4. The complete method, and where to go from here

Level 6: From reading to decision

This closes the first half of the course, the half about expectations, before we move into the six levels about the edge. Time to pull these six levels together into something that fits on one page and can be applied tomorrow to any S&P 500 company, and then to say honestly what you have and what you do not.

The first six levels, in six lines

• Price as a forecast (level 1): a quoted price is not an opinion about what the company is worth, it is the list of things the market already takes for granted.
• The value drivers (level 2): that list breaks down into sales growth, margin, incremental investment, cost of capital and the advantage period. Nothing more, and nothing less.
• The mechanics (level 3): how to walk the road backwards, from price to expectations, instead of the usual road from estimate to target price.
• The surprise (level 4): what moves a share is not the figure, it is the distance between the figure and what was discounted. An excellent set of results can sink the price.
• Competition and duration (level 5): the driver that explains the most value and is the hardest to defend is how many years the company will go on earning above its cost of capital.
• And this level: a written thesis, a refutation criterion, and size governed by confidence.

The sequence, step by step

• 1. Take today's price and treat it as a forecast, not as a verdict.
• 2. Translate it into expectations across the five value drivers, with figures and a horizon.
• 3. Compare those expectations with the history of the company itself and of its sector. Are they plausible? Have they been met before?
• 4. Find the driver where your reading differs. One. If it is all five, check your own inputs before you check the market.
• 5. Write down why you and not the market. If nothing better than "I have read a lot" turns up, stop here.
• 6. Check whether the competitive advantage can last as long as your thesis needs, and who might shorten it.
• 7. Write the thesis in five lines, dated.
• 8. Write the refutation criterion: quantity, threshold, deadline and consequence. Check that it could actually trigger.
• 9. Size by gap and by confidence, letting confidence take charge, and aggregate the exposure with what you already hold.
• 10. File it away, and review it on the date written down. Not when the price reminds you.

Abbreviated worked example (illustrative figures)

A company trades at 60. The reverse reading says: sales growing 5% a year, an operating margin of 14%, twenty-five cents of investment for every euro of new sales, and all of it sustained for nine years.

Steps 2 and 3: the figures are plausible; the company has grown at around 5% over the last five years and its margin has been close to 14% for some time. Step 4: you find no discrepancy on growth or on margin. You agree. Step 6: here you do not. Two competitors have launched an equivalent product, the price difference between them has narrowed over two years and you cannot see what stops it narrowing further. Your reading of the competitive advantage period is about three years, not nine.

Conclusion: on your reading, the company is not cheap but expensive, and the decision is not to buy. You do not even have to get as far as step 7. That is by some distance the most frequent output of the method, and probably its greatest contribution: most of the time it tells you the price already contains what you were about to argue.

What you have, and what you do not

Notice what appears nowhere at all: an ability to predict. You have not learned to know what a share will do. What you have is a method for working out what you would have to believe in order to buy it, for writing that down, for settling in advance what would make you change your mind, and for putting into each idea a size proportional to the solidity of your reading rather than to the size of the prize. That does not guarantee being right. It guarantees that when you are wrong, you will know what you got wrong, which is the only way for the twentieth decision to be better than the first.

And the other half of the question is still missing. The method tells you where you disagree with the price, but not whether that disagreement is exploitable, nor who is on the other side selling to you cheaply, nor how long a difference of opinion lasts once other people find it. Without that, step 5 — why you and not the market — gets answered with good intentions.

What comes next

The next six levels, 7 to 12, are precisely that other half, and they are the second part of this same course.

• Level 7, the four possible edges: informational, analytical, behavioral and horizon; what each one demands, and why the first is dead for a private individual while nobody can take the last one away from you.
• Level 8, what is discounted and what is not: what the efficiency hypothesis does and does not say, how a piece of news actually gets into a price, and why a plainly wrong price can stay wrong for years.
• Level 9, factors: what exactly a factor is, which ones have survived scrutiny, and the question that decides whether they deserve a place in your portfolio: whether they pay you for bearing a real risk or for exploiting somebody else's mistake.
• Level 10, why it wears out: how much return an anomaly loses the moment it is published, what happens when half the industry holds the same position, and why size destroys the edge that attracted it.
• Level 11, the structure of the index: the S&P 500 from the inside, who decides who gets in, what you are buying when you weight by market cap, and what passive flows do to a price.
• Level 12, a process that survives: how a hunch becomes a refutable hypothesis, the four ways of fooling yourself when testing an idea, and when to abandon something that has stopped working.

Outside this course there are three gaps these twelve levels do not cover, and each has its place. Macro explains where the cost of capital you have used here as a given figure comes from. Costs quantifies the difference between the return on paper and the one that ends up in your account. And Risk and portfolio management is the natural continuation of the previous module: sizing, maximum tolerable drawdown, leverage and portfolio construction. And if you also want to know whether a difference in results is luck or skill, that is Mathematics and statistics.