Wednesday, October 26, 2011

What's in Your View Finder?

By Weston Wellington

He is no longer with us, and the world is poorer for it.

A restless college dropout, he founded a wildly successful company whose innovative products touched millions of lives. He was a brilliant, dictatorial, and cantankerous leader, relentlessly pushing his staff to solve one impossible problem after another. He had no use for conventional market research, and trusted his own vision to create products with little detectable demand that flew off the shelves upon introduction. He zealously guarded his personal privacy but reveled in his role as a master magician on stage when introducing his firm's latest innovations to eager crowds of industry followers. Stockholders wore big smiles as the shares vaulted to one new high after another. In many ways, he was the antithesis of the conventional corporate chieftain, and despite his demanding persona, he was revered by employees, customers, and even competitors to a greater extent than almost any other chief executive in recent memory.

A tribute to the late Steve Jobs? No—to Edwin Land of Polaroid.

The son of a scrap metal dealer, Land dropped out of Harvard to pursue his own research at the New York Public Library on polarized light filters. He founded Land-Wheelwright Laboratories in 1934 with his former physics professor, and his low-cost polarizing filters proved useful in products ranging from sunglasses to army tank telescopes and gunsights. After the war, he turned his attention to photography and introduced the Polaroid-Land instant camera in 1948. Despite a stiff price tag of $89.75 the first shipment of 57 cameras sold out in a matter of hours at a Boston department store, and the firm never looked back.

Numerous improvements followed, and sales boomed as the cameras and film became smaller, lighter, easier to use, and less expensive. The stock price did likewise, and Polaroid became a bellwether "glamour" stock during the postwar bull market, soaring tenfold in just five years from 1963 to 1967.

When a cover story in Time appeared in June 1972, Polaroid seemed all but unstoppable. Land's inventive genius had resulted in an astonishing new industry with technology protected by a wall of over 1,000 patents. (Land himself held 535 patents, second only to Thomas Edison.) Eastman Kodak offered only token competition in instant photography, and was eventually vanquished in both the marketplace and the courtroom. Kodak was forced to pay Polaroid nearly $1 billion to settle a patent infringement suit and withdrew from the instant camera business. Polaroid shares reached an all-time high of $149.50 in mid-1972, amid intense excitement over the ingenious new SX-70 single lens reflex color camera and rumors of an instant movie product. Government surveys at the time identified photography as one of the fastest-growing industries in the country, and Polaroid appeared to be a key beneficiary: In the premium category (cameras selling for $50 or more), Polaroid was not only the undisputed leader but outsold all other global competitors combined.

Land was one of Steve Jobs' heroes, and the youthful computer tinkerer from California felt almost a mystical connection with the Cambridge scientist forty-six years his senior. Both were impatient perfectionists, often driving themselves even harder than their overworked employees. Land was infamous for wearing out staff members, who rotated in shifts while he focused on knotty problems. During one marathon research session, Land wore the same clothes for eighteen straight days. When Jobs had the opportunity to meet Land personally, he found that he and Land shared a peculiar characteristic: Both believed that new products were not invented so much as discovered. Both could visualize a product that did not yet exist down to its smallest details, and the task of development was thus akin to Michelangelo's description of sculpture: The artist's task was to remove the unnecessary material to reveal the beauty already contained within the stone.

Alas, Time's cover story marked the beginning of the end. The instant movie project ("Polavision") turned out to be a costly failure and led to Land's resignation in 1980. Jobs was dismayed when Land was pressured to leave the firm he had founded, calling him a "national treasure." Jobs would suffer a similar fate after a losing boardroom battle in 1985.

Although Polaroid products continued to sell well, the shift to digital photography caught the firm unprepared and slowly hollowed out the highly profitable film business. Polaroid filed for bankruptcy in October 2001. The research labs and film factories were shuttered, although the brand name, traded from one sharp-elbowed financier to another, survives as a ghostly reminder of its illustrious past. The years have been kinder to Eastman Kodak, but not by much. Founded long before Polaroid in 1888, it has outlived its former adversary but now struggles to avoid a similar fate.

What is the message for investors?

As we observed in a previous note, the forces of competition are relentless, and today's astonishing innovation may be tomorrow's commodity—or garage sale castoff. We have no reason to believe that Apple has anything but a bright future, but those of us tempted to concentrate our investment capital in a handful of exciting industry leaders should consider the fate of Polaroid before declaring, "It can't happen here."

