The Dumbest Investment I've Ever Seen

While 2008 was a bad year for us individual investors, it was downright nasty for the Wall Street smarty-pantses who started this mess.

If "sophisticated" traders at firms like Citigroup (NYSE: C  ) , Morgan Stanley, and what's left of Lehman Brothers learn anything from this debacle, hopefully it will be that they need to rethink the wisdom of massive debt and absurdly complex financial products.

They clearly haven't learned it yet
Take credit default swaps (CDSs) on U.S. government bonds, for example. They're essentially insurance policies. If the U.S. Treasury defaults on its loans, CDSs guarantee that other Wall Street firms would pay those claims.

It's true that, since October, the Treasury's balance sheet has taken on additional risk in the form of TARP and other bailout-related obligations.

But wait: What scenario can you imagine that would wipe out the U.S. Treasury yet leave AIG or even Goldman Sachs in good enough shape to pay out billions in T-bill claims?

Coming up blank? Me too.

Talk about a dumb investment
CDSs on U.S. government bonds are like insurance policies on a Monopoly game: Either you win and didn't need the policy, or you lose and get an IOU for money that's not worth the paper it's printed on. In other words, whatever happens, you're now down by whatever amount you paid for that policy.

So, why would some of the smartest minds in finance buy them?

Strangely, our brains are hard-wired to prefer certainty over uncertainty -- even if it sometimes means taking on higher risk. This psychological fact -- which is known as the Ellsberg paradox -- partly explains why Wall Street would take a certain loss in return for the false sense of security CDSs on T-bills provide.

Which got me thinking ...
If the dumbest investment around amounts to one with all downside and no upside, then the smartest would be the investment with almost no downside but tremendous upside.

And in fact, that's exactly what the best investors look for. Monish Pabrai, whose Pabrai Investments have managed 10.9% annualized returns since its inception nine years ago, compared to -2.9% returns for the S&P 500, explains his market-beating strategy as "heads, I win; tails, I don't lose much."

That is to say, he looks for:

  1. Simple, stable businesses with moats and high returns on capital -- think Procter & Gamble (NYSE: PG  ) .
  2. Distressed businesses in distressed industries, like Home Depot (NYSE: HD  ) .
  3. High-uncertainty, low-risk situations. He cites Microsoft (Nasdaq: MSFT  ) as an example, which in 1980, bought QDOS for $50,000 and sold a modified version -- MS-DOS -- to IBM (NYSE: IBM  ) . One year later, Bill Gates visited Apple (Nasdaq: AAPL  ) and got the idea of a mouse and graphical user interface for free. It wasn't clear if either MS-DOS or the graphical user interface would work. If they didn't, it wouldn't much matter to the bottom line. But if they did, it'd make quite a difference indeed.
  4. Large margins of safety. Warren Buffett's big bet on American Express (NYSE: AXP  ) in the wake of the Salad Oil Scandal -- which had been beaten down by a scandal that didn't ultimately affect its moat -- netted his company $3 billion on a $7 million investment.

Together, these criteria

  1. Limit your risk.
  2. Maximize your upside.

In other words, they're exactly the kind of smart investments we're looking for.

What does Pabrai like today?
Environments like this one are ripe for Pabrai's strategy because the market is full of stocks that Wall Street won't touch because it confuses uncertainty with risk.

As he recently told my Foolish colleague Morgan Housel, "Because of all the recent turmoil we've seen, there are some incredible opportunities outside the financial-services space. Right now, that's really the place to make some hay!"

Specifically, he's looking for companies trading at a discount to their book values and to their future cash flows. Who fits those criteria right now? I ran a quick screen to find out.

Each of these companies is highly profitable, became more profitable this year, and is trading at a significant discount to its book value:

Company

Price-to-Book Value

Return on Capital

Return on Capital Improvement

Industry

Manitowoc

0.5

24%

2%

Construction Equipment and Freezers

OM Group

0.5

15%

6%

Specialty Chemicals

Ternium

0.4

16%

9%

Steel

Data from Capital IQ, a division of Standard & Poor's.

Similarly, the following stocks are highly profitable, enjoy increasing sales, and are trading at low free-cash-flow multiples:

Company

Enterprise Value-to-Free Cash Flow

Return on Capital

Revenue Growth

Industry

Darling International

5.4

32%

40%

Agricultural Products

Terra Industries

3.1

38%

26%

Fertilizer

W&T Offshore

1.8

17%

39%

Oil & Gas Exploration

Data from Capital IQ, a division of Standard & Poor's.

None of these are official recommendations, but they could be interesting starting places for further research.

What you should do
Right now, the market is clearly pricing some bad news into stocks, which means that just like Buffett, Gates, and Pabrai, you can make a lot of money if you're willing to put in the work to separate the value traps from the tremendous bargains that are out there. To do that, you'll want to make sure your investments have:

  • Strong moats.
  • Limited or unlikely worst-case scenarios.
  • Honest and capable management.
  • Significant margins of safety to their book values or discounted cash flows.

These are just some of the criteria we, like Pabrai, look for when we evaluate investment opportunities at Motley Fool Inside Value. If you're interested, you can access all of our analysis, research reports, and best ideas for new money now. Click here to get started -- there's no obligation to subscribe.

