Forward or Backward?
by Jamie Hyndman, Mawer Investment Management
There’s a significant cohort of the investment community which suggests that the best approach to investing is to focus on a company’s historical data. In addition to many individual investors, this is the bread and butter of quantitative investment managers and also of fundamental indexing. These types of investors rely on a range of metrics that are derived from a company’s past experiences. For example, a company that has had high earnings growth, regular dividend increases and trades at a low price/earnings ratio might be considered a good investment.
While this approach is relatively easy to implement, there’s something missing. It’s also important to ask, “what does the future hold for this company?” Because investing based solely on historical data is akin to looking in the rearview mirror to drive forward – what’s behind you may be indicative of what’s ahead, but not necessarily.
Let me provide an example. Suppose a pharmaceutical company has developed some patented blockbuster drugs over the past few decades and has become very profitable. Well, this might be a good investment, but maybe not. The question that must be asked is about the company’s future – are its drugs coming off patent anytime soon and if so, does it have a pipeline of replacement drugs in the works? If not, generic drugs may steal market share and drive down the profitability of this company in the future, making it a poor investment today.
Furthermore, there are numerous other factors that could impact a company’s future profitability…perhaps there are burdensome new regulations coming; maybe a strong new competitor is about to enter the industry; labour might be about to unionize and raise costs; the management team that was responsible for the company’s past successes might be about to leave. Any of these issues, and many others, have the potential to make an otherwise appealing investment turn sour.
Make no mistake, historical data is useful. A successful historical track record does help to verify an investment hypothesis. However, we believe that knowing what a company has achieved in the past is only part of the story. The real value comes from the qualitative work, not the quantitative. That is, thoroughly assessing the prospects of a business model and management’s ability to execute on a go-forward basis.
Being fixated on the rearview mirror rather than the road ahead is a dangerous way to travel. In fact, history is littered with companies that appeared to be travelling down a safe road, only to find themselves lost.
Jamie Hyndman
Copyright © Mawer Investment Management
