Standing on the shoulders of giants
Jack Ferner and Ram Baliga made me a better investor.
Many of you probably thought I would say Warren Buffett. Don't get me wrong, he's played a huge role, as has his partner Charlie Munger. And I can't forget Ben Graham or Michael Porter or Michael Mauboussin or all of the others who have shaped the way I think about investments. But it was Jack and Ram who helped me put it all together.
Jack Ferner taught my "Value Creation" course at Wake Forest. He's not your typical professor -- he's a businessman, not an academic. The premise of Jack's course was to understand how companies create value and then to estimate, given that value creation, how much a company is worth.
Ram Baliga taught my "Global Strategy" course at Wake Forest. He's not your typical professor, either. He's one tough cookie. As potential managers, Ram gave us frameworks to use to formulate strategies within our companies. I turned the information around, using the frameworks to determine if a company's strategy was sound, sustainable, and capable of creating value.
Putting it all together
Jack and Ram gave me two important things: ways to think about business and way to translate those thoughts into information and knowledge that I can use to make decisions. By doing so, they helped me lay a foundation that can integrate additional ideas. So far, these are the most important pieces.
Competitive advantage is very important to my investment philosophy, and Ram's class gave me lots of frameworks to analyze it. Typically, companies that have a competitive advantage can generate excess returns on invested capital. The higher the returns, the more value created. I recently commented that I expected the returns at Whole Foods
Since return on invested capital is an important metric for me, I want to use it in my valuations. That's why I'm glad we built an economic value-added (EVA) valuation model in Jack's class.
Essentially, the model looks at the value created -- returns on capital less the cost of capital times the amount of capital invested -- over time and discounts them to the present. It's similar to a free cash flow model, but I like it better for a few reasons.
First, the model allows me to model returns over time. Typically, returns increase early in a company's life and then decay to the cost of capital over time. If the company has a competitive advantage, those returns can increase for quite a while, as has been the case with Nike
Second, the model allows me to focus more on the value drivers, something Michael Mauboussin stresses in his book, Expectations Investing. Based on the industry, I can learn which performance measures are most important, a notion recently echoed by another great investor, Mohnish Pabrai. For instance, Costco
Margin of safety
I know Ben Graham made margin of safety, purchasing an investment for less than it's worth, popular in the investment world. Actually, I wonder how many investors truly use it. I learned this in engineering school. Engineers use margin of safety when designing bridges to protect people. Investors should use margin of safety to protect themselves from themselves, as investment analysis is not the same as engineering analysis.
Despite its troubles in 2002, merchant energy company AES
How many companies truly have a sustainable competitive advantage and sell at a discount? If you said not many, you'd be right. That's why an investment philosophy like this requires lots of patience. It takes patience to focus on studying companies and waiting for them to become cheap enough to purchase. I studiedeBay
It also takes patience to wait for the market to close the gap between price and value, such as with my latest investment, outdoor sporting goods retailer Cabela's
The Foolish bottom line
So that's my story. Honestly, there's nothing new or grand about my investment philosophy. It takes the main concepts from lots of great investors before me. Jack and Ram gave me the tools to integrate the pieces to make good decisions. That's why I'm forever indebted to both.
Since I believe that stock market returns are a function of company returns and company returns are a function of competitive advantage, I want to find companies that create lots of value and make sure I don't pay a high price for them.
Does this mean this should be your philosophy, too? No. It certainly isn't going to work for everyone. But whatever your investment philosophy, stick with it. Learn its strengths and weaknesses. Practice it as much as you can. But always remember, there are no absolutes in investing. The idea is to make the best decisions you can.
Whole Foods, Costco, and eBay are all Motley Fool Stock Advisor recommendations. Cabela's is a Motley Fool Hidden Gems recommendation. To find out more about how these market beating newsletters can help improve your portfolio returns, click on either of the links for your free 30-day trial.
Retail editor and Inside Value team member David Meier owns shares of Nike, Cabela's, and AES. He is currently ranked 423 out of 23,460 investors in The Motley Fool's CAPS rating service. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.