Predicting the future is a tricky business. Avoiding the temptation to do so and focusing instead on the fundamental indicators of a company’s strength – or weakness – is exactly what the latest investment process in the Liontrust range is all about.

The Cashflow Solution, Liontrust’s European equity investment process formulated by new recruits Gary West and James Inglis-Jones, determines the profits a company is likely to achieve by, as its name suggests, focusing on cash flow.

“Most fund managers and sell-side analysts I know try to forecast the future and base their evaluation of an opportunity on that,” says West. “Academic evidence suggests, though, that forecasting is something people are extremely bad at. This isn’t just confined to investment. Studies have shown that doctors, for example, are overconfident about their ability to diagnose conditions.”

“We try to exploit situations where investors and analysts are most likely to be wrong.” Where a company is overly optimistic, it will tend to disappoint and share prices will fall. Companies that are prudent and cautious tend to encourage low expectations from the market, and as a result tend to surprise on the upside. This means opportunities for buying and short selling arise at opposite ends of the spectrum.

Cash flow is the best way to judge how cautious – or optimistic – those predictions are, and the growing acceptance of IFRS (International Financial Reporting Standards) in Europe means company accounts are now more reliable.

Historically, the data provided by companies across Europe varied widely, which meant the clues that West and Inglis-Jones look for in company accounts would have been unreliable – and the process impossible to support. But IFRS – which seek to harmonise the information that companies are producing – are increasingly being adopted by listed companies across Europe, making it possible to compare and contrast this data for the first time (see box over page).

“Cash flows reveal valuable information about the scale of a company’s investment decisions,” says West. “Strong cash flows are a good indicator of strong growth in future reported profits while weak cash flows often predict a collapse in reported profits.”