How to Invest (continued)

Chapter 7: Risk

Beginning investors, along with Wall Street, frequently view investment risk as stock price volatility—in particular the possibility of the stock price significantly declining. Shrewd investors view stock price and intrinsic value as independent, either able to rise and fall without the other following along. For shrewd investors, the risk is only one of two things: (1) The possibility of the price paid having been too high, and (2) the risk of the intrinsic value collapsing.

The stock price can, and will, occasionally decline—even when there is no important change in the intrinsic value.

To avoid risk, we want to make sure we are buying companies with durable earnings, and that we are not paying a price too high. In the next chapter we look at how to not overpay, but in this chapter we concentrate on avoiding risk. For investors, this should be the first test that is passed even before moving on to valuation.

Making sure a company has durable earnings, and simply skipping those that don't, serves three vital purposes:

1. It prevents the permanent loss of capital.
2. It powerfully mitigates psychological biases that lead to "buying high and selling low".
3. It protects the terminal value of an investment in its distant future, owing to investors continuing to assign a relatively high earnings multiple much further down the track. (NB: Many investors miss the importance of this one.)

Ultimately, the shrewd investor utilizes the "optionality of skipping" to bypass unpredictable businesses in favor of those rare, assets that offer high conviction and long-term robustness.

Durable earnings come in two flavors: the 'autopilot' variety, like a debt-free house quietly collecting rent, or the 'fortified' variety—businesses that face margin pressure but hide behind a formidable Economic Moat. There is no magic formula for durability; the secret is staying deep within your circle of competence so you can spot the real-world risks before they spot you.

When hunting for earnings that last, look for a 'triple-win'—at least 2 or 3 of these protective layers:

• High Switching Costs: Look for products that are 'sticky.' It isn't just about contracts; it's the massive headache of moving. Think of Gmail: it's free, but abandoning a decade of searchable digital history is a price most users won't pay.
• Network Effect (User Value): Gravity in numbers. The more people use the platform (like YouTube or Instagram), the more valuable it becomes for everyone else, making hard (to impossible) form a competing service.
• Network Effect (Industry Integration): Industry participants heavily involved with the service, creating value for customers or industry. Example 1: So many merchants have signed up to integrate Paypal that customers deem it worthwhile to use it, and vice versa (with so many customers, merchants deem it necessary to integrate). Example 2: Apple's developer community invests years mastering specific tools to earn a living; their expertise draws in customers, which in turn draws in more developers, creating a self-amplifying cycle.
• Income Diversification: Don't put all your eggs in one basket. Alphabet's spread of revenue streams offers a sturdier floor than Meta's, even though both boast powerful network effects.
• Obsolecense Diversification: Could there be some industry change that makes the whole business model obsolete? Example: Specialty insurers, with policies having mutually exclusive risk, such as Markel or W. R. Berkley, face less systemic 'clash' risk than automotive insurers.
• Scale Efficiency: Being the biggest kid on the block allows for cost-cutting that smaller peers can't match. It's less powerful than network effects, but it help.
• Structural Dominance: A moat that can't be bridged. Coca-Cola pairs massive distribution with a legendary brand, giving them the 'weaponry' to drop prices to low margins, and competitors forced to go even lower until they disappear.
• Pricing Power: A telling litmus test. Can the company hike prices without losing customers? If people love or truly need the product, the company owns the thermostat.
• The Debt Stress-Test: If there is high corporate debt (individual project-level non-recourse debt doesn't count) then don't guess: Ensure the company has a rock-solid history of positive earnings and the raw firepower to wipe that debt out (if they chose to) in just a few years using their cash flow.
• The 'Nature' of the Earnings: So many investors miss this one. It is easy to get complicated trying to find something profound about the firm's competitive position, whilst missing this simplier but powerful one — some earnings are durable by their very nature — durable by design — such as being near-necessary. Example: 'Real Assets'—infrastructure, wind farms, or real estate—provide a relentless, necessary stream of cash flow that ignores market whims. Provided the above Debt Stress-Test passes, the 'Nature' of the earnings can sometimes render them durable alone, even without any of the other features above.
• The ROE 'Smoke Test': A persistently higher Return on Equity than peers. This isn't what causes durability—it's the evidence that durability exists.

Shrewd investors rarely purchase smaller companies (below $1 billion in market cap) despite often having valuations that seem compelling, such as having grown rapidly and still carrying a PE ratio below 10. They may be purchased, but require a much higher category of knowledge of the individuals in management, coupled with a particularly deep understanding of the industry.

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Chapter 8: Valuing Companies

Before valuing a company, double check that found a wonderful business within your circle of competence with moat-surrounded durable earnings as discussed in the previous chapter.

