Peter Lynch, the fantastic manager of Fidelity Magellan Fund and the author of One Up on Wall Street, said that if you're a good stock picker, you're going to be right six out of 10 times. Using some advanced math, I have derived a corollary showing that this means a good stock picker will also be wrong four out of 10 times.
This quote has nothing to do with throwing darts at The Wall Street Journal, nor are we likely to find monkeys who will hit that six-for-10 mark. What we're talking about here are seasoned stock pickers who are getting down and dirty in the research process and trying to pick the very best stocks out there.
Yet even though these top-notch investors are still wrong sometimes, they are extremely disciplined and keep themselves from committing costly unforced errors.
I swung at a wild pitch
It was about two years ago now that I decided to purchase some shares of Scottish Re Group, a reinsurer similar to Berkshire Hathaway's (NYSE: BRK-B) General Re and Reinsurance Group of America (NYSE: RGA). Scottish Re's management had been too aggressive with its tax planning, and the ill-conceived strategy came back around to bite it in the form of big write-offs on its deferred tax assets. With the losses came downgrades from rating agencies, the loss of confidence from some customers, an almost complete turnover of management, and a massive sell-off in the stock.
This is where I stepped in front of the oncoming freight train. I thought the stock price at the time undervalued the assets that the company still had on its books, and I even had some confirmation bias in the form of a big investment in the company from Cerberus Capital and MassMutual.
The problem, though, was that Scottish Re's core business was never particularly good, and the same management team that had botched the company's tax planning also tried to jack up the company's investment portfolio returns by investing in structured mortgage debt -- including very healthy amounts of subprime mortgage debt. You can probably guess where the story went from there.
The agony of unforced errors
The reason mortal investors don't get 10 out of 10 is simply because it's impossible to predict the future. Companies that seem solid and even high-quality can turn out to be the exact opposite and splatter your portfolio with red ink.
Take Bank of America (NYSE: BAC), for example. Sure, there are plenty of people who would now say "you should have seen the signs," but five years ago, many -- including me -- thought B of A to be a high-quality leader in the banking sector. Unfortunately, it turns out that the company was taking on too much lending risk at the wrong time and had an unhealthy appetite for money-losing organizations (see: Countrywide and Merrill Lynch).
But I'll take a swing and a miss on Bank of America. I was wrong, but I was wrong after having concluded that it was an admirable business with solid leadership. With Scottish Re, I knew it was a mediocre business and that it had just kicked out some very questionable managers, but I chased it anyway. That's a blooper that'll make me cringe for a long time.
3,387 stocks
With more than 3,000 publicly traded companies worth $100 million or more, there's no reason that an investor should have to settle for a mediocre business. I'll go even further and say that investors shouldn't have to settle for a mediocre business, a high valuation, a management team that doesn't own a piece of the business it runs, or a lousy return on equity.
You can have it all, I swear. In fact, to prove my point, here are four stocks that meet exactly those criteria:
|
Company
|
Trailing-12-Month
P/E Ratio
|
Trailing-12-Month
Return on Equity
|
Insider Ownership
|
|
Microsoft (Nasdaq: MSFT)
|
8.8
|
50.0%
|
13.4%
|
|
eBay (Nasdaq: EBAY)
|
8.2
|
15.6%
|
15.3%
|
|
Best Buy (NYSE: BBY)
|
10.2
|
28.2%
|
17.5%
|
|
XTO Energy (NYSE: XTO)
|
8.8
|
15.1%
|
3.0%
|
Source: Capital IQ, a division of Standard & Poor's. Data as of March 12, 2009.
While these are all great companies, they're also all large and well-known. If you want to combine the same quality-defining attributes I've outlined above with the greatest potential for market-thumping performance, you may want to check out what the team at Motley Fool Hidden Gems has to offer. This all-star group of stock pickers is using the same process that I've used above -- and should have always stuck to in the past -- to find the very best small-cap stocks out there. You don't have to take my word for it, either -- you can check out what they're looking at right now with a free 30-day trial.
But if nothing else, keep my aching portfolio in mind the next time you want to buy a junk stock just because it's cheap.
Fool contributor Matt Koppenheffer owns shares of (alas) Bank of America, but does not own shares of any of the other companies mentioned. Berkshire Hathaway and Best Buy are Motley Fool Inside Value recommendations. eBay, Berkshire Hathaway, and Best Buy are Stock Advisor recommendations. The Fool owns shares of Berkshire Hathaway and Best Buy. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants …
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