How to Be Exactly Wrong

My 6-year-old daughter loves tagging along with me to Home Depot. I'd like to think it's because she enjoys hanging out with Daddy, but truth be told, she's more excited about picking out Mickey Mouse-shaped paint samples.

Recently, we were on our way to Home Depot when she asked the timeless question, "How much longer, Daddy?" I answered, "Honey, that depends." For those of you who spend time around 6-year-olds, you know how deeply unsatisfactory that answer is. When you're 6, everything has an answer, and that answer must be exact. "Why don't you know how long it takes, Daddy? Does anybody know?" That seemed like a thoughtful question.

Who knows for sure?
"Well, sweetheart, it's about 4 miles to the store, but we'll pass through more than 10 stoplights from here. If we get all green lights, it'll take us about eight minutes to get there. But if we hit every red light, it could take us 30 minutes. Chances are, we'll catch some green lights and some red lights, and it'll take us between eight and 30 minutes. But we can't know exactly what time we'll get there."

I then proceeded to hit every single green light and arrived in fewer than 10 minutes. We got our widgets and whozits, and then on the way home, held back by loads of traffic, we got stuck at every single red light. This was neither a necessary nor welcome demonstration of the concept, as far as I was concerned. And in the end, I have no idea how long it took us.

Beware false precision
Little did I know how this quotidian experience would reflect our investment philosophy and approach to valuation in our Motley Fool Hidden Gems small-cap service. Valuing businesses is an exercise in false precision for the same reason that keeps you from determining exactly how long it'll take to get across town. You will never have information accurate and complete enough to let you precisely divine the future. In our work, we simply want to put the probabilities of success in our favor.

For example, when I recommended Fairmont Hotels & Resorts to Hidden Gems members, I'd assessed its competitive position against other hotel giants. I also had a good idea of where the company's real estate should be valued -- a number far greater than its market capitalization. I thought that at $33.50, the stock was undervalued. But did this mean it would be worth $40, $50, or $60 soon? I didn't know. The answer depended on how Fairmont's executives managed the process of extracting value from the company's assets, among loads of other variables.

Should we not invest, then, until we have a tidy target price? Well, that usually doesn't work so well. A few months ago, I gathered some old research reports from last year, curious about how close some Wall Street analysts came with their one-year price targets:

Company

Analyst Firm

Target Price

Recent Price

Difference

Google (Nasdaq: GOOG  )

RBC Capital Markets

$550.00

$444.08

(19%)

Cisco (Nasdaq: CSCO  )

Deutsche Bank

$32.00

$24.18

(24%)

Oracle

Prudential Equity

$16.00

$19.43

21%

Yahoo! (Nasdaq: YHOO  )

Jefferies & Co.

$38.00

$28.09

(26%)

AMD (NYSE: AMD  )

Credit Suisse

$13.00

$6.16

(53% )

Baker Hughes (NYSE: BHI  )

Wall St. Strategies

$70.00

$69.11

(1%)

IBM (NYSE: IBM  )

Bear Stearns

$105.00

$115.52

10%

Let me say straight up that I'm not out to make any of the analysts look bad. Trying to consistently nail a price target like that is just an impossible task, and frankly, I don't think they should be trying.

A better way
Instead, in Fairmont's case, I came up with a range of fair prices between $38 and $76, based on assumptions tapped into the valuation tools at my disposal.

Of course, that's a huge disparity -- a difference between Fairmont having a market cap of $2.6 billion and $5.5 billion. But what it did tell me was that Fairmont would not have been attractive if its shares were priced at, say, $51. With my fair value of $38 to $76 per share, a $51 share price would open up the possibility of anywhere from a 25% loss to a 40% gain.

I don't like those situations. If you're 15 minutes away from a critical meeting and the drive could take from eight to 30 minutes, you'll be driving with anxiety. I don't like to drive, or invest, anxiously. Fortunately, Fairmont's stock was trading at $33.50, below my fair-price window of $38 to $76 per share. I recommended it, and we enjoyed a 34% gain before the company was acquired by Kingdom Hotels and Colony Capital.

Stacking the odds
That's how I approach my recommendations in Hidden Gems. My team and I create a range of potential fair values and then compare that with the shares' present value. Once we have that, we never stop re-evaluating.

On my way to Home Depot, the city may have erected a new stoplight, or there might be construction. The same is true in investing. As I look over our list of Hidden Gems, I see how many of our picks have undergone important events in just the past few months. Each time anything substantial happens, we re-evaluate by developing a new range of possibilities -- not by coming up with a specific target price.

Thus far, our results are extremely satisfying. Our recommendations have returned an average of 30% since the service began, versus 7% for equal amounts invested in the S&P 500.

We don't know what lies on the road ahead. Sometimes, we'll glide through an unending sweep of green lights en route to a market-smashing romp. Other times, a downed tree in our path will force us to sit patiently for an hour.

Rest assured, though, that we have every intention of getting you that Mickey Mouse-shaped paint sample as quickly and as often as we can. Want to try Hidden Gems for free? We're offering a special 30-day, no-obligation trial.

This article was originally published on Oct. 3, 2006. It has been updated.

Bill Mann is co-advisor of the Hidden Gems newsletter service. He owns no companies mentioned in this story. Home Depot is an Inside Value selection. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 29, 2008, at 12:04 PM, jbs4radio wrote:

    Mr. Mann,

    That was a very well structured and written article. An enjoyable read about the patience life encourages us to obtain each day.

    Jared Sams

  • Report this Comment On March 29, 2008, at 2:38 PM, Brettze wrote:

    During bear markets, it is like watching flies on the window and wondering how much longer it will still lives before dropping dead on the bottom of the sill....... During bull markets, it is much easier to hit targets but not during bear markets.... it is flies dropping dead time... When you see maggots coming out of flies guts, it is depression...

  • Report this Comment On March 30, 2008, at 3:36 PM, TheKiecker wrote:

    Wow i feel like ive been beaten about the head by an analogy. Give it a rest I got it in the first of the 5 paragraphs you used it in.

    Horrendous writing.

  • Report this Comment On April 01, 2008, at 9:39 PM, none0such wrote:

    @TheKiecker : congratulations, what you experienced in reading the article is what it is like having kids - the head-bashing tone presented here is mild compared to what my twin 5 and 1/2 year olds can dish out.

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