As fire refines gold, so suffering refines virtue. -- Chinese proverb
Fire is good and bad. It keeps us warm in the winter and heats our soup, but also occasionally destroys homes and kills people. In these frosty February days when I think about fire and money, I think about how they often intersect, in good ways and bad -- literally and figuratively.
Funds
When you're seeking amazing mutual funds, it's tempting to focus on funds with impressive track records that make you imagine you can double or triple your money in short order. But beware. Sometimes you'll run across a fund with a whopping five-year average annual return, but that's often because it had a single blowout year, the likes of which it may never see again.
That single big number, for that year, is averaged in with the other years' more typical numbers, resulting in a misleading average. Sure, it's accurate -- it's the legitimate average. But it doesn't mean you should expect that kind of return in the future.
For example, look at the Hodges (HDPMX) fund, which sports a five-year average annual return of more than 27%. At that rate, an investment of $10,000 would turn into more than $33,000 in just half a decade. The fund has a low minimum investment amount of $250, and its top holdings recently included Transocean (NYSE: RIG), Crocs (Nasdaq: CROX), Boeing (NYSE: BA), and Costco (Nasdaq: COST). Sounds good, doesn't it?
Well, take a closer look before you jump in. When you look at its three-year average annual return, you'll see that it's less than 12%, which should tell you something. It still does point to a fund that tends to outperform the overall stock market handily. But it's not such a huge outperformance.
The difference in averages is explained by 2003 -- when the fund grew by 80%, beating the S&P 500 by more than 50 percentage points. Folks, that's a hot number, but it's also an outlier -- a number that can throw off averages. Be sure to always look at several annual returns, not just an average.
Hot companies
Companies can be on fire, too. The good way is when they're firing on all cylinders, executing their strategy well. Such companies can present compelling investment opportunities, as long as their stock hasn't gotten ahead of itself. One example that comes to mind is Intuitive Surgical (Nasdaq: ISRG), which I discovered via our Motley Fool Rule Breakers newsletter. The stock has risen 25-fold in the past five years, and as my colleague Anders Bylund explained, "Intuitive Surgical continues to confound the analysts, having beaten every earnings estimate since the fall of 2002."
Another kind of fire happens when a company ends up in trouble, as Johnson & Johnson (NYSE: JNJ) did during its 1982 Tylenol-tampering crisis. Such crises can sink a company's stock, presenting a terrific buying opportunity for brave investors. You might look out for such situations -- but make sure the fire is one that's easy to put out, not a nine-alarm inferno that's already reduced the building to a shell.
Remember also that companies that have been through fires are often reinforced with lots of fireproofing. I suspect they'll be more likely to work to prevent future fires than other companies.
Stocks that sizzle
Stocks can be on fire, too -- and this not only attracts many investors but also dooms many. If a stock has tripled in value in short order, from, say, $20 per share to $60, you might be tempted to snap up shares, hoping to benefit from its next tripling. But remember that its intrinsic value, the price it really deserves at this point, might be closer to $40 or $50 than to $180. The stock may be overvalued now.
That's why it's often best to look for seemingly undervalued stocks, ones that offer a margin of safety. For example, MetLife (NYSE: MET) has a low price-to-earnings (P/E) ratio, but analysts expect the company to grow at nearly a 20% clip over the next five years.
Belongings on fire
Finally, remember that your beloved belongings can also catch fire. Be sure that you not only carry insurance, but that you carry enough insurance.