In the S&P 500, a company with average growth prospects typically gravitates around a P/E of 15. A higher multiple is only commanded by companies expected to grow at a superior rate. Whilst buying firms with a low P / E ratio gets to the essence of investing (paying a little as possible for each dollar of continuing earnings) it the word 'continuing' that matters - isn't just the earnings this year that we care about, but how the earnings continue very far into the future. For example, if the earnings are set to halve over the next 5 years, then you'd want to be paying an multiple of today's earnings of only about 7.5 so that in 5 years, for the same share price, the multiple of the halved earnings will be back at 15 (an average stock valuation). It's worse than this, though, as after 5 years and looking out to the 10th year, if the earnings continues to fall then the multiple assigned at year 5 will again be lower than 15. It is for this reason that we want to look further out than most other investors are looking.

The trick to outperforming the market is buying companies priced at the lowest multiple of Earnings 5 or 10 years into the future.

Steadfastness Test

Test 1 of 3: The first step is to continue the business into the future, 5 or 10 years away, and come up with an earnings per share (EPS) figure for that point in time. This will be impossible to do if you didn't find a company with durable earnings, but with great businesses it can be surprisingly reliable to do. We are not wanting to identify the central estimate for the EPS, but rather a lower bound that you are certain the EPS will exceeed.

Note: If you know the earnings 10 years away will be above some value that you have determined, then you also know the intrinsic value will be above a realistic multiple of those earnings.

Test 2 of 3: Secondly make sure there is litle to no risk of permanent intrinsic value loss over the extreme long-term (such as 30+ years). This throws out many more businesses off the list that may have passed test 1. The purpose of this second test is to ensure the business is still viewed favourably 10 years into the future, when looking out to year 20 from year 10. We want the truly-long-term future to remain bright for the business, prevening the earnings multiple from collapsing 5 or 10 years out.

Note: Note that the 'realistic earnings multiple', when step 2 passes, will often be rather high, exactly because investors looking at the company in year 10 out to year 20 will continue to assign a decently high earnings multiple.

Test 3 of 3: You determined 1-2 above yourself. Sorry.. what was that? Yes, that was the 3rd test. If you didn't, then you'll be susceptible to selling out as the quote falls and you start second guessing whether earnings are durable.

Once again, if you are not confident about either of these two steps, no problems—simply skip the investment and no harm has been caused. Shrewd investors do a lot of skipping.

But be cautious at this point: If you aren't entirely sure about how the business makes money and the long-term resilience of its market position, shrewd investors simply skip the investment here. It does not matter what price you pay for a business set to fail at some point in the future, and even the virtue of great patience won't help at all when things go south.

Ranking Opportunities

Unshrewd investors, such as trained economists, corporate finance departments and spreadsheet addicts, prefer to calculate the value of a company using the Discounted Cash Flow method (DCF): The sum of all the actual cash a company will generate over its entire life, with each future dollar adjusted (discounted) to what it is worth in today's money. That's a mouthful to take in, but perhaps fortunately, even when you deeply understand the concept, it has little use—theoretically ideal whilst practically a dud. The trouble is that the Discount Rate varies between companies according to how risky the respective earnings are, and by modifying the Discount Rate, it allows you to arrive at almost any number for the intrinsic value, so the valuable work that goes ino the future earnings predictions (what really matters) can be overwhelmed by large effect of the varying discount rates.

Shrewd investors much prefer the common-sense concept of opportunity cost is applied by evaluating a range of companies' Intrinsic Value Tomorrow ÷ Price Today, and buying those with the highest ratio. We also add all dividends received to our Intrinsic Value Tomorrow calculation, and denote it as IV0 when looking at the value now, IV5 when looking at the value 5 years away, and so on.

Makes sense, doesn't it? To invest successfully you want to know what the value is in the future, compare that to the price today, and own the companies for which the difference (the ratio between the two) is as large as possible. That's about as simple as it gets, and about as shrewd as it gets.

Comparing IV5 to the price today is generally looking far enough into the future to find value disconnected with price, but sometimes greater market inefficiencies can be found by looking even further out—as much as 10 years—to IV10.

Example: Alphabet

Risk Phase: Does Alphabet pass the durable earnings (Steadfastness Test) as calculated 28 July 2025?

1. Steadfast Test 1: Will earnings by extremely likely above some minimum baseline in 10 years? Answer: Yes. Advertising market share may decline but people will be performing much more product/service searches in 10 years so the total pie will be substantially larger than today; furthermore there is a large runway for advertising auction rates to increase with ever-improving targeting as more behaviour data is collected.
2. Steadfast Test 2: Extremely long-term test - is there any chance of catastrophic earnings loss after 20 years? Answer: No. It's a legal monopoly with insane network effects, and if broken up (unlikely substantially) constituent parts will continue to operate well.

