In the film Dead Poets Society, Professor Keating (Robin Williams) instructs his students to rip entire sections out of their poetry textbook and completely ignore what it says. "Carpe Diem" -- seize the day -- is his motto, and "suck the marrow out of life" is his philosophy. Poetry is more art than science -- written to be enjoyed and "to woo women" -- not to be analyzed under a microscope. The textbook that attempted to calculate values of "perfection" and "importance" to score poems? It was completely missing the point, and the value of the poetry itself.

As goes poetry, so goes investing
Just as the textbook "science" of poetry misses the point, so does the textbook "science" of investing. There is way more to investing than number crunching, and often, crunching the numbers leads to utterly ludicrous solutions. For example, I'm a big fan of diversification done right; it's protected my portfolio on numerous occasions. Yet the textbook teaching on diversification is shredder material, pure and simple.

The textbooks say that to achieve diversification, an investor must buy companies with a small or even negative correlation coefficient with one another, and by amassing a collection of such firms, an investor can be protected. Great theory, but in practice? Yuck. First, there's the heavy-duty math involved in calculating historical standard deviations and historical covariances. Then, there's the absolute nonsensical answers that often appear.

Nonsense from a textbook?
In the private Motley Fool Inside Value discussion forums, I recently ran through the calculations to illustrate the point. I figured out that, according to the textbooks, an investor would be better diversified buying Honda (NYSE:HMC) and General Motors (NYSE:GM) than buying Honda and Gillette (NYSE:G). That's right -- according to the bogus number crunching that dominates Wall Street investment philosophies, an investor is better diversified buying two automakers than buying one auto manufacturer and one leading consumer products company. The correlation coefficient between Honda and GM was very close to zero, making them excellent candidates, whereas the correlation coefficient between Honda and Gillette was more than 0.8, indicating nearly identical historical movements, and therefore poor diversification protection.

Yet as a Fool, I know better. I know that, at the end of the day, Honda and General Motors both make cars. They compete for the same customers, rely on the same raw materials, and face the same market reality that their products are rarely "must have right now" kind of items. As an investor looking for diversification, I'd rather own one car manufacturer and one consumer products company than two of either, any day of the week.

Textbook diversification and its complicated and nonsensical calculations? To the shredder!

More shredder material
Diversification isn't the only place where the texts deserve to be shredded. Whether it's the classic Capital Asset Pricing Model or one of its newer multifactor cousins such as Fama French, the textbook risk and return calculations that dominate Wall Street all suffer from a fatal flaw: They all rely on historical stock price movements to predict what will happen next. I've said it before, and I'll say it again -- the past is no prologue for the future; driving forward while looking in the rearview mirror is a great way to get into an accident.

Those models, no matter how much fancy math goes into them, say virtually nothing about the businesses behind the stocks. They wouldn't have told you to watch out for problems with donut baker KrispyKreme (NASDAQ:KKD) and stun gun manufacturer Taser (NASDAQ:TASR) prior to their recent descents. A simple glance at those businesses and financial statements would have provided ample warning that the stocks had lost track of the companies' true values and their prices were eventually destined to fall.

Textbook analysis techniques based on stock price movements? To the shredder, you go!

Stop the insanity
There is, of course, a better way to invest. And that way is with value. There are two simple keys to value investing -- keys that are obvious but often forgotten.

  • Each company has a fair value -- a price that represents the true worth of the firm.
  • Eventually, each company's market price will cross its fair value.

With those keys in mind, value investing becomes as simple as finding and buying the companies that currently trade below their fair values, then waiting for the market to drive their prices up to a more reasonable level. That's all there is to it. And what it takes to get there is a willingness to look beyond the textbooks to the true value of the business.

At Inside Value, lead analyst Philip Durell has done just that. He has built a portfolio of leading companies, all trading at or below their fair values when selected. In fact, two of his first 16 picks, long distance giant and bankruptcy survivor MCI (NASDAQ:MCIP) and stalwart door manufacturer Masonite (NYSE:MHM), were so undervalued that they've been snapped up as acquisitions by firms that knew a good deal when they saw one.

O Admiral! My Admiral!
In Dead Poets Society, Professor Keating's students eventually got it -- they understood that there was more to poetry and to life than the textbooks dictated. They learned that they must seize the day, ignore the idiocy in the textbooks, and control their own destinies. When they realized this, they stood on their desks and shouted, "O Captain! My Captain!" one of Keating's favorite lines from a Walt Whitman poem.

At Inside Value, our Professor Durell goes by the name TMFAdmiral. And his straightforward yet powerful investing strategy deserves a similar accolade, befitting his returns, which have, as of this writing, trounced the market by more than four to one since inception.

If you've got what it takes to shred the investing textbooks, abandon conventional wisdom, and invest based on what counts, then Inside Value is the place for you. The Admiral is even offering a free 30-day trial or, for a limited time, a 25% discount on a one-year subscription.

Fool Contributor and Inside Value team member Chuck Saletta owns shares of General Motors. The Motley Fool is investors writing for investors. The Fool has a disclosure policy.