One of the Riskiest Investments You Can Make

Go ahead. Call me crazy. It's music to my ears.

See, my best investments tend to happen when people call me foolish (with a lower-case "f"). Conversely, my worst investments are usually made when people tell me how great the trade is sure to be.

That makes sense. If people agree with your thesis, there's a pretty good chance that thesis is already priced into the stock. When this happens, there's not a lot of room left to be proven correct.

This is exactly what NYU finance professor Aswath Damodaran meant when he told Fool co-founder Tom Gardner in a 2005 interview that "one of the riskiest investments you can make is to buy into a company where everybody thinks the company is superbly run." In this case, any negative surprise could pummel the stock, while any positive news is already priced in.

Sure, it always feels nice to receive immediate positive feedback for your idea, but it's likely a sign that you've made a poor longer-term investment.

Avoid the lovefests
None of this should suggest that you can't make money buying shares of well-run companies; there just needs to be another factor the market is missing, in order for you to buy them at the right price.

Google (Nasdaq: GOOG  ) and Amazon.com (Nasdaq: AMZN  ) , for instance, are two of Fortune magazine's Top 50 Most Admired Companies. But because most people are already aware of this, they aren't great stocks to buy when everything looks peachy. Instead, the best time to buy stocks of well-run companies is either following a marketwide sell-off, or during temporary uncertainty surrounding the business.

Suffice it to say, then, that you won't hear about me recommending Apple (Nasdaq: AAPL  ) anytime soon. Look, there's no denying that Apple's a great company, and the stock could trade higher from here. Still, I'm skeptical whenever there's such a cheery consensus around a stock.

Though I'm sure I'd get some congratulatory emails if I said "buy Apple," I'd also have some unwelcome company -- according to Capital IQ, 38 of the 44 analysts that cover Apple have it as a "buy" or "outperform." Only two brave analysts think it's a sell. Their median target price for Apple is $320 (25% above today's price), and they expect Apple's long-term earnings to increase by 20% per year. That would be quite a feat for a $230 billion company.

Consider the comparative long-term earnings growth expectations for the five largest S&P 500 companies:

Company

Market Capitalization

LT EPS Growth Estimate

ExxonMobil (NYSE: XOM  )

$290 billion

9.6%

Apple

$230 billion

20.5%

Microsoft (Nasdaq: MSFT  )

$224 billion

11.5%

Wal-Mart (NYSE: WMT  )

$189 billion

10.9%

Berkshire Hathaway

$183 billion

5%

*Data provided by Capital IQ, as of June 13, 2010.

The problem with well-known, well-loved companies like these is that the law of large numbers kicks in, and it becomes increasingly difficult to continue the torrid growth rates of the past.

Frankly, I wouldn't take on that risk in my own portfolio.

Against the wind
On the other hand, Professor Damodaran also noted in the interview, "the best investment to make might be in a company where everybody is convinced the company is run terribly, because then all they have to do is walk and chew gum at the same time, and the market is incredibly surprised when things go right."

This is essentially what's happened with Kinetic Concepts (NYSE: KCI  ) , a medical equipment company that I recommended to our Motley Fool Pro members in October 2008.

At the time of the recommendation, the market was really down on Kinetic Concepts; it traded for just nine times trailing earnings. A few months prior, Kinetic Concepts had made a hefty acquisition that left it saddled with a large amount of long-term debt. Adding to the bearish case, competition in the advanced wound-management sector was heating up, and concerns about health-care reform were growing larger, since it seemed more likely by that point that Barack Obama would win the presidential election in November.

Though the market saw few bright spots for Kinetic Concepts, I found in my research that things weren't as bad as they appeared at first glance. First, Kinetic Concepts' CFO had successfully paid down the company's debt once before, which gave me confidence that he could do it again with the company's consistent free cash flow.

Second, I learned that Kinetic Concepts' Vacuum-Assisted Closure ("V.A.C.") wound care treatment was well-accepted in the medical community and had a mountain of clinical support in its favor. Given how busy doctors and nurses are, they aren't quick to change or learn a new system if the one they're currently using works well.

Finally, when I travelled to San Antonio for the company's analyst day, I came away very impressed by Kinetic Concepts' innovative culture and its plans for the future.