Securities Research Company, SRC Green Book, 1993 edition.

"Polaroid's Big Gamble on Small Cameras," Time, June 26, 1972.

"The Story of Polaroid Inventor Edwin Land, One of Steve Jobs' Biggest Heroes," 37signals, accessed October 14, 2011.

Tuesday, October 4, 2011

The Accuracy of Experts' Forecasts

By Larry Swedroe

There’s an overwhelming body of evidence on the inability of forecasters to make accurate predictions. This inability is one reason why efforts to outperform the market without taking more risk have failed with such persistence. This is true for both the stock and bond markets. The following is a recent example that while it might be easy to make a living selling forecasts, it’s very difficult for even the experts to make accurate forecasts.

A year ago, the Reuters news agency polled 16 money market dealers who do business directly with the Federal Reserve. These “primary dealers” — banks or broker-dealers — are market makers for government securities. They even consult directly with the US central bank and Treasury about funding the budget deficit and implementing monetary policy.

One might hypothesize that if anyone could get the forecast right it would be them. Reuters asked the dealers for their forecasts for Treasury bond yields three, six and 12 months ahead. Their consensus forecast was for 10-year Treasury note yields to rise from 2.5 percent to 3.2 percent by September 2011. Investors paying attention would shorten maturity risk. Today, we know that they were not only off by about 1.5 percent (the 10-year note now yields about 1.75 percent), but more importantly from a strategy standpoint, they got the direction wrong. Investors who paid attention not only failed to earn the term premium that existed at the time, and missed out on the large capital gains that the fall in rates produced, but now they’re faced with reinvesting at much lower interest rates.

But they weren’t the only ones that got it dead wrong. In February 2011, the bond “king” Bill Gross announced that the world’s biggest bond fund had reduced its US government-related debt holdings from 22 percent in December 2010 to just 12 percent in January 2011, the lowest in two years. In March, PIMCO announced it had eliminated government related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Fed ended its quantitative easing program.

By August, Gross admitted he had made a big mistake, and he reversed course.

The aforementioned failures of the so-called experts to get forecasts right is nothing new. William Sherden, author of The Fortune Sellers, was inspired by the following incident to write his book. In 1985, when preparing testimony as an expert witness, he analyzed the track records of inflation projections by different forecasting methods. He then compared those forecasts to what is called the “naive” forecast — simply projecting today’s inflation rate into the future. He was surprised to learn that the simple naive forecast proved to be the most accurate, beating the forecasts of the most prestigious economic forecasting firms equipped with PhDs from leading universities and thousand-equation computer models.

Sherden reviewed the leading research on forecasting accuracy from 1979 to 1995 and covering forecasts made from 1970 to 1995. He concluded that:

  • Economists cannot predict the turning points in the economy. He found that of the 48 predictions made by economists, 46 missed the turning points.
  • Economists’ forecasting skill is about as good as guessing. Even the economists who directly or indirectly run the economy (such as the Fed, the Council of Economic Advisors and the Congressional Budget Office) had forecasting records that were worse than pure chance.
  • There are no economic forecasters who consistently lead the pack in forecasting accuracy.
  • There are no economic ideologies that produce superior forecasts.
  • Increased sophistication provided no improvement in forecasting accuracy.
  • Consensus forecasts don’t improve accuracy.
  • Forecasts may be affected by psychological bias. Some economists are perpetually optimistic and others perpetually pessimistic.

Economist and Nobel Laureate Paul Samuelson observed: “I don’t believe we’re converging on ever-improving forecasting accuracy. It’s almost as if there is a Heisenberg [uncertainty] Principle.” Michael Evans, founder of Chase Econometrics (now IHS Global Insights), confessed: “The problem with macro [economic] forecasting is that no one can do it.”

The bad news is that no matter how much we want to believe in fortune tellers, the problem is that they all have cloudy crystal balls. One reason for the inability of even the experts to see through those clouds is that markets have a nasty tendency to provide surprises, which by definition are not forecastable. The result is that the efforts to try and manage returns are highly likely to prove unproductive. Instead, you should focus on the things you actually can control, the types and amount of risk you take, diversifying those risks prudently, costs and tax efficiency.

And finally, remember that since the underlying basis of most stock market forecasts is an economic forecast, the evidence suggests that stock market strategists who predict bull and bear markets will have no greater success than do the economists.