Not many of us have an overarching theory that guides us in our approach to picking winning stocks. But I think one could classify most stock pickers into one of three types. In this article, I’m going to present these types by creating a conversation between three imaginary investors whose last names are Buzz, Carr, and Chance.

(I’m assuming from the start that you believe that stock-picking can be profitable. If you’d rather invest in index funds, you can probably stop reading now.)

Buzz: Buying a stock is like buying a business. Well, it’s not just like buying a business, it is buying a business—a part of a business, to be sure, but still a business. Now, what do we do when we buy a business? We look carefully at the books and estimate the present value of the sum of all the future income and the terminal value of the business if we were to sell it down the road. It’s not a simple process, but it’s an essential one. It’s really the only way to invest wisely.

Carr: I find that a rather idealistic way of looking at stocks. I mean, “terminal value”? What’s the “terminal value” of a company? It’s a pretty random guess. So is, for that matter, the company’s earnings five years from now. No, buying a stock is more like buying a used car. You don’t calculate the earnings or the terminal value. You look at what similar cars cost and measure their advantages and disadvantages. You look under the hood to make sure all the parts still work and are in good shape. And then you bargain with the salesperson. There are other considerations too. Is this going to be your only vehicle (i.e. are you putting 100% of your savings into this stock)? Then you need to be able to use it to go to work and go to the store (in other words, it should be an all-weather kind of stock, not a speculative one). But if you already have a dozen cars and are just going to keep it in your hangar and drive it to occasional car shows, you can make a much more speculative bargain.

Chance: That’s a very wishy-washy way of looking at investing, in my opinion. Investing is like gambling: you calculate the expected return and then place your bets accordingly. What is the expected return? It’s the probability-weighted average of all possibilities. Look at it like buying lottery tickets. If there’s a million-dollar payout and there are only 900,000 tickets for a dollar each, your expected return on each ticket is $0.11, and that stays constant no matter how many tickets you buy. You can do similar calculations with stocks. By looking at historical returns of similar stocks, you can calculate the expected return on your investment. In other words, you do the math.

Buzz: But how do you define a “similar stock”? Each stock has hundreds of different characteristics. You can get into “risk premia” and “smart beta” and all that junk, but where does that get you? All the math in the world won’t allow you to estimate a stock’s “expected returns” with any degree of certainty. Let’s check these analogies out for a moment. Let’s say you had a million dollars and you could invest it in stocks, used cars, or lottery tickets. How much would you put into each one? Lottery tickets don’t pay you any dividends, and the terminal value of a lottery ticket is almost always nil. And used cars can only increase in value if their price goes up because they’re collectible. Stocks, on the other hand, are pieces of businesses that actually make money. Not only do they have a present and a future value, but they generate cash. They’re money-making machines. You have to look at stocks as businesses first and foremost.

Carr: Some stocks are actually money-losing machines. And not just some stocks: more than half the stocks on the market at any one time are going to go down in price, some of them catastrophically. The way to solve the million-dollar investment problem is to look carefully at the risk of each asset. A classic car is not going to suddenly plummet in value like an overpriced stock will. If you choose the right cars to buy, they are far safer bets than either stocks or lottery tickets.

Chance: There’s actually a good, mathematical way to calculate this. The historical returns on lottery tickets are terrible. The historical return on the stock market has been about 9.3% per year over the last twenty-five years, while the historical return on classic car investing has been about 6.8% per year over the same period. Depending on how you think the historical returns should be adjusted to come up with expected returns, you’ll either allocate your entire $1 million to stocks or put some in classic cars and some in stocks.

Buzz: Fine. But how do we go about choosing the best stocks to invest in? My discounted-cash-flow method does an excellent job. As long as you get your formulae right, you can depend on it to make you money. It can’t necessarily be fully automated, and you sometimes have to dig pretty deep into the financial statements. But logically, it can’t be beat.

Carr: But what about the massive drawdowns that come with value investing, Buzz? I mean, they’re truly massive. Pick the hundred cheapest stocks by any criteria or a lot of different criteria put together, invest in them, and you’ll get drawdowns of seventy percent at times. There are reasons why the stocks you buy are priced so low. Many of them are seriously defective. Take my advice: the real way to pick stocks is to choose the most reliable, safest bets. Check out all your stock purchases from every possible angle before you decide what to buy.

Chance: You’re not making mathematical sense, folks. Investing is gambling, and you have to maximize your expected returns if you want to make a profit. Look. I can design a system that has been robustly backtested using rolling returns that will get you a far higher yearly return than either of you will ever get. As long as you trust history and use criteria that make good, sound, financial sense, as long as you use robust backtesting methods to avoid too much curve-fitting, you can consistently beat the market through stock-picking by trusting the numbers.

I myself combine all three approaches. From Chance, I take the idea of backtesting historical returns to come up with an algorithm that selects stocks with similar characteristics to those that have performed well in the past. From Carr, I take the idea of evaluating all my stocks as carefully as possible and eliminating or diminishing my investment in the most risky of the lot. And from Buzz, I take the ratio of unlevered free cash flow to enterprise value as one of the mainstays of my investment system, and I only buy stocks that I judge to be selling below their real value.

Is there one single correct way to pick stocks? I don’t think so. But if you’re going to maximize your returns, you want to consider the underlying assumptions behind why you’re buying what you’re buying, and how those assumptions will play out if challenged by opposing assumptions. That’s what I’ve tried to do with this dialogue.

CAGR since 1/1/16: 41%.