Written by Nicholas Hirschey (July 2004)

Grinnell College's Student Endowment Investment Group is an investment organization. We manage our portfolio of equity securities with the goal of achieving superior risk-adjusted returns on our invested capital. But though we actively manage these funds, we expect to do so with low turnover. High asset turnover is often the consequence of speculative attempts to guess the timing and direction of the market, and we do not anticipate that we can have success using such tactics. As a consequence of the group's size and techniques, we invest in only a handful of companies. As managers of a portion of our college's endowment, we have the advantage of an infinite investment time-horizon and, consequently, try to keep a long-term focus when considering investment options. We feel that our best chance for success is to find a small number of firms with unrecognized potential to turn in superior operating performance over the next 3-5 years, purchase positions in those companies, and then hold them so long as w e feel they are undervalued.

We aren't trying to do anything too complicated. We want good companies with good management in good businesses at a good price. But as the record of investment professionals attests, finding such companies and profiting from their purchase is difficult. It's a game which many people attempt, and at which few consistently succeed.

Our ideal investment is in a company with distinct competitive advantages that translate into superior profits net of investment and growth and that have gone unrecognized by the general market. A competitive advantage can take the form of a unique product, a widely-recognized brand name, exceptional research and development, or superior management. There is no standard measure for one firm's advantages over any others; a company can have success for any number of reasons, including luck. Now, identifying these advantages can be tricky.

We won't presume that as a group of full-time students, we have the resources (including time) to intricately examine all the aspects of a business and identify the individual factors that make one company more successful than another. Instead, we'll take most of our clues from basic accounting statements filed with the SEC. So if a firm's accounting statements show above average value creation, we'll deduce that the firm benefits from certain competitive advantages.

As for measuring profitability, the statistic we'll rely on most is a company's return on equity (ROE). A high return on equity reflects well on a firm's ability to use company resources to generate profits. The ROE is determined by a firm's profit margins, total asset turnover, and financial leverage. We cheer high profit margins and high asset turnover, but are wary of excessive leverage. There's no point in a high ROE if it is a product of excessive debt that threatens the economic health of a firm. Because of this, aside from finding companies with a high ROE, we want to make sure this level of ROE is sustainable.

As far as determining reasonable prices for businesses, we want to find above-average companies selling at below average prices. In simple terms, this could be a higher than S&P 500 average ROE and lower than S&P 500 average P/E. Averages for the S&P 500 can be easily found at Barra's website. But we hope to be more precise than this simple rule-of-thumb. To do so, we use discounted present value (DPV) analysis. Our DPV models reflect our best assumptions about future earnings or cash flow growth, multiples, and risk. Admittedly, our models will be inexact, but they give us a sound standard basis for making our decisions.

Our approach is based on the concept of value investing. We neither believe that investors are always rational nor think that the market is entirely efficient. Emotions creep into the marketplace, and we'd like to think that we can profit from the swings in stock price that occur when emotion overcomes reason. We don't underestimate the difficulty in doing this, in going against the Street's opinion, but we give it our best shot. We expect that at most times, most equities are appropriately priced. But if something happens in a company to throw it off a bit (some temporary, fixable, short-term problem), we hope to swoop in and buy stock at depressed prices and then profit when the company's operations and stock price "revert to the mean".

But this focus on finding values does not imply that we don't care about growth. Growth is just as legitimate a determinant of value as hard assets and current profits, though much harder to predict. We've brought this into our analysis with the DPV models and focus on ROE. We like to see healthy internally-funded growth, funded by a high ROE. If we can find a company with a consistently high ROE, consistent earnings growth, and consistent growth in book value, we know it's worth more than a company selling at a modestly cheaper price but with no growth prospects. We won't pay excessive prices for growth, but we will pay for it.

In essence, we want to run a successful investment operation as a practical platform for testing the analytic skills and academic theory we're learning in the classroom. We hope to achieve healthy returns while taking only modest risks. At Grinnell College, a school that depends mightily on the produce of prudent equity investment, we believe this endeavor is particularly relevant.