Academic investing wisdom generally asserts that in order to generate better returns, an investor needs to take on more risk. Over the years though, most of the best investors have repeated in one way or another the idea that investing success comes from generating high returns without taking big risks.
In fact, it's probably not much of an exaggeration to say that the holy grail of investing is the low-risk, high-return investment opportunity.
I was recently watching an interview that Charlie Rose did with investing great Wilbur Ross, and Ross gave his version of this theme, saying, "We like to take perceived risk instead of actual risk."
Sounds great, right? Of course, in those 10 words you have the kind of wisdom that sounds simple, but is much easier said than done. So how exactly do you navigate toward high-return situation where there's only perceived risk? I've got three steps to help get you there.
1. It all starts as perceived risk
At the end of this, we want to be left with the stocks that just have perceived risk, but to start, we should pull up all of the stocks where investors see risk. The easiest way to do that is to simply pull up a list of all the stocks that investors have been aggressively selling.
I went ahead and pulled up all the stocks that have a market cap of more than $100 million and have lost a third or more of their value over the past year. While these are relatively arbitrary numbers -- considering the S&P 500 index is up slightly over the past 12 months -- a 33%-plus loss would suggest that investors are scared of something.
2. Winnow the list
Here's the conundrum we're left with. The list that I generated above contains more than 300 companies. While I know we're all ready for some grueling research (you are, right?), 300 companies is a bit excessive. However, we also need to be careful that we're not eliminating too many good opportunities from the list.
To bring my list down to size, I decided to apply two additional metrics -- valuation and Altman Z-score. The Altman Z-score is a formula based on a number of different financial metrics that is used as a predictor of bankruptcy. Companies with an Altman Z-score of less than 1.8 are considered to be in grave financial danger. I went ahead and cut those from the list.
This eliminated names like YRC Worldwide (Nasdaq: YRCW ) and Energy Conversion Devices (Nasdaq: ENER ) . While these companies could end up working out their problems and posting big gains, both have seriously traumatic financial statements.
The other factor I used to get the list to a more manageable size was valuation. Specifically, I only kept stocks with a price-to-book value of less than 1. This leaves us with just the stocks currently valued at less than the net value of their assets -- that is, total assets minus total liabilities. When you can buy a company for less than the value of its net assets it doesn't eliminate risk, but it sure cuts it down.
With this factor, I see more likelihood that we're eliminating companies that are actually good opportunities. For instance, Diamond Offshore Drilling's (NYSE: DO ) stock has been hit hard by the mess in the Gulf of Mexico. However, this is also a company with a very reasonable balance sheet, a high return on equity, and roughly two-thirds of its business outside of the U.S. But its stock won't make the list because of its 2.3 price-to-book value ratio.
But despite the potential loss of some good opportunities, I think these cuts will bring us down to a smaller, more focused, higher-probability list.
3. Digging in
After applying those two additional criteria, it's time to get our hands dirty. Since low-risk, high-return investments are what every investor would like to get their hands on, it takes some work to track them down. So now that we've cut down the list of possibilities to a more manageable number -- 43 for my list -- we need to go beyond the headline numbers to figure out where there's actual risk of losses and where there's just perceived risk.
Western Refining is a bit of a mess right now. Like fellow refiners Valero (NYSE: VLO ) and Tesoro (NYSE: TSO ) , Western has been hammered by the drop in refining margins -- which is the spread between what a refiner pays for crude oil and how much it can charge for its refined product. The upshot for Western and the other refiners is that the refining margin tends to be cyclical, and it won't stay down forever. At the same time, though, Western is in a more precarious situation than other refiners because of its heavy debt load.
I'll be putting more research time into Western, but the stock's low valuation, the underlying value of refining assets, and the low-end of the industry's cycle make me think investors are imagining a lot more risk than is actually here.
As for Winn Dixie, differentiation is tough in the grocery industry and so competition is brutal and profit margins are low. Winn Dixie hasn't even been a particularly smooth operator compared to other grocers though. Over the past 12 months, the company's operating margins have trailed competitors like Safeway and Kroger. Top that all off with the fact that the company emerged from a bankruptcy filing back in 2006, and you have a pretty lackluster picture.
But post-bankruptcy Winn Dixie has very little debt and is producing more than enough cash flow to cover its interest payments. The company is now executing a turnaround plan that will hopefully help it produce returns more in line with the rest of the industry. This has all been met with a lot of skepticism from investors, though, and so the stock currently trades at a steep discount to the rivals mentioned above.
Have a low-risk, high-return opportunity that you'd like to crow about? Head down to the comments section and share your thoughts.
Low-risk, high-return stocks are great long opportunities, but when real risk is there, maybe it's time to get short.