The goal in Part I of the book is to show how to identify the perfect investment, which we explain is one where a stock has been mispriced. We also show that the investor must identify a path for the mispricing to correct and be able to exploit the opportunity. To determine if a stock is mispriced, the analyst needs to calculate the stock’s intrinsic value, which we cover in detail in the first four chapters of the book.

We define the value of an asset in Chapter 1 and show how it is valued using a discounted cash flow model. We use this approach to value a business in Chapter 2. Because assessing competitive advantage is critical to determining the value of growth, we discuss these topics in depth in Chapter 3. Finally, we use these tools in Chapter 4 to show how to think about a security’s intrinsic value.

To determine if a genuine mispricing exists, we need to define the conditions under which a stock will be efficiently priced, which requires a detailed discussion of market efficiency. We begin in Chapter 5 with an explanation of Eugene Fama’s efficient market hypothesis, which we show are the rules the market follows to set prices. We then discuss the wisdom of crowds in Chapter 6 and show it as the mechanism that implements the rules in the market. We then explore behavioral finance in Chapter 7 and show how the rules can become strained or broken when a systematic error skews the crowd’s view.

To establish if a mispricing is genuine, the investor must demonstrate that he has either an informational advantage, an analytical advantage, or a trading advantage. If the investor cannot identify specifically why other investors are wrong, show why he is right, and articulate what advantage he has, then it is unlikely he has identified a stock that is truly mispriced. We discuss these topics in Chapter 8 and then define a catalyst as any event that begins to close the gap between the stock price and your estimate of intrinsic value.

In Chapter 9 we show that risk and uncertainty are not the same thing and that the difference is often misunderstood. We then discuss the three components of investment return—the price you pay, your estimate of intrinsic value, and the estimated time horizon. It is the authors’ experience that most investors spend the bulk of their time focusing on calculating their estimate of intrinsic value, while failing to estimate accurately an investment’s time horizon. We feel this focus is a mistake as time is a critical factor in determining the investment’s ultimate return. We then move the discussion to how through research an investor can significantly reduce risk by increasing the accuracy and precision of both the estimates of intrinsic value and the investment’s time horizon.

By the end of Part I we will have shown how to vet the perfect investment.