The BuyChart of the day: Long-termism
This chart depicts why long-termism is your superpower. But you should take this historical data with a (large) grain of salt.
This seems like conflicting messages. Allow me to clarify.
On long-termism, history suggests that:
- As your time-window expands, your range of outcomes narrows. That’s good. That feels safer.
- As the range of historical returns narrows, the average and median numbers can be taken more seriously. For a wide distribution of outcomes (like the 1-year or 3-year ranges), averages or medians aren't usable.
- There’s a low chance that you’ll lose money if you stay invested for the long haul – at least 15 years.
On using historical data:
- This chart is not a forecast. It’s just a history-cast.
- Past performance is not a guarantee of future performance. Forget "guarantee", it’s highly unlikely this performance will be repeated.
- But too often, “history-casting” masquerades as forecasting. Too often, analysts or robo-models simply predict the past.
- Ask the obvious question: What is the common-sense, business-economics, non-statistical reason why history should rhyme?
How do we reconcile long-termism with skepticism about long-term historical data?
We start with our desired or required return. Then we ask "what needs to happen" to get there. Historical data then becomes a "sanity check". We call this process Buycasting. And it’s why we call our flagship stock analysis tool The Buycaster.
Underrated: Buycasting beats Forecasting.
Not believing in forecasting doesn’t mean not caring about the future. In investing, of course we care about the future. In fact, the current price of our potential investment or holding is almost entirely dependent on market expectations of the company’s future. The problem is that everyone’s just guesstimating about the future. Whose guesstimate do we believe?
FORECASTING: “The attempt to predict the unknowable by measuring the irrelevant; a task that in one way or another, employs most people on Wall Street.” – Jason Zweig in The Devil’s Financial Dictionary
We have no time to predict the unknowable by measuring the irrelevant. We’ve taken the guesswork out of investing in The Buycaster. We Buycast – which means that we back-solve from our objective to “what needs to happen” to get to our objective. 2 important points:
- Our objective is our long-term target return.
- The Buycast is calculated and depicted in the form of “revenue growth we need to believe to – rationally – expect the stock to deliver our target return.”
That’s a mouthful. Sorry. Here’s an example:
But the key word there is “rationally”. To calculate the BUYCAST, we had to make some rational assumptions along the way as we back solved from our target return to the “revenue growth we need to believe…”. You can find the details of this back solving process in the Appendix of The Buycaster.
Those assumptions, by the way, are not forecasts. They are not declarations of what we believe “will happen”. They are reasonable (often conservative) assumptions that we believe can happen easily. This is a nerdy topic, and we could spend hours on it. But we won’t bore you – for now, here are examples of rational assumptions we make in The Buycaster:
- Exit Multiple is limited to a max of 20X future free cash flow.
- Gross Margins remain the same as they have been over the last 12 months.
- Fixed Operating Costs grow at a slower rate than they have been over the last 3-5 years (some economies of scale). This is not a forecast. It’s a reasonable scenario.
The point is that we don’t forecast. We back-cast. In fact, we buy-cast – using reasonable assumptions where we need to. At the end of the day, whether we’re forecasters or soothsayers or wizards or Buycasters, we’re all dancing around a very simple game:
“Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do,” says Buffett. “It’s imperfect but that’s what it is all about.” – Robert Hagstrom from The Warren Buffett Way
It’s a simple objective – simple but not easy. It’s not easy because there is no formula for each of the 4 variables listed by Buffett:
- Probability of Loss
- Amount of Possible Loss
- Probability of Gain
- Amount of Possible Gain
Forecasters try to predict each of these variables. We think that’s a lot of wasted effort for something that we all know will be wrong. In the Buycaster, here’s how we roll:
- Amount of Possible Gain: Given (by the user) – this is the target return.
- Probability of Gain: Estimated by our Sanity Score – it’s not exactly a probability calculation but the idea is the same.
- Amount of Possible Loss: We calculate a potential capital loss – IF we believe the Sanity Rating and end up buying the stock only to be proven wrong in time. That’s the event we quantify in terms of capital loss.
- Probability of Loss: Estimated buy our Safety Score – again, it’s not exactly a probability calculation, but it’s halfway there.
The leap from our Sanity and Safety Scores to actual estimates of probabilities of gain or loss is purely a subjective one. When we look at the Buycast or the Sanity Score, we must visualize these numbers along with the story of the underlying business – it’s competitive advantage, economic moat, and its growth strategy. Otherwise, the analysis is incomplete…
However, The Buycaster serves as a quick Rationality Check if we already have a good idea about the story of a company. We’ve heard from our subscribers that the most frequent use-case of The Buycaster is performing a sanity check on an investment idea they’ve heard about somewhere else.
The Buycaster doesn’t proclaim what it thinks will happen. It simply does the number crunching to depict “what needs to happen”. It quantifies – approximately – Buffett’s 4 variables. It’s imperfect, but it’s the best number-crunching solution we’ve come up with after 2 decades of investing.
Incidentally, we recently launched our latest tool: The Fundcaster. And in this dashboard, one can Buycast an Index ETF – bottom-up, stock by stock, and rolled up – instead of relying purely on past data like the previous chart.
Here’s a snapshot of the Nasdaq 100, for example, in the Fundcaster. Past returns have no bearing on this Rationality Rating: