testable hypotheses can help in this and also alleviates the tendency to anchor on particular outturns.
It is also likely that the motivations at play in the long term differ from those embedded in standard theory. Standard theory in investment suggests behaviours and policies will be designed to maximise the return to shareholders; it is it is akin to and as unrealistic as the standard theory that states a firm’s only goal in the short term is to maximise profits. The extent to which politics influences markets or regulation determines behaviour in banking and insurance are two current examples of where maximising shareholder value may take a back seat. On both counts, behavioural analysis is useful…Article continues in the Autumn 2016 issue of Professional Investor [login required].