In an earlier article, I discussed legitimate reasons why even seasoned, obviously talented investors can get crushed by the market. I also argued that learning to get crushed like they do can be a surefire path to profitability. (No, really. Click here if you don't believe me.) This time, let's dish some dirt and discuss two key reasons why, um, less talented types frequently get shellacked. These are mistakes you'll want to avoid like the proverbial plague -- or maybe like financial stocks, beginning around March 2007.
Mistake No. 1: Not doing the math
Despite the market's deeply erratic behavior over the last 18 months or so, fundamental analysis is not dead. Far from it. Investors who go running after hot-prospect "story" stocks are likely to get burned, particularly amid the current market environment.
Consider Freeport-McMoRan Copper & Gold (NYSE: FCX ) . It's a solid company in terms of operational acumen, but all too many investors used the mining concern as a play on the commodities boom. It sported a nosebleed P/E back in the earlier years of this decade. When the commodities boom went bust, alas, so did the company's valuation. For the 12-month period that ended with the market's close on February 2, Freeport's stock had sunk by roughly 80% below its yearly high. Current P/E: 3.5.
Ouch, of course. But for long-term investors who've done their research -- and waited patiently for valuation reality to exert its eventual gravitational pull -- the story may have a happier ending. That's the lesson we can learn from masters of fundamental, brick-by-brick research such as Warren Buffett and Bruce Berkowitz -- senior manager of the fine, Buffett-esque Fairholme (FAIRX) fund. Each has fared far better than the broader market over the last 12 months, for the same reason they've trounced it over the course of many years: They do their homework.
Not for nothing, after all, is Fairholme's portfolio stocked (pun intended) with the high-quality likes of Pfizer (NYSE: PFE ) and UnitedHealth (NYSE: UNH ) . As of the fund's most recently reported portfolio, those names soaked up more than 20% of assets. That's a concentrated strategy, but it's also focused on high-quality companies with lengthy track records of cranking out free cash flow -- a key Fairholme metric. Indeed, the investment maxims listed on the fund company's website include this gem of Foolish wisdom: "Cash counts (it's the only thing you can spend)."
Other Fairholme principles include "A to Z (research all aspects of a company)" and "Back to front (dig into the minutiae)." With those mantras in mind, one suspects that the team also sussed out those two health-care firms' profitability profiles relative to their current valuations. On the former front, each company checks in with industry-surpassing return-on-equity and return-on-asset figures, two key tools for gauging management's knack for getting the biggest bang for its company's bucks. And in terms of valuations, both look like bargains now, too, with prices that reflect a P/E discount to both their own historical averages and the broader market.
Bottom line: Crunching the numbers can go a long way toward helping you separate promising investment prospects from also-rans. Failing to do so can lead to a deflated portfolio.
That said, some wet-behind-the-ears types get spanked for putting too much faith in their elegant math, falling prey to the perils of false precision. Speaking of which …
Mistake No. 2: Doing the math
Fairholme fan though I am, the second of our crushing concerns causes me to quibble with another of the company's otherwise rock-solid investment maxims: "Don't guess (know!)."
Clearly, I'm no advocate of guessing when it comes investing, but I do take issue with that parenthetical. Rarely, if ever, is it possible to "know" with the kind of certainty that that exclamation mark seems to imply, particularly when it comes to the very tricky business of valuation. Sometimes companies that look like deep values go deeper still. Meanwhile, up-and-comers with little (and perhaps even nothing) in the way of free cash flow can take off like rockets once a catalyst -- such as a new product launch or FDA approval of a hotly anticipated pipeline drug -- finally kicks in.
The two conclusions we can draw here:
- If you want to avoid getting crushed, don't fall in love with your math. When it comes to investing, that will inevitably be at least somewhat fuzzy.
- Don't stuff your portfolio full of just those names that lend themselves to green-eye-shade financial analysis. Even seemingly conservative holdings can blow up, as the recent history of Bank of America (NYSE: BAC ) illustrates. Once a titan -- and even a relative stalwart, as the financial tsunami began to rage -- the company traded with a P/E of roughly 6 as recently as this past March.
In all things, moderation
If you want to avoid getting crushed, diversification is key. With that in mind, savvy investors should be willing to hold, at least at the margins of their portfolios, a clutch of more aggressive concerns. These companies' status as prospective investments can't be confirmed by quant work alone, but their presence can add a welcome jolt of diversity and profit potential to a lineup that might be top-heavy with stalwarts.
One suggestion for finding them: Supplement your number-crunching with a qualitative assessment of a company's capacity for "creative destruction" -- i.e., an ability to disrupt and improve the way we live our daily lives. Doing so can reveal tomorrow's Google (Nasdaq: GOOG ) or Apple (Nasdaq: AAPL ) . Both companies' radical breakthroughs fundamentally changed our behavior -- and their early shareholders, not coincidentally, were richly reward for the risk they took on as, um, early adopters.
The market's massive, protracted fire sale has pushed both those firms to P/E levels well below their historical averages, a trait that may cause your inner value hound to howl. While you're howling, though, don't neglect those companies whose capacity for disruption has yet to be fully realized. Their upside opportunity as investments, after all, may be even greater than more established revolutionaries. (And yes, I realize that's an oxymoron.)
Cases in point?
Well, as Fool founder David Gardner put it in the first issue of his Rule Breakers investment service, "We are talking America Online in 1994. We are talking Iomega, maker of the Zip drive, in 1995. We are talking Amazon.com in 1997. We are talking Celera Genomics, which decoded human DNA, in 1999."
Those firms' first fans fared well indeed, and if you'd like the inside scoop on picks of the current disruptive litter -- potential game-changers with profit potential aplenty -- consider taking Rule Breakers for a risk-free spin. There's absolutely no obligation to stick around if you find it's not for you, but remember: The future really is now -- provided you know where to find it. Click here to use Rule Breakers as a roadmap.
Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire investment service and doesn’t own any of the companies mentioned. Google is a Motley Fool Rule Breakers recommendation. Apple, Amazon.com, and UnitedHealth are Motley Fool Stock Advisor recommendations. Pfizer, and UnitedHealth Group are Motley Fool Inside Value picks. The Fool owns shares of UnitedHealth Group. You can check out the Fool's strict disclosure policy right here.