Understanding forecasts and stock tips

Tips, forecasts, projections all have their merits but don't put your house on them without question.

According to the renowned economist J.K. Galbraith there are two types of forecasters — those who don’t know and those who know they don’t know. It’s a useful maxim for sharemarket investors to bear in mind because while forecasts have their place, markets have a knack of delivering twists and turns that even the experts can't foresee.

There's certainly no shortage of forecasts for investors to choose from. A smorgasbord of sharemarket tip sheets provide forecasts, for a fee, while broker groups and investment houses regularly issue forecasts of their own You'll also come across various share forecasts peppered through the financial press. Adding to the pool, many listed companies provide forecasts of profit figures.

However Henry Jennings, a broker with Cube Financial, says in the current volatile climate, "companies are becoming increasingly reluctant to provide profit forecasts". Not only is it getting harder to stick to a forecast, he adds, "the market tends to severely punish those companies that get it wrong".

Among the variety of forecasts available, Jennings says that banks generally provide earnings forecasts because their revenue stream tends to be reasonably stable. Resource companies on the other hand typically limit their forecasts to production quantities simply because there is no certainty about either the grade of what’s being dug out of the ground, or the price that will be paid for it.

If you are looking for forecasts of earnings, yields or even future share prices, plenty of brokers and share tipsters provide them. These are usually determined according to various modelling scenarios that factor in current and likely future market conditions. Jennings says that analysts must be able to back up their forecasts, though he notes "they tend to change frequently, often in response to changing market conditions or unexpected events like takeover bids".

And that's where the weakness in forecasts lies — they are essentially predictions of the future based on information available today. According to Colin Whitehead, an analyst with investment group Fat Prophets: "The data used to generate some forecasts may have originated in a business environment that won't prevail in the future."

He cites the credit crunch as a classic example of how a swiftly changing playing field can render forecasts meaningless. Even within a stable environment, Whitehead notes that forecasts can "chop and change according to the news flow".

Whitehead points out an additional downside, saying: "Forecasts tend to take on a consensus (or average) estimate" with few individuals prepared to voice an opposing view. According to Whitehead: "This is why there is a great deal of risk associated with relying on forecasts, and it's when investors become attached to a set of numbers that things can go awry. A much better approach is to develop a strong understanding of a company’s business model."

Jennings believes forecasts can be useful for smaller stocks which are typically more difficult to research. However he cautions: "It's easy for investors to be misled by forecasts, especially when they are constantly being revised." Whitehead and Jennings agree that forecasts have their place but add that they are just one element in the armoury of information available to investors. As Whitehead puts it: "Your view needs to be balanced with other information."