I realize that a huge debate has arisen between investment pros touting classic value investing and stock picking, and the advocates of modern portfolio theory. I'm sure we aren't going to settle that here. Probably the only element I can add is that even Buffett believes that the vast majority of investors are going to be better off investing via the MPT model. He recognizes that what he does is not typical nor a model that others can readily follow.
More than that... Typically any investor with less than $100,000 in investible assets (the overwhelming majority of Americans), Buffett argues, is best off letting an index fund execute that application of MPT for them.
But MPT is chiefly a probabilistic, not a financial analytical model. Both MPT and value investing have assumptions, but it's where those assumptions lie that's the issue for me. Inherent to CAPM is the use of market data to predict market data. Beta is a very debatable measure of actual risk. WACC, as a component of DCF analysis, doesn't take into account economies of scale, whereby cost of capital doesn't remain fixed as a company grows.
But I'm a metrics expert. I never advocate using the resulting output (the market behavior) to predict future resulting output. The real inputs lie in the underlying business... Granted, markets may operate independent of those facts to a degree, but the tendency for a company with consistently bad operating performance to do well on the markets, or vice versa, is far more remote than the tendency of market metrics ability to predict market metrics.
Value investing has its limitations... because there are industries where business value is somewhat difficult to predict. This is, of course, why I primarily stick to businesses that are very easy to break down... manufacturing sector stuff. There's no end to them. The reason that not everyone has figured this out is because, and this is a secret but I'll tell you (yes I'm beeing a bit cheeky): The world is so much more full of morons than it is shrewd people, adding 100,000 more shrewd people tomorrow isn't going to dilute the effectiveness of my valuation model (nor its relevancy in the M&A world).
So narrowing it down to manufacturing businesses, which make and sell widgets.... there's a direct correlation between working capital and operating cash flow. So these are the primary two high-level components I consider, because, as I've mentioned before, whether Company XYZ has gold doorknobs or bronze, 5000 square foot headquarters or 500,000, isn't going to tell me anything about how well they convert inventories to revenue.
I then come to two metrics: Terminal value and enterprise value. I compare the proximity of the two, and arrive at some price with a margin of safety... a sizable margin of safety. If market price is currently at or below that safety level, I consider that a buying opportunity provided the company meets all my other criteria, including The Three M's (management, moat and money).
Occasionally this produces dogs if I've ignored or miscalculated upon a material fact (such as the outcome of the impending bankruptcy of Smurfit Stone and the terrible acquisition by Rock Tenn that shortchanged investors badly)... but I've not had much of a problem beating the S&P for the past few years, partly because depending on my level of confidence in an analysis of the facts for a given company, I may adjust my margin of safety and/or my asset allocation accordingly to minimize risk.
The companies in the S&P are chosen by some asset valuation method as well... Beating the S&P is not an impenetrable barrier, but it does require some work. It's just a lot less work for me than for the average person who has no professional background in business valuation, sales forecasting, etc. who might otherwise find themselves entirely at the mercy of analyst reports that I, as a matter of routine, completely ignore.
My most important function as an investor, and the most important behavioral attribute that contributes to what I feel is pretty adequate success in the markets, is as a protector of principal. Secondary to that is my view of the investor's role as a strategic acquisition expert, not a trader of stocks. Acquisitions strategy cannot rely on probabilistic valuations, but real world valuations based on real inputs and outputs impacting operating cash flows... the reason the business exists, and the core reason anyone places value on any business regardless of how they arrive at that value... still comes back to the consistency with which the company's operations are generating money.
