The Problem With Simply Investing in Great Companies

In the video below, The Motley Fool speaks with Roger Martin, strategy expert and dean of the Rotman School of Management at the University of Toronto. Martin says that investors looking for great businesses should focus on whether the company has a clear "Where to play" area that they're focusing on and that they have a "How to win" with a solid customer base.

As Martin points out, however, that's only half of the equation. Evaluating the expectations the market has built into the stock is a whole different skill set and one that can derail even investments in such great companies as Apple (AAPL 1.27%) and Microsoft (MSFT 0.37%).

A transcript follows the video.

The full interview with Roger Martin can be seen here, in which we discuss a number of topics including Bill Ackman, innovation, corporate responsibility, executive compensation, and how to pick great companies. Martin is the coauthor of "Playing to Win," a new book that focuses on strategy and which he cowrote with former Procter & Gamble CEO A.G. Lafley.

Brendan Byrnes: As an investor, from your perspective, you have an inside view of quite a few companies. What do you think investors should look for, from the outside, at companies that are maybe doing things the right way from a strategic point of view?

Roger Martin: Boy, it's a really hard question. Lots of people say, "You're a strategy guy, Roger, so what's your investment advice?"

I say you have to be careful. There are two things that are completely different. One is the real operations of a company and then there's the expectations surrounding those. I have no experience, no insight, no nothing, on evaluating the expectations.

I could say to the person, "Here's what I would do. If I wanted to understand whether that company was going to perform well over time, I'd ask myself the question, "Do they have a very clear "Where to Play"? Can you tell from the outside that they want to play here and not there, and they're sticking to this?

Then they have a "How to win." Here's an offer that they have to their customer base there. If you can see that, and you can see that clearly, that company has got a better likelihood of performing well over the long term.

Now, it may just be that everybody else looking at that says, "They're unbelievable. They're even better than you think they are, or better than reality," in which case buying that stock would be a bad idea.

I often point to Microsoft. Microsoft, I sometimes feel sorry for them. I probably shouldn't, but you know what their stock price has done for the last 10 years?

Brendan: Just about nothing.

Martin: Nothing. Nothing. During those 10 years, has Microsoft done badly? No. They've doubled in sales and tripled in profit. But nothing.

Why? It's because 10 years ago, even after the big dot-com crash, even after that, people had these huge expectations for how wonderful Microsoft was going to do. They've done wonderfully and everybody said, "Yeah, that's kind of what we thought."

Look at Apple now. At $700, everybody was saying, "This is the best company. They're doing so fantastically," but they were saying, "They're going to keep on doing that forever," and it's $427 today. Is that because Apple's a bad company? Heck, no. It's one of the best companies on the planet.

That's where there's two skill sets, Brendan, that are completely different. One is running and understanding the real operations of a company and then the other is understanding market sentiment.

The reason why Warren Buffett is worth whatever it is, around $50 billion, is he's one of the few guys that I know of in the world who has profound understanding of both. That's why he can do two things. He can take companies private and make lots of money on them and invest with an unbelievable track record.

There aren't many people who can do that. There are either people who can invest and have a fantastic track record or people who can really run companies fantastically, and the intersection is just a tiny, tiny, tiny little number.

Brendan: Throw in Warren Buffett's free float from the insurance companies.

Martin: Right. Yes.

Brendan: Roger Martin, very interesting. Thanks again. Good to see you.

Martin: My pleasure to be here.