Value Phase: Calculate IV10 / price

EPS gains over 10 years	= 14% per year, with cloud services comprising 20%+ of earnings at year 10. This requires a thesis, which is too long for this article.
Gain or loss from normalizing the earnings multiple	= 26 (typical P/E) ÷ 21 (present P/E) = 24% above what the present quote gives
Dividend	= ~8% additional gain over 10 years assuming reinvestment (~5% without reinvestment)
IV10 / price	NB: Normally IV10 is calculated as lower bound EPS in the 10th year × an earnings multiple likely by investors looking from the 10th year out to the 15th year + re-invested dividends. Then divide IV10 by price today. NB: We can alternatively view IV10 / price as: The multiple over the price today to reach the normalized value (plus dividends) 10 years into the future, as below. = 10 years of 14% return, adjusted down to end the 10 years with a normal P/E, and adding 8% for the dividends = (1.14)10 × (26 ÷ 21) × 1.08 = 5.0 As published 28 July 2025 that's a really high IV10/price ratio.

Holding Only The Best

With a collection of companies passing the above tests of durable earnings, and for the even shorter list for which you can confidently calculate the IV10, the final step is to compare the IV10 / Price ratio across each of them (with 2.0 a rather typical opportunity, and 4.0 or higher an excellent opportunity). Then purchase just top 3-5 companies with the very highest IV10 / price ratio.

When you find a new investment opportunity that is better than anything you own (the IV10 / price ratio is higher than everything else), you can sell the company with the lowest IV10 / price ratio, and replace it with the new opportunity. This approach will encourage you to hold some firms almost 'forever', and in rare cases that you sell it will usually be owing to the price becoming euphorically high such that the IV10 / price ratio has declined, prompting you to replace it with another opportunity (or your already-held highest ranked opportunity at the time). The approach causes you assume an ownership mentality, but to the extent that there is any selling, you are generally always buying low and selling high.

The Shrewd Shortcut: For Those Without Endless Time

Fortunately, you don't have to pick individual stocks to stay shrewd. An index ETF will do the heavy lifting just fine! In the long run, the discipline of staying invested with an index ETF such as 'SPY' or 'RSP' and only managing our own psychological devils will be far more life-changing than the marginal gain you might scrape from outperforming the market.

Let's be honest: identifying truly 'Steadfast' opportunities requires a massive time commitment both to the individual firm analysis, and to continually keep up to date and deepen (arguably more important than to 'widen', as relates to investing) your Circle of Competence. If you haven't done that deep-dive legwork, you will be far more likely to succumb to cognitive biases and panic-sell during some future temporary price dip. By holding an index-tracking ETF, you trade the stress of the 'analyst' for the peace of the 'owner'—allowing you to truly set and forget.

You can also evolve into a stock-picker over time. Start with an index ETF as your foundation, then gradually layer in individual companies as your Circle of Competence deepens. This hybrid path offers the reliable safety net of an ETF and the intellectual challenge of hand-picking winners—a lifelong hobby that, for the shrewd, is far more rewarding than any crossword puzzle can offer.

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Chapter 9: The Psychology of Shrewdness

As the late Charlie Munger, the billionaire partner of Warren Buffett, famously observed: 'A lot of people with high IQs are terrible investors because they have terrible temperaments.' To be shrewd, you must realize that your greatest enemy isn't the market; it is the evolutionary wiring of your own brain - great for escaping imminent threats, but often working against us in our strange modern world.

The Munger Mindset: Avoiding Standard Misjudgments

• Loss Aversion: Our brains feel the pain of a loss twice as intensely as the joy of a gain. Shrewd investors train themselves to see a market dip not as a tragedy, but as a clearance sale on future wealth.
• Social Proof (The Herd): Young investors often feel a biological urge to increase stock exposure when their friends are, reinforced with positive media messages, and sell when their friends are selling, reinforced by Blood on Street! articles. Shrewdness is the ability to be 'fearful when others are greedy, and greedy when others are fearful.'
• Sunk Cost Fallacy: When you start to understand that you were wrong about the business, but refuse to admit it because of the money lost, and time invested, towards it.
• The Commitment & Consistency Bias: Once we publicly announce we love a stock, we find it almost impossible to admit we were wrong. Munger suggests we should 'try to destroy our best-loved ideas' every year to stay objective.

Start some conversations on the venerable Berkshire Hathaway board about these, and more of Charlie's insights.

This is but a brief taste of the fascinating world of investing psychology. The main message is that just knowing how to invest is perhaps half of what makes us shrewd, and the other half is overcoming our lack of patience and emotional biases, such as responding to fear or greed, to make change-of-strategy decisions at the worst times. This is where having like-minded companions around you at Shrewd'm can really help to keep you on the right track, which is a lovely compounding curve when looked at from afar.

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And one companion to keep for life: The Shrewds’ Glossary — every term in this guide, and every term the finance industry will ever throw at you, defined in plain language on a single page. Bookmark it; Shrewd investors keep it one click away, and jargon never wins an argument here again.