Some believe the key to long term investing is the magic of compounding annual returns. Compound annual returns is a valuable tool to evaluate different investment options, but it does not tell the whole story. Compound annual returns does not reflect investment risk. Investment returns are volatile, meaning they can vary significantly from one year to another, and compound annual returns does not reflect volatility. Regardless how attractive compound annual returns might look, any approach with high volatility is very risky and definitely not the answer to successful investing. The goal is to achieve above average compound annual returns with below average volatility.
Our research has shown the common sense way to achieve this goal is to invest in companies that make an Economic Profit. The fundamental premise of our valuation model is based on a company making an economic profit versus an accounting profit. A key difficulty in measuring either definition of profit is in defining costs. We believe that looking at return on capital minus a charge for the use of that capital produces a much better view of the value of a company. Measuring the real return on capital invested is what Economic Profit approach seeks to accomplish.