Many years ago, when I was undergoing my engineering training in school, the professors in several classes would require that I write my assumptions before showing the solution on homework problems. Most of us found this to be quite annoying because we were certain that the assumptions were obvious, and it just took more time and effort to write them all out. Over time though, I began to realize just how important our assumptions are, and how vital that training was in school. Some of our assumptions are so deep, we don’t even realize we are making them. In fact the more fundamental and deep they are, the less we even realize we are making an assumption. So, it is absolutely critical to develop the skill to uncover what they are because you always make assumptions whenever you solve a problem, whether you realize it or not.
For example, you assume that when you turn the key in your car in the morning (or press the start button) to go to work, your car will start. When it doesn’t, and your assumption is violated, you are suddenly thrown into the chaos of reality. This thing you thought you understood -a car- you now realize you know little to nothing about, and is actually composed of a bunch of complex systems inside that you never even thought about.
Here is an example from investing. When you calculate a price to earnings ratio or a price to cash flow ratio to determine if a company is over- or under-valued, you are assuming that the price you use and the earnings / cash flow that you use are correct. But what if they aren’t? What if the price you are using is misquoted? This is probably not so likely, and would be discovered shortly when you return to look at the price again later and it is different. However, a more real and terrible scenario is this – what if the company is lying about its cash flow or earnings on the financial statements? Now, you don’t even realize that your assumption is wrong and that you are being misled. This is why, for our Star List of companies for potential investment, we insist on companies that are based in countries where respect for rule of law and property rights are strong. If a company is in a country where it is considered perfectly ok to lie to achieve its aims if it can get away with it or if it can bribe the right people, then you cannot trust even the most fundamental assumptions you make about the company. If a company can have all of its assets suddenly confiscated without due process or without having done anything wrong, its value will also be very different from what you expect.
Even in countries where rule of law and property rights are strong, it is only too human for managers to want to tilt things in their favor within the accounting rules for earnings in order to earn their end of year bonuses. This is why we like to look at cash flows instead of earnings. Earnings are designed to allow smoothing out of things, so that the investor can get an idea of the smooth progression of earnings over time. Cash flows, however, must be recognized when the cash moves into or out of the business. So, for example, if a company builds a large plant, earnings can be smoothed by amortizing the plant over its useful life, but cash flows must be recognized when the company pays for the plant. Earnings will be smoothed and averaged, and cash flows will have large jumps up and down because of this. But this opens earnings up to more manipulation. Over time, cash flows and earnings are supposed to converge. Personally, I would rather manually average a bunch of cash flows and smooth them out myself, while being more certain of their accuracy, than allow the company to average the earnings for me and open myself up to an earnings manipulation. When incentives are not aligned, you must do your own due diligence to ensure you are not being misled, even if not intentionally, by the other party.
Further, even in countries where rule of law and property rights are strong, I would avoid companies that seem to have a culture of dishonesty. Dishonesty with investors, customers, suppliers, employees, and even dishonesty with themselves just leads to problems. Once such a culture takes hold, it is difficult to root out, and will often grow worse over time. It usually only gets better after the company suffers some type of crisis and change becomes necessary.
Another common assumption is around the discount rates and future cash flows that you project for a company when doing discounted cash flow analysis of a stock. If you assume the discount rate is low, and interest rates move up a lot, you must now adjust your discount rate upwards. Your company’s future cash flows are now discounted more agressively to the present value. This is why changes in expectations about interest rates have such an effect on the market. When it becomes apparent that the Federal Reserve will begin to cut interest rates or raise them, markets often move quite a bit at such inflection points as the market reconsiders the collective assumption that it made about discount rates.
Further, when you project future cash flows for a company, you usually assume some smooth progression of cash flows (smoothly increasing, or decreasing). Your assumption will be wrong, the question is by how much. Cash flow might be high one year and small or negative the next. Sequence of returns matter, too. If you assume large cash flows in earlier years and smaller cash flows later years, and the reverse happens, your final calculated value for the stock will be different. We are assuming that the precision we are using to calculate the stock value is much greater than it really is. We will talk about this particular erroneous assumption in the next post and how to deal with it because I see a lot of investors making this mistake.
Another common assumption that we make is that the stuff we don’t know is unimportant or at least less important than the stuff we do know. If you think about all of the aspects of a company’s markets and carefully calculate its present value based on this, but you fail to consider that all of its factories are constructed on the same earthquake fault line, the thing you don’t know about can suddenly become very important to the future value of the company under the right circumstances. There are many logical fallacies that people fall prey to, and many of them are based on assumptions or shortcuts that we make (often called heuristics). These assumptions may work in some cases and not in others, so it is good to start to develop the skill of understanding what your assumptions are and when you make them.
Nothing is guaranteed in investing, and we will be wrong at times, but we want to increase the ratio of good to bad decisions as we invest, and understanding our assumptions is key to this. Ideally, when we develop our Star List of companies, if we have made good decisions, the failure rate of such all-star companies will be much lower than a set of randomly picked companies. Even better, the failure rate should be much lower than the failure rate of a set of decent companies such as those included in the Dow, S&P 500, or another comparable index when looked at over long periods of time. If you simply reduce the number of failures or low performers, your investing performance will be much better over time.
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