The Abyss Looks Back
I have said before--it’s certainly not original to me--asset valuations are ultimately no more and no less than the discounted PV of an expected stream of revenues. All else is speculation or FOMO.
As to that income stream, or that discount rate, you’ll rightly point out that these, being future, are also speculative. “Past results are not a guarantee of future performance.” Just so.
How speculative, and for whom? Is it possible to discern things that *might* work from the things that are almost certain not to work? We’d at least like to advance that art and science (because it’s both), since we’re forced to make scores of such judgments on a pretty frequent basis. People close to the work with skin in the game can and do successfully forecast the outcomes of their decisions.
So how is it that the business cycle seems punctuated by, or instigated by, people, both lauded experts and rank-and-file, who got it spectacularly wrong?
I’ll leave psychoanalysis to others, and from tulip mania to the last housing bust (which is teetering on the edge of a redux), it’s a safe bet that this boom-bust feature is a perennial feature of the financial geography. And I’ll leave off an assessment of mistakes that were made and how we might be making them again. In economics, it seems hindsight is even less accurate and more contentious than foresight.
It does seem that a mental feature of the business cycle is a broad fear that having crashed things will never rise again, and having risen steeply for some interval, they can never fall. The first produces a certain blindness to good news, and the second, an aversion to hearing bad news. “Don’t fight the Fed,” it is said. Or more colorfully: “As long as the music is playing, you’ve got to get up and dance.” [Charles Prince, 2007]
Independent, privately held companies constructively have a semi-illiquid long position on economic stability and growth. How does this translate? We bear the uncertainty of investments that don’t produce the expected stream of payments and/or the cost of capital goes up. Liquidity dries up, we’re out of covenant, and we have no opportunity to walk back the mistake. For all our efforts, if not outright crisis, we endure enhanced drudgery and slowed progress to our goals. We never quite recover the lost ground.
There is a remedy, and it is human nature to avoid it. It is a process of comprehensive forecasting and planning. One of our clients called it “looking into the abyss” (I don’t know how deeply he read Nietzsche, but safe bet he was not a fan). Here’s the thing: in finance the abyss doesn’t look back, it only feels like it does.
In quiet times it feels unnecessary. Quiet times don’t last, and planning is art and science and muscle—if it’s deployed when the need is undeniable, it’s either entirely too late or at least late enough to get into trouble that could have been avoided.
It’s also a way to stay true to your business, your goals: yourself—getting a deeper intellectual bulwark to stop fads, trends, “expert” opinion, from talking you out of your common sense, which often turns out to be, in times of economic transition, entirely uncommon.
What is it about stress testing that, well, stresses business owners so much? Again, the abyss: does it look back? Or, if you don’t see it, it assumes that it can’t see you, either (apologies to both Nietzsche and Douglas Adams here)?
My own experience is more that planning, and in particular negative scenario generation, are akin to looking in a very unflattering mirror. It’s not so much that it reveals us to be ugly, but that it shows us to be inconsistent. And so what? Anyone charged with leadership is bound to be, what with various demands on our time, the interplay of risk and uncertainty, and the evolution of our businesses. It’s less a fault to correct than a reality to be understood and managed.
“When the facts change, I change my mind. What do you do, madam?”
I’m pleased to report earlier attribution of this quote to Winston Churchill, not, as is more common, to J.M. Keynes.
In finance you look into the abyss to avoid falling into it. It *is* unpleasant, but it both avoids the worst trouble and in the interim, tends to tune up performance.
If I can characterize the typical objections—
It *does* look back, which is to say, talking about potential trouble can bring on trouble by making stakeholders look for the exit.
You can miss out on gains a *long* time before anything bad happens which may or may not erase some of them.
Economic growth will continue and the train is leaving the station; miss out now and the opportunities will be too far out of reach (is this FOMO?).
The answer? Well of course you don’t share doomsday scenarios with your employees. Any leader’s role is to create an island of stability so the people doing the work can focus without being frozen by continuous uncertainty. It takes serious mental effort and discipline to distinguish something that *could* happen to something that *will likely* happen.
As to FOMO and weighing seemingly certain gains sooner against speculative losses later: this is not merely a contrarian position. The whole POINT of a planning/forecasting process is to hone your judgments, to know more completely when you can afford to sit still and what misjudgments could ruin you.
Should you invest in an expansion?
What factors have to be true for it to meet liquidity and profitability targets?
How much room is there for you to bet wrong and still be viable until either the macroeconomic landscape changes or you adjust? How does this compare to deferring that expansion until a later date?
Exploring unpleasant possibilities by means of a deep planning process reduces so much emotion and uncertainty to questions of fact, and if not fact, at least transparently calculable risk. It significantly shrinks the realm of the unknown. The point is, in Tom Sr.’s observation from decades of doing this work—success takes less work, less risk, and less time.