In the film Dead Poets Society, Professor Keating (played by 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.
Poetry is more art than science -- written to be enjoyed and, as Keating says, "to woo women" -- not to be analyzed under a microscope. Regular meter and catchy rhyme can make for a good poem, but great poems require heart and mind. If it were as simple as following the rules, we'd be a nation of Shakespeares.
As goes poetry, so goes investing
Just as the textbook "science" of poetry gets you only halfway there, so does the textbook "science" of investing. There is more to investing than number crunching, and often, crunching only the numbers can lead 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 alone 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? Absolutely nonsensical answers 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 and General Motors than buying Honda and Gillette. 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.
As a Fool, I know better. I know that Honda and General Motors 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. The numbers screened a candidate for me, but that candidate was clearly for the shredder.
More shredder material
The textbook risk and return calculations that dominate Wall Street all suffer from a fatal flaw: They rely on historical data to predict the future. I've said it before, and I'll say it again -- the past is no prologue; driving forward while looking in the rearview mirror will only get you in a wreck.
Wall Street models, no matter how much fancy math goes into them, say virtually nothing about the businesses behind the numbers. They wouldn't have told you to watch out for problems with doughnut baker KrispyKreme or investment bank Friedman Billings Ramsey (NYSE:FBR) before recent drops. A deeper reading of their press releases and financial statements, however, would have provided warning that the stock price was no longer tracking those companies' true values.
If it were as simple as following the rules, we'd be a nation of Buffetts.
One step beyond
There is, of course, a better way to invest. Use the rules to screen for candidates and your mind to identify the very best opportunities. At Inside Value, we screen for stock prices that are down. Every day, stocks fall. Some fall for good reason; others fall for no reason at all. After using the rules to find our candidates, Philip Durell breaks the rules to determine the companies ripe for a rebound. This is value investing, and it has two simple keys:
- Every company has a fair value.
- Eventually, market price will meet that fair value.
The textbooks would tell you to steer clear of the scandal-ridden company. Take Tyco (NYSE:TYC), for example. In July 2002, Tyco fell to $8.16 per share, shedding more than 80% of its market value from the beginning of the year, on the heels of an SEC review of its accounting methods and former CEO Dennis Kozlowski's less-than-exemplary behavior. The company also took one-time hits totaling $12 billion to spin off CIT (Tyco Capital), restructure after management upheaval, and bring the books -- subjected previously to "aggressive accounting" -- back in line. This sent Tyco's net income far south of zero.
But did those developments affect the fair value of the company?
Some further investigation proved that it did not. Kozlowski was replaced, core businesses remained strong, and revenue actually grew from $34 billion to $35.6 billion in the same year net income fell from a $4 billion gain to a $9 billion loss. Seeing that Tyco was decidedly unprofitable in 2002, the textbook would have told you to stay away. And many did.
Yet by 2003, Tyco was profitable again, and this year Tyco expects to have record earnings. The stock again trades above $30 per share. Investors who broke conventional wisdom realized a 277% gain on their Tyco investment in less than three years. They saw the fair value in the company (Rule No. 1), and the market eventually saw it, too (Rule No. 2).
At Inside Value, lead analyst Philip Durell has been able to build a portfolio of leading companies that were all trading at or below their fair values when selected. In fact, two of his first 16 picks, telecom giant and bankruptcy survivor MCI and stalwart door manufacturer Masonite, were so undervalued that they've been acquired by firms who saw a good deal after Philip did.
There are always values to be found in the market. Remember when McDonald's (NYSE:MCD) was losing the Burger Wars to Wendy's (NYSE:WEN), among others? Or when Nike's (NYSE:NKE) reputation was sullied by its use of child labor? Or even when it looked like Altria (NYSE:MO) might be bankrupted by tobacco lawsuits? Shares of these companies suffered in the wake of these developments, but their fair values never changed, and the stocks have since rebounded 150%, 200%, and 130%, respectively. Recently, both Philip and Warren Buffett found another value in Anheuser-Busch (NYSE:BUD).
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, build on the shortcomings of 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. His straightforward investing strategy has trounced the market by more than 4-to-1 since inception. Join the Inside Value community by taking us up on a 30-day trial -- for free. You'll get two stock recommendations a month, as well as full access to all our back issues. Come and see what other companies the textbooks would have you unprofitably ignore.
This article was originally published on April 8, 2005. It has been updated.
Fool contributor and Inside Value team memberChuck Saletta owns shares of General Motors. Krispy Kreme is a Motley Fool Stock Advisor recommendation. The Motley Fool isinvestors writing for investors.
