How to Make Big Money With Less Risk

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.

Two companies from my list that I will definitely be taking a closer look at are Western Refining (NYSE: WNR  ) and Winn Dixie (Nasdaq: WINN  ) .

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.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookies were harmed in the making of this article.


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  • Report this Comment On August 27, 2010, at 5:59 PM, TLassen wrote:

    "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"

    Thank you for a good article, but I would be careful with statements like the one above. Companies which trade below their book value (or net assets value) do so because they fail to earn any significant returns on their investments capital (LT debt + st equity) once all their direct operational costs have been removed (including debt and equity financing).

    In my view, DD is needed to assess whether those companies might not just be value traps.

  • Report this Comment On August 27, 2010, at 7:07 PM, TMFKopp wrote:

    @TLassen

    "Companies which trade below their book value (or net assets value) do so because they fail to earn any significant returns on their investments capital (LT debt + st equity) once all their direct operational costs have been removed (including debt and equity financing)."

    That's a pretty bold statement. Sometimes that's going to be true, but sometimes it's not. Take WNR for example. Currently, the company is not producing sufficient returns on its capital -- heck, it's producing losses. But back in '05, the company produced a 55% ROC. So is today's negative ROC a sign that the company has gone completely downhill or is it primarily a matter of cyclical refining margins?

    As I noted up in the article, narrowing down based on a low book value multiple doesn't produce a surgical cut leaving us with only great companies. But I do believe that it is a good rough cut to get the list down to a size that sufficient due diligence can be done.

    Matt

  • Report this Comment On August 28, 2010, at 10:06 AM, x937 wrote:

    I've made good money in an odd way...I bought stocks that I thought I wanted to hold long term..but they would go up 10 or 15 percent in the short term, so I would exit the position. I can do this about twice a year, confidently. I"ve been doing this for 15 years. I thought I was not doing as well as the experts, however in recient years when their portolios crashed, mine was in cash (lol). I've got to say, people did not enjoy my joy when the market crashed and I was not in....lol.. I'd now question all profits (Buffet and Cramer), and do very well, sometimes betting against them. Dont think it's a good plan? I've gone from 7K to 25K, and that's after taking 10K out for a house downpayment. Stop being part of the herd, question advise, and question the contrary position! Stop looking for advise in these articles, people are SHEEP...bet on the herd, not based on a loud mouthed sheep. Stay away from cult stocks (apple). Why do you always have to be in-it? The only time I tend to loose, is when I'm increasing my foreign exposure (either when I bought ford, or db), it's just too international, and too many variables.

  • Report this Comment On August 28, 2010, at 11:02 AM, TLassen wrote:

    @TMFKopp

    Maybe bold, nontheless it's true. We can not ignore the correlation between real earnings and market levels.

    Are you suggesting that millions of investors have missed WNR? The market sees WNR destroying its current 2B investment capital by almost 200m a year. Yes part of the current negative ROIC is cyclical. Meanwhile the company has a real business to run, while strapped for cash. Maybe thats why they went back to equity market to raise more capital in 2009?

    The point I made, is still valid, an investor following your advice, to screen for low price to book value, without understanding the connection between real earnings and market added value (Market Cap less Book Value) is bound to be 'value trapped' more often than not.

    respectfully Tlassen

  • Report this Comment On August 28, 2010, at 2:24 PM, plange01 wrote:

    ever since the buy and hold theory died you can no longer buy stocks that you like of make sense.you have the but the current stocks in the news take your chances and be ready to turn them over.take one of the 5 biggest money making companys ever microsoft this stock was at $25 a share 10 years ago it close this past friday at $23.93..look how much you would have made holding this blue chip the last 10 years!!!

  • Report this Comment On August 28, 2010, at 2:38 PM, TLassen wrote:

    @plange01

    thats just completely true. Buy and hold works very well for dividend paying companies that increase their divs annually.

    MSFT is not a good div play, but to say that 10 years of holding MSFT was not worth it because the charts only show Capital Gains is shortsighted. Calculation of real returns: Capital gains + dividend return divided by Initial Cost.

    I have held a block of MSFT since 1998 and my real returns are 22%.

