The Taoist concept of wu wei is about natural action -- knowing when to act and when not to act. It can also teach us a lot about investing.
Literally "non-doing," the principle of wu wei is found in the martial arts disciplines of aikido and judo, where the goal is to use an attacker's force to the defender's advantage. The ancient Chinese military strategist Sun Tzu preached this discipline in The Art of War, advising men "to avoid what is strong and to strike at what is weak."
While we might not be engaging in hand-to-hand combat in investing, we should learn how to use the market's emotions to our advantage. Warren Buffett's famous quote, "Be fearful when others are greedy and be greedy only when others are fearful," whether intentional or not, is quite Taoist in principle. In essence, the Oracle of Omaha is saying that the key to long-term investing success is to avoid what is temporarily strong and buy what is temporarily weak.
Wax on, wax off
To illustrate, let's hop in our Delorean and set the flux capacitor to June 2000. The Los Angeles Lakers had just won the NBA championship, boy bands ruled the airwaves, and "new economy" technology stocks were all the rage. Meanwhile, industries like energy, railroads, and machinery were largely ignored and written off as antiquated.
Looking back, it seems obvious what investors should have done -- the Nasdaq is still down more than 30% since then, while the Vanguard Energy Index (VGENX) fund is up nearly 300% -- but in 2000, the choice wasn't so simple. At the time, crude oil was around $25 a barrel, and with other commodities also under pressure, demand for industrial products and services was quite low.
These gloomy fundamentals, in contrast with the allure of promising new technology, made it psychologically easier for investors to buy, say, Pets.com over Caterpillar. It may have been the easy choice, but it wasn't the right choice. Again, buying what was temporarily weak would have been the better investment in the long run even though it was the harder decision to make.
Today, there are once again a number of sectors that have fallen out of favor and present strong buying opportunities for the patient investor. In fact, two of our favorite sectors at Motley Fool Pro are health care and financials. It's true that there could be some trouble spots within those sectors, but there are also strong companies that have been thrown out with the proverbial bath water and deserve a closer look.
Health-care values abound
In the health-care sector, for instance, we bought the medical equipment maker Kinetic Concepts in late 2008 at a time when the market was overly concerned with the debt the company took on to acquire LifeCell and patent challenges to its highly profitable VAC Therapy wound-care system.
To the first concern, we noted that the chief financial officer had experience successfully paying down debt once before and that Kinetic Concepts generated more than enough free cash flow to deleverage once again. Second, we learned just how valuable and widely used the VAC Therapy brand was in the medical industry, and given that doctors and nurses tend to stick with what they know works for their patients, we weren't as concerned as the market was regarding competition threats.
Since then, Kinetic Concepts has won a number of patent judgments, and our investment is up 82% versus 42% for the market over the same period. We still consider it a "buy" today.
At Pro, we see similar value in Medtronic (NYSE: MDT ) . Medtronic shares are down slightly this year, largely because of lower-than-expected patient procedures, longer product development cycles, and the ever-present "health-care reform uncertainty."
Sure, it didn't help matters that the company lowered fiscal 2011 earnings guidance, but we believe Medtronic is properly managing the business for the long run. First, it expects to launch 60 products over the next two years -- that's more than is expected from Stryker (NYSE: SYK ) , Zimmer Holdings (NYSE: ZMH ) , and St. Jude Medical (NYSE: STJ ) combined. Plus, Medtronic's 2.4% dividend yield can keep us company while we wait for the share price to rebound.
Financials -- yes, financials
As far as financials go, we prefer smaller regional banks and non-bank financials like conservatively run insurers and brokerage firms.
In March, for example, we bought shares of the SPDR KBW Regional Banking exchange-traded fund, which holds roughly 50 small regional banks spread out across the United States. It's true that these regional banks have significant exposure to commercial real estate, but we dissected each of the underlying holdings of the ETF and found them to be, on the whole, sufficiently capitalized to absorb possible losses.
To illustrate, a number of the ETF's underlying holdings -- including Bank of Hawaii, Valley National (NYSE: VLY ) , and IberiaBank -- were strong enough to maintain their dividend payouts through the credit crisis. Other holdings, like Signature Bank (Nasdaq: SBNY ) and Old National Bancorp (NYSE: ONB ) , were among the first banks to repay TARP funds in early 2009.
Surfing the waves
Buffett may not have studied the Tao Te Ching, but avoiding what is hot right now and buying what's not is at the heart of value investing. If done properly with patience and discipline over time, you can greatly improve both your investing accuracy and your returns.
At our Motley Fool Pro service, we have a stated goal of profitably closing at least 75% of our positions, which forces us to focus on the price we're paying for our investments. Buying out-of-favor yet strong investments at good prices greatly reduces our risk of overpaying and realizing permanent losses. Kinetic Concepts, GlaxoSmithKline, and SPDR KBW Regional Banking ETF are just three investments that fit this bill today.
Since we launched Pro in fall 2008, we've stayed well above our 75% accuracy goal and complement our stock and ETF investments with options strategies to generate additional income. If you'd like to learn more about our strategies at Pro -- as well as get a free report with strategies for growing your wealth, simply enter your email address in the box below.