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  • peristentone peristentone Jun 2, 2011 10:18 PM Flag

    Durable Competitive Advantage - Method

    Leo, you are living in a stock market test tube. In this fantasy lab experiment, investors can give your hedge fund $50B. You, Leo, invest $1 of that $50B and generate $1M. Your annual letter to shareholders says "Hey, I am a genius, I made $1M with $1 of your money. I want a raise."

    Your shareholders do a different calculation. To the shareholders who invested, they compare the $1M against the $50B you talked them out of, and that means they got .02% return on their money. The shareholders meet together and say "Who is this clown who takes $50B of our hard earned money and returns less than 1% and thinks he is a genius?"

    In the real world, people who give a company or person money demand a return on the investment they made. Part of what makes a manager talented is his ability to raise the right amount of capital at the right time, and to neither over or under allocate capital to the business. The most talented managers in the very best businesses get this point. When they retain excess capital that degrades their return on equity, they distribute the excess as dividend. They raise just a bit more than they can reasonably invest, which maintains the overall return on equity to the historical norm.

    In your financial test tube this is all stupid. But I assure you that Board of Directors and CEOs of 95 out of 100 Fortune 500 companies care about this issue as core. Professional investors care about this issue as core. None of these would regard the guy who gets $50B and makes $1M as a genius. He would get fired quickly. In your mind that may make all of the Fortune 500 and professional investors stupid.

    If you have any interest in exploring the world outside your test tube, I would recommend you buy a book in Australia named Value*able by a successful fund manager named Roger Montgomery:

    This guy is a Buffett and Graham disciple who has the clearest explanations of return on equity I have ever read. I tried to convince him to release the book in US through Amazon Kindle, but he seems intent on maintaining control of distribution, which is silly, but fortunately he understands stock valuation better than book distribution.