Pssst! Buddy! I've got a secret for you: We've made some mistakes here at The Motley Fool. Not all of our investment recommendations have panned out.
Of course, you know that already, because everybody makes mistakes. Unfortunately, you don't get to hear much about them in this business. No one likes to call attention to their own past blunders. But you deserve better, and not just for honesty's sake. Mistakes can teach us incredibly valuable lessons, and those who try to ignore them are doomed to mediocrity.
Today, I'm going to bring you some notable errors from one of the best investors around: Motley Fool co-founder Tom Gardner. Please, read on. See what mistakes even expert investors can make. Then learn from them -- and save yourself a lot of money down the road.
Here are some hard-learned lessons Tom shared with members of his Hidden Gems small-cap investing service:
1. Avoid companies in unpredictable regulatory environments
In Tom's earliest days with the service, he really liked Talk America -- a discount provider of local and long-distance telephone service. At the time, it seemed like a bargain. It traded at just six times free cash flow, with a solid balance sheet and a growing business.
However, certain industries are susceptible to the whims of the U.S. or foreign governments. Talk America occupied one of them. Tom says he did not properly appreciate "that its operational success was founded on the quicksand of lobbying the Federal Communications Commission."
The lesson here: Companies that are at the whim of heavy lobbying and government oversight can shift quickly and cause you pain. Tom recommended Talk America at $10.63 and sold at $8.27, and the company traded as low as $5 before it was ultimately acquired by Cavalier Telephone.
2. Beware of light insider ownership
One of our biggest worries as investors lies in getting management to act in our best interests. Some executives seem oblivious to shareholder concerns. I doubt AIG (NYSE: AIG ) , for example, really considered shareholders when setting up bonus systems that ultimately rewarded the very folks who brought it to the brink of disaster.
Managers who own a good chunk of their company, however, are much more likely to make decisions that positively affect the share price. While it's true that very many companies with low insider ownership will be great performers, we like to stack the odds on our side. Who do you think cares more about their company's stock price -- the managers at memory maker STEC (Nasdaq: STEC ) (36% insider ownership), or AIG (0.2%)? Google (Nasdaq: GOOG ) (22%), or Flamel Technologies (0.8%)?
Flamel was one of Tom's early recommendations, and the biotech's management team at the time didn't demonstrate much of a knack for creating shareholder value. After nearly four frustrating years following Flamel, Tom sold it off at a considerable loss.
3. Study competitive advantages closely
Here we're talking about Wal-Mart's (NYSE: WMT ) economies of scale, or eBay's (Nasdaq: EBAY ) powerful network effects. The ability to ascertain the strength of a company's competitive advantages is one of the most powerful tools an investor can possess. The differences between vast, deep moats and dry, shallow trickles are not always obvious.
For evidence of fortified moats, Tom looks for companies that have "lots of customers, a unique product experience, and a focused management team." He looked back at picks such as eSpeed, which developed an electronic trading platform, and saw quite the opposite: a small customer base, very little differentiation, and management that seemed unable to fix problems.
4. Assess the uses of cash
Warren Buffett once said that allocating capital is management's most important job. That certainly makes sense; after all, a business exists to turn the money it has into even more money, right?
Managers can take cash and invest it back into operations, buy back shares, make acquisitions, or return it to shareholders in the form of a dividend. Rarely should a company just sit on its money. Flamel, at the time, was a struggling $300 million company burning through a $100 million cash position, and it was failing to make good use of that capital.
To assess management's capital allocation efficiency, use the metrics of return on equity and return on invested capital. Companies like Apple (Nasdaq: AAPL ) and Amazon.com (Nasdaq: AMZN ) score very high in these departments -- with ROEs of 32% and 23%, respectively, despite their large cash positions.
Foolish bottom line
Importantly, Hidden Gems' successes have far outweighed the mistakes, with returns easily beating the market since the service began more than six years ago. In the interest of equal time, I'll soon follow up with lessons on the team's successes.
Until then, you might be interested in the 10 stocks Hidden Gems suggests you buy first for your portfolio. For the next 30 days, you can see those companies and have access to the entire service, free of charge. Here's more information.
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