In his 1996 book The Road Ahead, Bill Gates noted, “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” If we were to illustrate what Gates is talking about, my guess is it would look something like this:
Gates was writing about technology and the internet, but I can’t help thinking about how over- and under- estimation unfolds in the Canadian market.
Investors tend to think in linear terms about their expected outcomes which lead to many behaviours that can impact long term performance. One of the major misdirections is assuming that if the average return of an investment is 5% per year, then one should expect to earn 5% each year they hold it. That’s obviously a disappointing expectation because we know that the good years and bad average out over time, making any one year hard to predict with certainty.
Applying such linear thinking to the real (non-linear) world causes investors to bail too early when they’re in the “overestimation zone” and things don’t immediately go as planned. On the flip side, investors in the “underestimation zone” tend to sell too early because they’re in a hurry to take profit, worrying about the next drop. This is isn’t to say that forming expectations about markets and events should be avoided. Instead, to avoid disappointment and stay in the right frame of mind, investors should consider Gates’ quote in setting healthier short term and long term expectations. Thinking linearly works great in algebra, but almost nowhere else.
In the real world, high quality companies go through this over/underestimation pattern constantly. In charting their share prices, one can see rather clearly the stair-step patterns over years and in some cases decades as trading price wiggles around either side of intrinsic value. I’ve included three such examples below that we currently hold in the Growth Portfolio.
Example one, in the materials sector:
Example two, in the consumer staples sector:
Example three, in the technology sector:
Notably, this pattern of under/over valuation in high quality companies can be seen over shorter time frames as well. Also notable, this idea doesn’t work so well in companies with cyclical or low cashflows.
Stepping back a moment, in the past three months we’ve seen a major change in investor preference for certain sectors and asset classes. As much as investors have changed their minds about the value of gold, oil, the dollar, and growth, might they now be over- or under- estimating their expectations of the effects of inflation, forest fires, government deficits, and low interest rates? Forecasting is not a habit I’m fond of, but I think it’s fair to say that the market’s perceptions of some of these events are being influenced by the highest degree of investor pessimism since 2009. Bad news only maintains its effect for so long before the world adjusts, things go back to normal, and we expect more from our future selves than we have today. Also known as optimism.