In short, all the things that could have gone wrong at Kinetic Concepts were for the most part priced in to the stock at the time we bought it, leaving the upside potential greater than the downside risk. Since then, Kinetic Concepts has achieved much of what I expected it would -- the debt is being paid down, and the V.A.C. business remains strong. Our position at Pro is up 76%, versus 20% for the S&P 500.

Put the odds in your favor
As the legendary value investor Sir John Templeton famously said, "If you want to have a better performance than the crowd, you must do things differently from the crowd." It's a simple notion, but often overlooked. When we buy along with everyone else, we increase our risk of paying too dearly. Frankly, I can't think of a crazier way to invest.

At Motley Fool Pro, we have an ambitious goal of profitably closing at least 75% of our trades. So far, we're ahead of this mark. The best way to keep up that performance is to buy things for less than they're worth, which often means going against the grain. We combine our rigorous valuation work with options strategies, to generate additional income and obtain better buy and sell prices.

If you'd like to learn more about our strategies at Pro -- as well as get a free report with five strategies to grow your wealth in a volatile, range-bound market -- just drop your email in the box below.

Motley Fool Pro analyst Todd Wenning has fingers crossed that the Reds can keep it up through the All-Star break. He owns shares of Kinetic Concepts. Microsoft and Wal-Mart Stores are Motley Fool Inside Value picks. Google is a Rule Breakers recommendation. Apple and Amazon.com are Stock Advisor picks. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Kinetic Concepts and has a disclosure policy.


Read/Post Comments (10) | Recommend This Article (51)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 14, 2010, at 6:17 PM, Turfscape wrote:

    I agree whole-heartedly. I own AAPL and greatly admire the company...but I don't recommend the stock as a buy, right now. Don't get me wrong: I think Apple will continue its growth over the next few years...but greater gains will be had elsewhere. I'm riding out my AAPL investment to my own target price, then rolling it into another stock with greater potential for bigger gains.

  • Report this Comment On June 14, 2010, at 6:33 PM, bellatrix wrote:

    I can't believe you get payed to say the obvious. Nice racket dude. nice racket!

  • Report this Comment On June 14, 2010, at 6:42 PM, Borbality wrote:

    one more point for boring long-term dividend payers?

  • Report this Comment On June 14, 2010, at 7:17 PM, thisislabor wrote:

    how do this trading ideas complare to something say like Discounted Cash Flows?

    how do you discount in a positively favoring market and discount in a negatively favoring market into the cashflows of a company to derive at a price yield?

  • Report this Comment On June 14, 2010, at 8:59 PM, SaintJoachim wrote:

    payed?

  • Report this Comment On June 14, 2010, at 10:27 PM, xetn wrote:

    "Sure, it always feels nice to receive immediate positive feedback for your idea, but it's likely a sign that you've made a poor longer-term investment."

    By this statement, nobody should purchase any stocks recommended by TMF!

  • Report this Comment On June 15, 2010, at 4:07 PM, BMFPitt wrote:

    I had a WoundVAC for 2 months in 2008 (you don't want to know the details, not fun), and seeing what they can charge (I had to cover 15%) I can see how they were able to easily pay that debt.

    Buy hey, it does what it is made for.

  • Report this Comment On June 15, 2010, at 8:10 PM, Stagewalker wrote:

    I guess what amazes me the most is that 38 out of 44 analysts like a stock that has not paid a dividend in recent memory. Can you spell PONZI?

  • Report this Comment On June 16, 2010, at 6:43 PM, thisislabor wrote:

    xetn. thanks, i was trying to figure that out... man, i get the point of the article sometimes and then I get to the end of it and I get confused again. w/e...

    Thanx guys!

  • Report this Comment On June 19, 2010, at 5:12 PM, GrumpyGopher wrote:

    The investment I've lost the most money on are the 'hot' stocks. Lesson I've gathered is by the time a shrimp in the investing ocean like me figures something, the big boys already had that priced in. I think there is something to be said for stable well run companies though.

    Stuff that goes out of favor is stuff I look at. I usually hold for a year for the tax break...homebuilders I'm looking your way this fall.

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