Not making predictions can be an uncomfortable behavior for many investors, given their daily diet of analyst estimates, company forecasts, valuation metrics and price targets. But resisting the urge to foretell future events is increasingly necessary as the digital transformation of the economy causes the pace of change to accelerate which, in turn, creates an even more unpredictable world.
Instead of trying to shoehorn a set of assumptions into a particular world view, investors are likely to better serve their clients’ long-term goals by focusing on finding companies that stand to see lasting benefit from the transition of the global economy to digital from analog. As such, the winning traits for long-term investments are adaptability and maximizing non-zero-sum outcomes, where all parties benefit from taking part in a transaction because the value creation is so great that no one wants to find other providers.
The market has recently provided ample opportunity for investors to retest basic assumptions and reassess the range of outcomes for many businesses. Take Netflix as an example. The biggest streaming provider’s stock surged more than fourfold over the four years through October 2021 as its global subscriber base more than doubled. Over the next six months, it gave back all those gains, returning to levels last seen in late 2017.
The pullback culminated in a 35% slump on April 20, a day after Netflix forecast a decline of 2 million subscribers in the three months through June and said it lost 200,000 customers in the first quarter, the first drop in a decade.
The same day, Pershing Square Capital Management said it sold its stake in the company, three months after disclosing it to investors, for a reported $400 million loss.
“We require a high degree of predictability in the businesses in which we invest due to the highly concentrated nature of our portfolio,” Pershing Square founder and Chief Executive Officer Bill Ackman said in a release. “The dispersion of outcomes [for Netflix] has widened to a sufficiently large extent that it is challenging for the company to meet our requirements for a core holding.”
“We require a high degree of predictability” is at odds with the state of the world today. The range of outcomes for Netflix always included the potential for a decline in subscribers, perhaps with a higher probability following the pandemic-driven increases in its business.
While there are many styles of investing, the ones that rely on narrow predictions or do not take into account the possibility of a wide range of outcomes are likely to increasingly underperform strategies that recognize and accept the unpredictability of the world. The ideal investment would rely on virtually no predictions, a notion greatly at odds with the training most investors receive.
The number of predictions correlates directly to position size. If a security’s valuation implies a need to be correct about only a small number of assumptions to drive stock performance over time, a larger proportion of portfolio assets can be allocated to it. Equally, the inverse is true—if the range of possible outcomes is wide and expanding, making for less certainty about future growth, the position size should be smaller or exited.
Our false confidence in our abilities to make predictions leads investors to frequently make the mistake of placing securities with a wide of range of outcomes at the top of the portfolio. This can be a devastating portfolio construction mistake.
The smart approach is to build a portfolio on a bedrock of resilient names with a narrow range of potential outcomes, complemented by a longer tail of optional investments in smaller companies in the earlier stages of their life cycle that show asymmetric traits.
Disciplined assessment of potential future outcomes is especially important during times of upheaval. The market has a particularly hard time finding equilibrium in times of heightened uncertainty, which today is principally based on rising concern about global conflict, consequences of pandemic stimulus programs, and the probability of significant rate hikes aimed at taming inflation.
This combination of concerns has led investors to buy into the narrative that companies need to be currently profitable to be good long-term growth investments. However, this too is an example of a prediction, one that is grounded more in fear than reality. Investors seems to have forgotten—hopefully temporarily—that companies investing in their own future growth, and in the overall size of the ecosystem in which they operate, tend to create more value over time.
Key characteristics of the current selloff are that investors are lumping all growth stocks together, while assuming long-term inflation and structurally higher rates. That’s one possible outcome. But a safer prediction that relies on fewer narrow assumptions is that technology investment cycles are likely to speed up on the back of rising innovation, accelerating our adoption of new technologies, which may drive down rates and inflation, since innovation has always been a powerful deflationary engine of growth.
We can’t say with any degree of certainty which of these possibilities will come to pass. The only thing we know for sure is that we don’t know what the future will bring, so rather than spending time making predictions that more than likely will turn out to be wrong, why not focus on seeking out companies that are creating and benefiting from that future—whatever it may turn out to be?
Brad Slingerlend is co-founder and an investor at Denver-based NZS Capital, which manages more than $1 billion in assets.