  • Report this Comment On August 28, 2010, at 2:39 PM, TLassen wrote:

    @plange01

    thats *NOT* completely true

  • Report this Comment On August 29, 2010, at 10:38 AM, scanlin wrote:

    Dividend payers are a good starting point. But you can increase the yield another 3-6%/year by writing 5-10% out of the money covered calls on those.

    MikeS

    http://www.borntosell.com

  • Report this Comment On August 30, 2010, at 3:17 AM, TMFKopp wrote:

    @Tlassen

    "Companies which trade below their book value (or net assets value) do so because they fail to earn any significant returns on their investments capital (LT debt + st equity) once all their direct operational costs have been removed (including debt and equity financing)."

    "Maybe bold, nontheless it's true."

    Well, no, actually. In many cases it's very untrue. TRV, L, ACGL, CVH, IM, and MRH are just a few examples of companies that deliver 8% or better returns on capital yet trade below book value.

    In other cases, like WNR, the company currently does not currently produce a compelling (or any...) return on its capital, but has the capacity to in the future.

    "Are you suggesting that millions of investors have missed WNR? "

    I'm suggesting that millions of investors have been scared off by the current numbers and may not be thinking about the fact that that kind of performance may not persist forever. The recency effect is a common cognitive bias.

    Of course, if what you're suggesting is that markets are efficient and there couldn't possibly be an undervalued stock that millions of investors have misjudged... well, then we're just not going to agree since I'm not on board with the efficient markets school.

    But after spilling all of this ink, if your point was just that investors need to be aware of what they're investing in and do diligent research... well, that's very true, and it remains true whether you're focusing on low book value, low earnings multiples, or whatever other method one might use for finding stocks.

    Matt

  • Report this Comment On August 30, 2010, at 6:24 PM, TLassen wrote:

    "Well, no, actually. In many cases it's very untrue. TRV, L, ACGL, CVH, IM, and MRH are just a few examples of companies that deliver 8% or better returns on capital yet trade below book value"

    Matt, think we are not speaking the same language here!

    I stated companies earning no significant returns on their investment capital, ONCE their cost of capital has been removed will trade below their investment capital and by extension below their Book Value.

    With the exeption of TRV with a return spread of approx 8%, the other 4 companies all have negative return spreads. Meaning their ROIC less their COC is negative. The companies may appear to be profitable, thus having positive EPS, but they dont actually add any shareholder value because their cost of capital exceed their returns. Consider the COC as the hurdle rate that the companies must clear in order to add value or create wealth for their shareholders. Consequently, value traps.

    TRV is the exception, could be a good candidate for an undervalued company, However, there may be some expected revenue decreases that would make the Market trade TRV below value.

    For the EMH remark, will not get into a discussion about it, except to say that if the EMH had been called Informed Market Hypothesis instead, to reflect the underlying concept of the market reacting to new information even sceptics like you may have taken notice. The word 'efficient' is unfortunately sometimes equated with 'rational', and I dont think anyone seriously believes the markets are always rational.

    But I dont want to 'spill any more ink' with this article.

    respectfully, Tlassen

  • Report this Comment On August 31, 2010, at 2:28 AM, TMFKopp wrote:

    @Tlassen

    If you're checking back... I'd be curious to see your COC calculations. As long as we're taking a more academic route to this, COE should be at a rock bottom levels. With T-Bills yielding 0.25%, pretty much every calculation should end up with a pretty low COE, even if you use 7% as the equity risk premium (which I think is too high).

    "if the EMH had been called Informed Market Hypothesis instead, to reflect the underlying concept of the market reacting to new information even sceptics like you may have taken notice."

    Taken notice? Maybe. Believed in it any more than I do? Nah, probably not.

    Matt

  • Report this Comment On August 31, 2010, at 6:47 PM, easyavenue wrote:

    @Tlassen

    As I see it, you made a blanket statement using if..., then "always" logic when you shouldn't have done so. TMFKopp is pointing out that you can't make an always statement because it is not true 100% of the time. You admit it yourself with TRV, which doesn't fit your always logic.

    I understand you think for practical purposes your calculation IS a 100% statement. But TMF said not so, and besides, less than 100% does not equal 100%. So you agree to disagree.

    The part about efficient markets is really a side issue, and IMO anyone can argue semantics any way they want. Just ask a political spin doctor ala "I never inhaled." Or any lawyer.

