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, 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 (NYSE: GS  ) 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 had managed 10.9% annualized returns through the end of last year since its inception nine years ago, compared with minus-3.1% annualized returns for the S&P 500 with dividends reinvested, 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 PepsiCo (NYSE: PEP  ) .

2. Distressed businesses in distressed industries, like Starbucks (Nasdaq: SBUX  ) .

3. High-uncertainty, low-risk situations. He cites Microsoft as an example: In 1980, the company bought QDOS for $50,000 and sold a modified version -- MS-DOS -- to IBM. One year later, Bill Gates visited Apple 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 in the wake of the Salad Oil Scandal -- it 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, since the market is full of stocks that Wall Street won't touch -- because it confuses uncertainty with risk.

As Pabrai 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

NRG Energy

0.7

10%

3%

Utilities

Penn West Energy Trust (NYSE: PWE  )

0.4

12%

9%

Oil and gas exploration

U.S. Steel (NYSE: X  )

0.4

21%

10%

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

Alpha Natural Resources (NYSE: ANR  )

4.1

13%

36%

Coal and fuels

Darling International

4.9

32%

40%

Agricultural products

Foster-Wheeler (NYSE: FWLT  )

6.5

54%

34%

Construction and  engineering

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.

This article was originally published on Jan. 29, 2009. It has been updated.

Ilan Moscovitz owns shares of Apple but not of any of the other companies mentioned. Apple and Starbucks are Motley Fool Stock Advisor recommendations. American Express, Starbucks, and Microsoft are Inside Value recommendations. PepsiCo is an Income Investor selection. The Fool owns shares of American Express and Starbucks. The Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (30)

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 05, 2009, at 5:07 PM, Raven7090 wrote:

    Sounds good to me. Here IS a recommendation: buy as much PWE under $10 as you can. Then sell it at $20 within 24 months AND collect the dividend as a bonus!

  • Report this Comment On March 06, 2009, at 12:00 PM, nmmmnu wrote:

    I am very bullish on oil, however I do not like when a stock falling, and I do not know why.

    Any idea why PWE is that low, much lower than other oil related stocks like PBR, XOM etc... - give me anything, even CNBC version :-).

  • Report this Comment On March 06, 2009, at 12:13 PM, ironman50 wrote:

    Buying PWE at these prices is a gift that does not occur very often - $20 in 24 month is even probably low. Look at the price on all of the Canadian trusts with oil at $45 today, and where they traded when oil was at $45 a few years ago. Even factoring in the looming tax consequinces in 2011, they are still a steal - oil will hit $100 again in less than 2 years due to current lack of exploration.

  • Report this Comment On March 06, 2009, at 2:53 PM, nmmmnu wrote:

    >>> Even factoring in the looming tax consequinces in 2011

    This is "acnoledged" into the price, two years ago all trusts similar to PWE fall because of this. You can see it on the chart.

  • Report this Comment On March 09, 2009, at 1:55 AM, rootbeermyhorse wrote:

    damn..that 5 year chart scares me!

  • Report this Comment On March 11, 2009, at 7:55 AM, nmmmnu wrote:

    Posibility for speculative arbitrage with PWE

    http://nmmmnu.blogspot.com/2009/03/posibility-for-speculativ...

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