Ilan Moscovitz owns shares of Apple but not of any of the other companies mentioned. Apple is a Motley Fool Stock Advisor recommendation. Home Depot, American Express, and Microsoft are Inside Value recommendations. W&T Offshore is a Motley Fool Hidden Gems pick. The Fool owns shares of Procter & Gamble and American Express. The Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (109)

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 January 29, 2009, at 7:26 PM, BENSELL2 wrote:

    Can't believe you would write this article and not do your homework. Or did you write it months ago? Present data does not resemble the data in this article.

  • Report this Comment On January 29, 2009, at 11:48 PM, brrrfox wrote:

    Excellent article, my question: How do you find capable and honest management?

  • Report this Comment On January 30, 2009, at 11:04 AM, murbard wrote:

    Well, that's why you buy Euro denominated CDS on US treasuries in Europe and Yen denominated CDS on US treasuries in Japan.

    True, the issuer default is massively correlated with a US Govt credit event, but that's discounted in the price.

    Still, you're better of with a put on US treasuries, since it pays in both cases : whether the Govt gets out of debt through the printing press or with default.

  • Report this Comment On January 31, 2009, at 8:43 AM, btukwh wrote:

    Read chapter 20 of the Intelligent Investor. It sums up the concept described in this article. This isn't a new thought, but it's a good one.

  • Report this Comment On February 01, 2009, at 8:45 PM, TMFDiogenes wrote:

    brrrfox,

    That's an excellent question. Here's a few things you can ask yourself: 1) In letters to shareholders and conference calls, does management give credit to others and take blame where appropriate? 2) Does it sound like they are talking to you as a business partner or do they pump their own stock? 3) Is their compensation reasonable and based on long term metrics? 4) Do insiders own a lot of stock? 5) Have they been investigated or convicted of anything in their past? 6) What has been their performance since they began working at the company and at previous jobs?

    Hope that helps.

    murbard,

    I agree. The difference is that if you make the right call, puts could be exercised but those CDSs never could because there'd be no one left to pay your claim. I believe the CDSs are usually denominated in Euros, but that still wouldn't help if every financial institution went bankrupt.

    Thanks,

    Ilan

  • Report this Comment On February 06, 2009, at 2:01 PM, EnsignSuder wrote:

    What, exactly is a "moat" as the term is used here?

  • Report this Comment On February 06, 2009, at 5:43 PM, Phred58a wrote:

    The easiest answer is to think of a castle. The purpose of the "moat" was to prevent easy entry to your castle by an enemy. So companies that have a wide "moat" have some "barrier" that makes it difficult for other companies to compete against them.

    It might be patents that they hold, the large financial cost to get a similar company up and running, the technical skill or knowledge required to produce the product or service, or the name or reputation of the products they product.

    A company with a narrow "moat" will typically have a lot of competition or the potential for a lot of competition in the marketplace since what they do is not unique.

  • Report this Comment On February 06, 2009, at 10:45 PM, rwk2008 wrote:

    In fact, the idea for the mouse and graphical interface didn't originate with Apple. It was developed at the Xerox Palo Alto Research Center. Xerox produced the Star workstation in the mid-1980s, which was the model Apple build on when it developed the Mac.

    If the rest of the information in this article is as faulty as this item, no wonder people following Motley Fool advice are all losing money.

  • Report this Comment On February 07, 2009, at 1:42 AM, TMFDiogenes wrote:

    Phred, that's a great explanation. Also, Ensign, Rich Greifner has a good article that gives more detail on this topic that's really central to how Buffett invests.

    http://www.fool.com/investing/general/2008/01/15/i-like-big-...

    rwk, You're right that Xerox, not Apple, invented the mouse and graphical interface. But if you read the article, I say that Gates got the idea while visiting Apple, not that Apple invented them.

  • Report this Comment On February 09, 2009, at 7:50 PM, onthesidefornow wrote:

    The first home computer with a GUI or graphical user interface was the Apple Lisa. The very first graphical user interface was developed by the Xerox Corporation at their Palo Alto Research Center (PARC) in the 1970s. Steve Jobs, visited PARC in 1979 (after buying Xerox stock) and was impressed and influenced by the Xerox Alto, the first computer ever with a graphical user interface. Jobs designed the new Apple Lisa based on the technology he saw at Xerox.

    http://inventors.about.com/od/cstartinventions/a/Apple_Compu...

  • Report this Comment On February 10, 2009, at 8:35 AM, vortex123 wrote:

    "In fact, the idea for the mouse and graphical interface didn't originate with Apple. It was developed at the Xerox Palo Alto Research Center. Xerox produced the Star workstation in the mid-1980s, which was the model Apple build on when it developed the Mac.

    If the rest of the information in this article is as faulty as this item, no wonder people following Motley Fool advice are all losing money."

    Well, the article says absolutely nothing about the origin of the mouse and graphical interface. It simply said Gates decided to replicate the idea after seeing it at Apple, which is true. Actually read what the article says before criticizing.

  • Report this Comment On December 14, 2010, at 3:04 PM, mikecart1 wrote:

    I guess Citigroup wasn't so bad afterall huh?

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