Generating outperformance isn’t linked to accuracy but to identifying big trends. It doesn’t matter if your projected EPS is 5.10 or 5.20; spending hours on fine-tuning this estimate to 5.25 isn’t going to add much value.
Likewise, assuming an efficient market hypothesis, if your estimate is close to the consensus and actual earnings are close to the same, there is unlikely to be any room for alpha generation.
However, if your earnings estimate has a significant variance from the consensus and actual earnings are close to your estimate, you unlock an alpha and achieve outperformance. You need to find that variance.
Last year, I met someone who asked me for a low-risk investment suggestion. I recommended Engro Fertilizers (PSX: EFERT) to him and he said that current earnings were unsustainable due to expected expiry of concessionary gas. And I met so many other people who shared the same opinion. Alhamdulillah, to my benefit, people were probably not reading EFERT’s financial statements in detail. The management had mentioned in its notes that they were already provisioning the expense at higher gas prices. I didn’t even need to come up any EPS estimate as the gap between expectations and actual earnings was way too big, which then led to very steep movement in price 🙂
Likewise, my experience of running an automotive company helped me understand the kind of economies of scale that Sazgar Engineering (PSX: SAZEW) could realize in the March/2024 quarter. While my friends were concerned about sustainability of its gross profit margins, Alhamdulillah I told them that they should prepare for further expansion. And we saw the rally that ensued post the result.
In another case, back in 2017, the stock market was betting on an amazing result from ATRL right after the completion of its upgradation project. My friends were estimating the net impact of the project with a depreciation expense at an estimated useful life of 20 years. Alhamdulillah, to my benefit again, they had not checked its accounting policy which clearly mentioned that plant and machinery were depreciated on a 10-year life. The net impact turned out to be negative in the end 🙂
Some of the readers might feel that I am boasting with these examples 🙂 However, the idea is to explain that the devil is generally in the details, but it can be in the macros too. For example, Alhamdulillah again, I realized early on that AMD had turned around its products and technology whereas Intel was still focused on its market share. AMD stock is up 5x over the past 5 years and INTC stock is down 50% over the same period.
What we must understand is that identifying big trends that differ from market expectations can lead to huge outperformances. In this backdrop, it is essential to understanding market expectations as well. You win half of the battles by knowing yourself and the remaining half by knowing your opponents.