Make Sure Risks Are Compensated!

(Editor's note: Our annual stock-picking guide, Stocks 2005, is on sale now. Bill Mann, the editor of Stocks 2005, agreed to let us excerpt his introduction letter to this year's version. We hope that you'll pick up a copy of Stocks 2005, but regardless, we hope you enjoy some of the wisdom and insight that Bill imparts with the following words.)

Approach love and cooking with reckless abandon. -- t he Dalai Lama

We come to say goodbye to a wild 2004, welcoming with open arms 2005, the Chinese Year of the Rooster. I included the Dalai Lama's quote above because I think that it is wonderfully instructive. There are things for which putting yourself on the line can lead to great, great things, and for which the cost of doing so is ultimately pretty low.

In love, the greatest relationships in the world are ones where you cherish the other person more than you cherish yourself. That's ultimately free. Similarly, some of the greatest cooking of all time comes from sheer curiosity, the knowledge that if you try something and fail, your loss is capped at a single meal. Go ahead, use Altoids in a marinade for duck. What is the worst that can happen?

Not that the Dalai Lama spends much of his time considering securities analysis, but you may note that he does not include approaching money or wealth with reckless abandon. There is a reason for this: The cost of being wrong can be severe. Money lost in poor speculations isn't just a loss of the actual dollars invested, it's also the loss of every potential additional return those dollars can no longer generate for you.

As you'll see in a moment, we achieved something fairly extraordinary with Stocks 2004. We selected 11 stocks, and at the end of a year, every single one of them is valued higher than it was a year ago. This achievement has many causes, but there are two main ones. The first, of course, is luck.

Some of these companies, such as Garmin (NASDAQ:GRMN) and Chico's (NYSE:CHS), traded much lower than their starting prices during the year, only to rally as we came close to print time. When both the start and end points of an investment are arbitrarily defined, the reported results are inevitably a bit of a coin flip.

But the second reason for our success is that we spent a great deal of time making absolutely certain that each pick offered an appropriate risk/reward profile. The Motley Fool's investors are risk averse. Not in the "we're going to buy gold, bury it, can some okra, and live in an underground bunker" kind of way. They are risk averse in the sense that they seek to accept no risk for which they are not offered reasonable compensation.

Let me show you what I mean: One of our better selections from last year was Rex Moore's selection of 7-Eleven (NYSE:SE), which has risen more than 50% in the last 12 months. This was a company that had gone through some severe operational issues, failed to earn profits for years, been bailed out by what had been a Japanese subsidiary, and was getting back on its feet with some real operational improvements. Obviously, there is some risk that a company with such a recent history could fail.

But Rex's analysis told him something. Not that the company absolutely wasn't going to fail -- there's no way for an outsider to really know that in advance. Instead, he figured that the market had priced 7-Eleven's stock at a level that substantially underestimated the chance of success in turning the company around. I took a look and agreed with him, and 7-Eleven became an extremely successful selection for us.

If you understand this component of investing, you'll be ahead of 90% of the participants in the stock market, including many investment professionals. Every company has risk, and every investor who has ever placed a "buy" order has at one point been bitten by risk. But there is no shame at all in taking a calculated risk, when you think that the odds are in your favor, even when the risk becomes reality and wins out in the end. Yes, you read that right -- if you accurately assess that the market is overreacting to the potential of a risk, you have made a good investment decision, even if in the end you lose money.

A child of five could understand this. Fetch me a child of five! -- Groucho Marx

What we've seen throughout 2004, particularly at the end, was a repeat of 1999 -- a great many investors have seen their portfolios go up simply by making incredibly risky decisions. They forget, if they ever knew it in the first place, that risk factors don't matter until they matter, and then that's all that matters. At which point, of course, it's too late. As I write this in mid-November 2004, companies such as Travelzoo (NASDAQ:TZOO), Google (NASDAQ:GOOG), and Sirius Satellite Radio (NASDAQ:SIRI) trade at such high premiums that only one company in thousands could ever come close to achieving the operational gains to justify them.

Might they make it all the way through 2005 without collapsing? Absolutely. In fact, one or more of these companies may defy the odds and fulfill all expectations. But the risk of failure here is huge, and each dollar lost in silly speculations is one that will never be able to work for you again.

The point is simple: If you're going to lose money in investing, and it is assured that at some point you will, lose it the hard way. Make sure that the odds are in your favor.

I make these statements to set expectations for what you will find in these pages -- we did not spend months searching for the next trader's plaything, like Travelzoo. We're not out looking for likely short-squeeze candidates or low float micro-caps. Our analysts had a simple task: I asked them to use their own special talents and styles of security analysis to select the company they thought offered the best risk/reward scenario.

The results are not companies that you could place in any investing silo, be it "value," "growth," or anything else. Motley Fool Rule Breakers editor David Gardner and writer Tim Beyers offered a company that has sat squarely in the middle of a sector that has seen booming share prices this year. Income Investor editor Mathew Emmert found a company that operates a commodity business but does it extremely well, and pays out a big dividend to shareholders to boot. James Early identified a battery company that the market has hated for years but that has made great strides of late to get its act together. In each and every case, the underlying merit of the company is that we believe it is cheaper than it should be. Let's hope that in 2005, like 2004, the market ultimately agrees with us.

In years past, I have made a habit of decrying the tyranny of a one-year review for selections as an arbitrary period in which some ideas may have peaked, while others are yet to come, if they ever will at all. So this year I have done something about it. Below you will see the returns, as of the date of this writing, of every company selected in Stocks 2004. But I've also gone back and calculated the returns for Stocks 2003, as well as Industry Focus 2002, the predecessor of this product. I hope you find the presentation of longer-term returns illustrative to the power of focusing on risk-limited investing. Please pay particular attention to the overall returns from Industry Focus 2002 in spite of the fact that not one, but two of the selections have been complete losses. As I said before, risk limitation does not equal risk elimination.

We opened with a quote from the Dalai Lama and heard from Groucho Marx in the interim, so I'll close with the words of another wise man, Wayne Gretzky. The Great One once said, "You miss 100% of the shots that you don't take." That we don't succeed every time we invest belies one last truth: Perfect knowledge is impossible. If you were to insist on perfect information before you plunked down your money on a company, you'd never invest at all. You should always search for more information and understanding, but remember that history has shown time and again that one of the biggest risks in investing is not doing so at all.

Bill Mann is the editor of Stocks 2005, as he was with Stocks 2004, Stocks 2003, and Industry Focus 2002. He owns shares of none of the companies mentioned in this article. Stocks 2005 is on sale for alimited time, so act now!