Antti Ilmanen contrasts two forecasting methods. Objective forecasts (e.g., using market yields) predict higher returns from low valuations. Subjective forecasts (from investor surveys) extrapolate recent performance, becoming most bullish precisely when objective measures signal the most caution, creating a dangerous conflict for investors.

Contrary to popular belief, earnings growth has a very low correlation with decadal stock returns. The primary driver is the change in the valuation multiple (e.g., P/E ratio expansion or contraction). The correlation between 10-year real returns and 10-year valuation changes is a staggering 0.9, while it is tiny for earnings growth.

The old PE model is obsolete in software. With high revenue multiples (7-8x) and low leverage (30% debt), firms must genuinely grow the business to generate returns. About two-thirds of value now comes from selling a larger, more profitable company (terminal value), not from stripping cash flow.

Before concluding a company can sustain extraordinary growth, consult historical data ('base rates') on how many similar companies succeeded in the past. This 'outside view,' a concept from investor Michael Mauboussin, provides a crucial reality check against overly optimistic forecasts.

Allocate more capital to businesses with a highly predictable future (a narrow "cone of uncertainty"), like Costco. Less predictable, high-upside bets should be smaller positions, as their future has a wider range of possible outcomes. Conviction and certainty should drive allocation size.

Anchoring valuation on a company's typical price-to-sales ratio helps identify buying opportunities when margins are temporarily depressed. This avoids the pitfalls of methods like the Magic Formula, which can mistakenly favor companies at their cyclical earnings peaks, leading to underperformance.

For Terry Smith, deep financial analysis (margins, cash conversion, incremental returns) always comes first. He meets management not for short-term trading updates, but for a singular purpose: to understand their philosophy and metrics for allocating capital between dividends, buybacks, reinvestment, and M&A.

Media headlines of 10% stock market returns are misleading. After accounting for inflation, fees, and taxes, the actual purchasing power an investor gains is far lower. Using real returns provides a sober and more accurate basis for financial planning.

While many investors screen for companies with high Return on Invested Capital (ROIC), a more powerful indicator is the trajectory of ROIC. A company improving from a 4% to 8% ROIC is often a better investment than one stagnant at 12%, as there is a direct correlation between rising ROIC and stock performance.