Forecasting is never an easy task. In the complex and fast-moving world of emerging markets, it's particularly difficult. We believe investors would benefit from adding a broader approach to their research toolbox.
Typically, investors rely on earnings data, growth forecasts and management guidance on cost cuts to identify investment opportunities. When looking at an airline company, for example, a common approach might be to focus on passenger numbers, possible capacity increases and forecasts of fuel price. But such an analysis is highly sensitive to small changes in assumptions, which in turn can dramatically alter the investment picture.
It’s even more problematic in emerging markets. Investors frequently struggle to find enough historical data to do their research. Information is often limited and transparency poor. And many emerging-market economies change so fast that any analysis of historical data––when available––can be misleading.
Inside vs. Outside Views
So what’s the alternative? Nobel Prize–winning psychologist Daniel Kahneman and fellow researcher Dan Lovallo in 1993 defined two forecasting methods. One is the inside view, which equates to forecasting the cost of a kitchen renovation by looking at a detailed plan’s cost estimates. The other is the outside view, which would do the same by looking at the average cost of broadly similar projects.
According to Kahneman and Lovallo, most people take the inside view, but analyzing just one specific situation at a time can make people overly confident and blind to alternative outcomes. The outside view, they conclude, tends to be more realistic because its conclusions are based on a broader sample of possible developments.
Frequently, fundamental equity research is based on the inside view. We think investors of all stripes—and in all regions—would be well advised to complement that with an outside view. And it may be even more important when investing in emerging markets, because transparency is often lacking and reliable information can be hard to find. Investors can look at a plethora of historical examples from developed markets, other emerging economies or even different industries to see how events can evolve, customers can behave and competition can change. The outside view helps to reduce the tendency for forecasts to remain too close to the present situation or to overemphasize the importance of current trends.
This approach can help with different forecasting challenges.
Will financial deregulation be good for Chinese banks? Taking an outside view might show that banks sometimes initially benefit from the increased flexibility to lend. After a number of years though, that flexibility mixed with some inexperience in loan underwriting often results in more bad loans.
What about the future of heavy industries? Looking at the past 100 years of shipbuilding as an example, one might notice that production shifted from Britain to Europe and then to Japan before moving to Korea and then to China. Each transition shared many similarities, including the struggle of older and smaller shipyards to survive as ships became bigger and competition increased. These changes can help us understand the long-term evolution of many heavy industries—as well as the rise and fall of companies and countries—which will certainly include major emerging markets in the coming decades.
And food consumption? Recent trends in emerging markets can only tell you so much. Instead, to understand how food markets will evolve in developing economies, it’s probably more useful to look at how the modernization of lifestyles affected diets in the developed world over several decades, as we discussed in a recent blog on obesity trends.
Taking an outside view might require creativity and additional legwork to find appropriate and relevant analogies. The effort is frequently rewarded.
By emphasizing an outside view and tapping into a rich archive of historical examples, investors can add clarity to an otherwise volatile and murky world of emerging markets.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.