The Common-Sense Smell Test
Challenge valuations that have lost contact with economic fundamentals
- Difficulty
- Easy
- Time to result
- ~days to results
- Steps
- 5
- Confidence
- 92%
The Common-Sense Smell Test is a first-pass safeguard against valuations detached from economic reality. Begin with the underlying fundamentals: revenue, profit, cash flow, affordability, and the assumptions connecting them to price. Then ask whether the story remains credible without relying on novel metrics or universal optimism. A failed smell test does not automatically prove that an asset will fall immediately, but it identifies where further diligence and caution are necessary. The mechanism is deliberately simple: observable contradictions trigger deeper investigation rather than being rationalized away. It is especially useful during bubbles, when institutional confidence and sophisticated models can make obviously fragile assumptions appear respectable.
Origin
Libby Cantrill developed this instinct while valuing technology companies at Morgan Stanley during the dot-com bubble and reinforced it while observing unsustainable housing assumptions before the financial crisis.
Core principles
- 01Markets and asset prices move in cycles.
- 02Economic fundamentals eventually matter.
- 03Complex models should not override obvious contradictions.
- 04Question assumptions even when experienced people accept them.
How to run it
- 1
Establish the fundamentals
Document the asset's revenue, profit, cash flow, debt, affordability, and other measurable economic supports.
Pro tip Use the simplest reliable figures before introducing elaborate forecasts.
Watch out Do not substitute attention, popularity, or a fashionable metric for an economic foundation.
- 2
Expose the assumptions
Write down the assumptions required to connect current fundamentals to the proposed valuation.
Pro tip Pay particular attention to growth rates, margins, financing conditions, and terminal values.
Watch out Assumptions that require unprecedented outcomes deserve a larger margin of safety.
- 3
Apply the smell test
Ask whether a reasonable outsider would find the valuation plausible given the underlying economics.
Pro tip Explain the valuation in plain language; incoherence often becomes obvious when jargon is removed.
Watch out Seniority, consensus, and sophisticated models do not make a contradiction disappear.
- 4
Investigate the contradiction
When the story and fundamentals conflict, seek disconfirming evidence and compare the situation with prior cycles.
Pro tip Look for leverage, relaxed underwriting, or newly invented valuation conventions.
Watch out A correct diagnosis does not provide precise market timing.
- 5
Adjust the decision
Demand a greater margin of safety, reduce exposure, or decline the opportunity when the contradiction remains unresolved.
Pro tip Record why the opportunity failed so the decision can be reviewed later.
Watch out Do not turn caution into a blanket refusal to consider genuinely innovative businesses.
In the wild
As a technology investment-banking analyst, Cantrill questioned how companies with no profits and hardly any sales were being valued. Senior colleagues suggested that experience would teach her why the prevailing approach made sense, but the subsequent collapse validated her concern that prices had become disconnected from fundamentals.
→ The experience established a durable skepticism toward narratives that cannot pass a basic economic reality check.
During business school, Cantrill heard classmates argue that everyone should receive a housing loan regardless of income. The proposition failed her smell test because repayment capacity was being treated as irrelevant.
→ The same common-sense test highlighted fragility before the housing crisis.
Common mistakes
Replacing analysis with intuition
The smell test should identify questions and contradictions, not replace full financial analysis.
Deferring blindly to experts
Experienced people may share the assumptions sustaining a bubble, so authority is not a substitute for evidence.
Confusing diagnosis with timing
An asset can remain disconnected from fundamentals for a long time before prices correct.
Is it for you?
Best for
It is best for investors, analysts, and decision-makers evaluating assets during periods of exuberance.
Not ideal for
It is not sufficient by itself for pricing early-stage ventures whose value legitimately depends on uncertain future options.
From the transcript
“common sense actually does typically prevail.”
“the markets are cyclical.”
From the episode
Libby Cantrill Discusses Fixed Income and Equities
Libby Cantrill