What’s Wrong with a Little Overoptimism?

As societies advance and reap the rewards of economic growth, it is natural that investors hold an optimistic view of the future. There is a danger, however, of excessive, or misplaced optimism by financial market participants and companies’ management teams, which can lead to decision-making that produces investment outcomes ranging from sub-optimal to damaging.

Overoptimism can create an illusion of invulnerability and a perceived lower likelihood of misfortune, leading to the improper calculation of potential risk and reward. Although the phenomenon of overoptimism and its risks are well established, overly positive expectations persist, despite an abundance of data showing its threat.

One example of structural overoptimism can be found in the 2020 report published by the Federal Reserve Bank of San Francisco, titled: “Wringing the Overoptimism from FOMC Growth Forecasts”.¹ This assessment of past economic projections provided by Federal Open Market Committee (FOMC) participants revealed that between 2008 and 2016, initial GDP forecasts routinely exceeded both final forecasts and actual reported growth, often dramatically so. It was also noted that FOMC members routinely fail to project economic recessions, despite the recurring nature of economic cycles. After 2016, there was greater acknowledgement of the problems in forecast methodology, which brought about a reversal between 2016 and 2019 as initial GDP forecasts started low and were subsequently revised upwards. Only time will tell if the overly optimistic bias has indeed been corrected, but the potential for bias amongst the astute members of the FOMC is clear.

Pertinent to Canadian equity market participants is the habitual overoptimism amongst sell-side analysts’ bottom-up consensus earnings forecasts. The chart below, courtesy of TD Securities, depicts the trend of street-wide consensus forecasts since 2007 through to June 30, 2021. Like the initial case for FOMC participants described above, analysts’ forecasts customarily overestimate final forecasts and ultimately, the reported results. The chart below depicts this tendency towards overoptimism.

One arena where overoptimism and its consequences are routinely observed is with the capital allocation decisions made by companies’ management teams. Amongst the myriad of other biases that can influence decision-making, overoptimism here really stands out. Less than sober assumptions can have a compounding effect, as those expectations serve as the foundation for additional forecasts further out in time. Long-term success can turn on the prudent consideration and optimization of decisions to reinvest, pursue mergers and acquisitions, undertake effective share buybacks, or implement well-executed dividend plans. It is paramount that return exceeds the associated cost of capital and is not distorted by excessively positive views of the future. The boards and management of companies face ongoing capital allocation dilemmas, and their judgments can have a great bearing on the sustainable growth and profitability of a business and its translation into long-term shareholder value creation.

Corporate Canada has not proven itself immune from such pitfalls. In fact, the relative prominence of cyclical aspects in the Canadian equity market landscape, such as commodity producers in Energy and Materials, as well as related businesses in other sectors, can give rise to more challenging forecasting. For example, a deeply cyclical business experiencing bumper profits may be inclined to pursue acquisitions or repurchase its own shares at peak cycle prices that far exceed the underlying full cycle intrinsic value of the investments. Across any sector, an overly aggressive pursuit of reinvestment, mergers and acquisitions can prove particularly costly, especially when compounding estimate errors are used to justify the stretching of balance sheets. With dividends, the proper calibration of future expectations is also critical. Paying out dividends that are beyond the reasonable means of a business can be highly destructive.

When assessing investment opportunities or the effectiveness of the management of a business, there should be consideration of a wide range of realistic potential outcomes. Franklin Bissett’s equity investment approach is reliant on our ability to achieve unbiased long-term forecasting of business fundamentals. While we are not immune to errors, our favourable track record over time is in large part a function of our awareness and avoidance of systematic biases such as overoptimism.