    Sorry guys, sometimes I can't help myself. Maybe this'll help: This is a test. This is only a test. Had this been a real emergency.... You will now be returned to your regularly scheduled program.

  • Report this Comment On August 31, 2010, at 6:56 PM, easyavenue wrote:

    x937

    Almost forgot. Which stocks are you doing this with?

    I had someone else tell me this same thing several years ago and he was using some american stalwarts... I can't remember which ones. But he only followed those few stocks and the market in general. Oh, and he moved large sums around to catch dividends quite frequently.

  • Report this Comment On September 01, 2010, at 3:50 PM, TLassen wrote:

    Matt

    To reply to your ‘interest in my COC definition’

    Far more important than establishing a COC % is to understand the importance of the hurdle rate. Traditional GAAP accounting, via EPS, misses the concept of added value to investors. Companies can show positive EPS, even increases in EPS, while not actually adding value to their shareholders. A company with 7% return on its total capital (equity + debt capital) but one with 6% capital cost is actually only creating 1 cent of value to shareholders for every dollar it earns. In contrast, companies earning less than their cost of capital are destroying shareholder value, which indicate investors are better off somewhere else. The COC represents the minimum rate of return at which a company produces value for its investors. In other words the capital cost represents my opportunity cost of taking on the risk of investing in the first place.

    For COC, I use the following method, based on the belief that an un-levered company’s cost of capital is equal to its equity cost (put the d/e ratio at ‘zero’ and you will see what I mean)

    COC= COE + (debt/equity ratio * COE minus CofDebt)

    I use the historic 6% market returns as a base equity cost and modify it depending on GDP growth and inflation rates. Due to the current favorable inflation rate, and the unfavorable GDP growth rate, I am now using 6.6% as my base COE. So for an un-levered company I use 6.6% COC.

    I use regression analysis on the whole S&P 500, where ‘x’ is the ROIC/COC ratio and ‘y’ is the Market Cap/Investment Capital ratio. This analysis shows 85% of EPS positive companies that do not clear their hurdle rate, trade in a narrow range around their total investment capital.

    In my comments I pointed out that ‘making big money with less risk’ (that WAS the title of your article) is not found by screening for companies that trade below their book value. The fact they trade below BV does not indicate there is higher likelihood of future increased returns to the shareholders and certainly does not indicate less risk. I stated those companies trade below their BV for a reason, strongly correlated to their lack of current real profits and therefore they are actually riskier investments.

    I will be careful of my wording if I comment on your articles in the future.

  • Report this Comment On September 02, 2010, at 4:47 PM, TMFKopp wrote:

    @Tlassen

    I promise I'm not debating just to debate :), I'm interested to see where we're seeing things differently here...

    You noted above that the list of companies I presented in a comment (TRV, L, ACGL, CVH, IM, and MRH) were all earning below COC with the exception of TRV. Then you said that you're currently using 6.6% as your COE currently. As I noted above, all of these companies have earned a ROIC of above 8% over the last 12 months. I took a quick look at Lowes more closely and it looks like its cost of debt is around 5.5%. The COC / ROIC spread may not be huge for all of these companies, but it would seem to me that they're all positive.

    As to your more general point, yes, I agree that in general the market will place a lower value on a company's equity if it's currently not earning much on that equity. But -- and this is where the whole efficient (informed??) market thing comes in -- I'd contend that the market tends to be very short-sighted and often overreacts to current results and incorrectly assumes indefinite persistence of that current performance. The same happens on both sides of the coin -- investors also tend to get too excited about companies that are growing and award them hefty multiples.

    From a non-academic viewpiont -- and this may be the prime place where we disagree -- I would almost always say there is less risk in a company with a sub-1 book value with low current returns than there is for a high-grower with a hefty P/B ratio.

    And while I say that I take it from a non-academic viewpoint, the outperformance of low-multiple stocks has been shown in academic settings (specf Fama and French's work).

    Matt

  • Report this Comment On September 02, 2010, at 4:49 PM, TMFKopp wrote:

    Also:

    "I will be careful of my wording if I comment on your articles in the future."

    Eh, only if it doesn't hold you back from commenting. It's been an interesting discussion and I hope to see more comments from you in the future.

    Matt

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