masters of the universe, it was also the starting point for the emergence of independent financial managers with clout—money managers who could demand that the senior management of publicly traded companies adhere to value creation principles and move away from perks.
The demands made to the corporate managers were in the form of earning a rate of return in excess of their cost of capital, thereby creating and not destroying value. This revolution, while at times taken to extremes over the past two and half decades, has helped transform how companies are managed. Corporate strategies have been impacted by independent fi- nancial managers.
A central component of the independent financial managers’ approach was a near obsession with creating value.
Earning a rate of return in excess of the cost of the capital possessed by a firm was the mantra. New methodologies such as Stern Stewart’s economic value added (EVA) and Holt’s cash flow return on investment (CFROI) be- came the rage. The value-creation craze even found its way to Wall Street an- alysts as several major Wall Street firms began incorporating value-based approaches (as they were known) into their research methodologies.
The importance of all this and the value to investors is how the dy- namics of managing a business changed. Senior corporate management could no longer ignore the imperative of earning a rate of return on in- vested capital in excess of the cost of that capital.
Whether in regard to a stock investment or a business investment, the issue is the same: Investing involves a risk/reward trade-off. That trade-off must be made by producing a rate of return that is greater than the required return. If not, value is destroyed, because the opportunity cost of not utiliz- ing that money elsewhere at a rate greater than the required return is a value-destroying proposition. This development is profound as it has changed the economic and investment landscape dramatically over the past several decades and has led, no doubt, to the improved managerial skills of corporate leaders today. Senior management knows that the capability of fi- nancial managers, not to mention other more growth-oriented and acquisi- tive corporate leaders, will step into the picture and take the assets of the business away from existing management in the form of a merger or acqui- sition and attempt to earn a rate of return in excess of its cost of capital, its required return. This development has literally changed corporate America.
ture. No one knows exactly what the formula is. And that is where the next phase of modern finance will take us—into the heart of the investor.
Yes, we know the objective mind, but we cannot calculate the subjective heart. Yes, we know how to calculate the present value of the future eco- nomic profit, but we cannot determine with great accuracy how rational investors will be. Nor can we ascertain exactly how the future will un- fold—how the economic landscape, the technological landscape, the com- petitive landscape, the geopolitical landscape, and the like will look years from now. Yet somehow we investors must exercise our best skills and best judgment to determine what the inputs might be.
In the case of investor behavior, the tools at our disposal today will have to do, as they provide us with an imperfect but productive way of making investment decisions. In the following chapters, I describe how to blend the objective and the subjective into the valuation model inputs, thereby producing a comprehensive investment strategy and, ultimately, an effective portfolio.
Investing, as you will see frequently mentioned throughout this book, is a social science. And a social science means people, with all their wants and needs and fears and desires. In other words, it is people and not programs that are at the center of the process. From the early days of the modern fi- nance era, which began in the 1950s, attempts have been made by academi- cians to divorce the personal or human factors from the valuation process and depict investors as rational, risk-averse, and capable of assessing an in- vestment opportunity and making a dispassionate, unemotional decision to act. That is the basis of the modern portfolio theory (MPT) and the efficient markets hypothesis (EMH). But logic and now facts from the research of a new wave of academics schooled in the principles of behavioral finance have blown holes in the dispassionate investor myth that is based on MPT and EMH. In fact, it is amazing that it took so long to prove that investors are not always rational, not always risk-averse. Sometimes they are irra- tional, overexuberant, or excessively pessimistic. In other words, when it comes to money and investing, people can and do react to their “animal spirits” of fear and greed and act accordingly. (The story, however, is a little more complicated. Consider the pressures on that breed of investor called the professional money manager, a/k/a portfolio manager, discussed on page 72.) With a base established in sound valuation principles, we can now move on to our next topic: the development of our investment strategy.
CHAPTER 2
Investment Strategy:
Concepts and Principles
W
ith our valuation principles and processes firmly in hand, we are now ready to take the next step toward building and managing an effective portfolio: the creation of a well-thought-out, well-developed investment strategy.Investment strategy begins with a set of core beliefs. These core beliefs are our guiding light that enables us to frame the investment strategy issue.
The core beliefs are then applied to the conclusion reached from our in- trinsic valuation models. The valuation models give us the theoretical in- trinsic value of an asset. However, the intrinsic value is a benchmark number upon which other factors must be brought to bear—factors such as various market metrics, investor psychology, and divergences. For it is the investment strategy conclusions, partly derived from our valuation work and partly derived from our market metrics, that give an investor the best chance of implementing the sectors and styles investment approach advocated in this book.
Once we have our investment strategy in place, we can then move on to the single most important investment decision an investor will make: the asset allocation decision. As it is the dominant determinant of investment performance, special attention is paid to getting the asset allocation deci- sion right. At least, that is what we try most earnestly to do.