Astronomers, Astronauts and Styles of Investing

I believe the answer lies in the way they each look at the world. CEOs understand their businesses are extremely nonlinear, and that their future performance is affected by myriad internal and external factors. In most businesses, many of these factors are hard to quantify and nearly impossible to forecast. Also, entrepreneurs and CEOs are usually operating with incomplete data sets. They have only some information at their disposal, and they implicitly make assumptions about the missing information and execute. Then they tweak their execution as more data become available. It's a continuous, unending process with constant tweaking and experimentation.

Investment managers, on the other hand, look at the business from a distance and have a perfect view of the past. Based on the past and other trend data, they build linear models for the future. If a business has grown yearly sales consistently at a 10% to 15% clip, its models are likely to assume a 10% to 15% growth rate for the next few years.

A Meeting of the Minds

When the linear and nonlinear thinkers speak to each other, the exchange can be quite funny. On many a conference call, analysts will ask questions related to expected growth rates or cash flows for the next few quarters or years. From the analysts' perspective, CEOs appear to be stonewalling when they sidestep these questions and list nonlinear factors that make analysts' forecasts difficult.

With companies that provide earnings guidance, I've found two things to be true. They either suggest numbers based on the most pessimistic view of their business, or engage in accounting games to make the numbers. As Buffett succinctly points out, "Companies that fixate on making the numbers are likely to make up the numbers." And being optimists as a group, sometimes their most pessimistic view ends up being too optimistic, and then we get "revised lowered earnings guidance."

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Mohnish Pabrai is the managing partner of Pabrai Investment Funds, an Illinois-based value-centric group of investment funds. At time of publication, Pabrai held a long position in Berkshire Hathaway, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He appreciates your feedback at [e-mail]. You can access his Web site at www.pabraifunds.com.