Lesson 2 of 9
What makes a reason falsifiable
A reason is falsifiable when you can name, in advance, the filed figure whose movement would refute it. Three common reasons, rewritten so each can fail.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A reason is falsifiable when you can name, in advance, the filed figure whose movement would refute it.
- "It is growing" is not falsifiable alone. It needs a second condition on the capital that produced the growth.
- An unfalsifiable reason cannot lose, so it looks stronger every year, whatever the business actually did.
A reason is falsifiable when you can name, in advance, the filed figure whose movement would refute it. Naming a figure only after the business disappoints you is not a test. It is a description of what already happened, and it will be a different figure every time.
The same reason, unfalsifiable and falsifiable
Not falsifiable
- "It is growing."
- No figure named. No level named.
- Confirmed by almost anything.
Falsifiable
Names the figure in advance
- "Revenue grows at least 8 percent a year, and the return on the capital added stays above 10 percent."
- Two named figures. A level on each.
- Can be checked against every filed year.
Only the second reason can lose. That is the entire test.
Why this is worth doing
A falsifiable reason can be wrong, and you find out. An unfalsifiable one can be wrong forever, and worse: it strengthens, because nothing ever costs it anything. Five years of holding a company teaches nothing about a reason no observation could have dented.
"It is growing" needs a second condition
Growth alone is satisfied by growth that destroys value. Greenwald's argument is that growth inside a competitive business earns only the cost of capital and creates nothing; Buffett's 1992 letter makes the same point from the value side: growth is an input to the valuation, and its contribution can be negative.
"Management is excellent" and "it has a moat"
The rewrite for management is a condition on the return earned on capital added over several years, not one. A capital allocator shows up in the return on money put in during their tenure. Profit lags the capital by years. A one-year window fires on the timing of a factory, not on a decision.
The rewrite for a moat is a condition on the stability of gross margin over the company's own filed years, not its level. A barrier to entry, if real, shows up as the ability to hold price when someone attacks it. Gross margin is not comparable across companies, because what sits in cost of sales is a presentation choice, but a company's own series is comparable with itself.
A filed figure and a derived figure break differently
A filed figure is a line in a statement, and two sources reading the same filing agree on it. A derived figure is computed from lines and inherits every choice made along the way: whether cash is netted off invested capital, whether a lease liability counts as debt. A condition on a derived figure has to record the formula, not just the name, or "it broke" becomes a claim two readers disagree about.
A reason can be correct and unmonitorable
The common mistake here is reaching for a nearby figure when no figure fits the reason. A proxy reports "holding" about something it never measured, and it keeps reporting that while the real reason fails. The correct move is to write the reason down, mark it unmonitorable, and date it.
Check yourself
What makes a reason falsifiable?
- Writing it in confident language
- Naming, in advance, the filed figure whose movement would refute it
- Checking it against the share price each week
Show the answer
Answer: B.
Naming the figure only after a disappointment is not a test. It has to be named before anything moves.Why does 'it is growing' need a second condition?
- Because revenue figures are unreliable
- Because growth funded with capital earning less than it costs destroys value, and a growth condition alone still passes it
- Because growth is never a good reason to hold a company
Show the answer
Answer: B.
In the worked example revenue grew 15 percent while the capital added earned 6 percent, below its 9 percent cost.What does the moat rewrite condition on?
- The company's market share relative to its nearest competitor
- The stability of gross margin across the company's own filed years
- Whether the company has ever cut prices
Show the answer
Answer: B.
A moat, if real, shows up as the ability to hold price when attacked. Gross margin is not comparable across companies, but a company's own series is comparable with itself.Sources
- Greenwald, Kahn, Sonkin and van Biema, Value Investing: From Graham to Buffett and Beyond, 2001, on growth inside a competitive business earning only the cost of capital.
- Buffett, Berkshire Hathaway shareholder letter, 1992, on growth as an input to value that can subtract as easily as it adds.
- Penman, Financial Statement Analysis and Security Valuation, on reformulating statements to separate operating profitability from financing choices.
What this leaves out
- The three reasons rewritten here are common ones, not reasons this page recommends holding.
- The levels in the figure are illustrative. The level depends on the company and the reason, which the next two lessons cover.
- The worked example uses round invented inputs to show an arithmetic relationship, not a fact about any company.
- Falsifiability is a property of the reason, not evidence for it. A reason can be perfectly falsifiable and wrong.
- Nothing here is advice about any security.