Learn From a Fool's Mistakes

"Invert. Always invert."
--Charlie Munger, co-chairman, Berkshire Hathaway

Fool co-founder David Gardner is one of the most successful stock pickers of the last 20 years. With several 10-baggers under his belt, including Marvel Entertainment and Netflix (Nasdaq: NFLX), it's clearly useful to study his successful picks.

But I've already done that in a previous article, so instead, I'm pulling upon the wisdom of Charlie Munger to help us squeeze all the insight we can from David's career. Instead of studying his successes, we'll invert the process. I'd like to dissect David's most horrendous picks over the last decade. If there are things that can trip a guy like David up, I'm pretty sure they'd completely blindside me.

The painful picks

Because hindsight is always 20/20, I'm not going to nitpick. Instead, I'd like to focus on three very broad themes I noticed in doing my research.

Lesson No. 1: Never underestimate the importance of leadership
In three out of the four companies listed above (Headwaters is the exception), there was some level of questionable activity occurring at the highest levels of the company.

With Satyam, it was outright lying. The company had been misstating earnings, revenue, and margin figures to look much more favorable than they really were. Management tried to cover up these accounting tricks by attempting to acquire a real-estate and construction business that the CEO's sons were involved in. Investors caught the whiff of something foul, and within a matter of days in early 2009, the stock lost almost 90% of its value.

Krispy Kreme and Force Protection were also called out for accounting shenanigans, though clearly on a less monumental scale than Satyam. Both companies ended up restating or reclassifying their financial statements as a result.

This should teach all investors two very important things:

• It's not all about the numbers. A company is a living, breathing organism with the CEO sitting at the helm. They need to be examined just as closely as the company's metrics.
• Find CEOs who are willing to face the cold, hard facts. Listen in on conference calls to see if it seems like trouble spots are being handled head-on, or if they're just being glossed over.

Lesson No. 2: Companies that try to grow too fast will lose steam
Krispy Kreme had been a venerable institution in the American Southeast for decades before David came upon the company. The chain of glazed-doughnut producers had a cult-like following and experienced early success when it started building franchises across the continent.

But in the end, its expansion plans were simply too ambitious, oftentimes diluting the quality of its product, charging its franchisees too much money to finance their growth, and cannibalizing its stores through poor geographical locations. The nail in the coffin came when the company decided to ship its products, boxed and cold, to gas stations and convenience stores -- thus eliminating its iconic slogan of "Hot Doughnuts Now."

This, again, should remind us of some important principles:

• Instead of trying to become full-grown overnight, look for companies that take their time growing. Netflix, with its deliberate move toward Canada before crossing the seas, is an excellent example of methodical growth.
• Go back and see Lesson No. 1, as it will ultimately be the leadership team that chooses the growth strategy for the company

Lesson No. 3: Small-cap stocks that rely on the government are dangerous
It's never a good thing to rely heavily on one customer to boost your earnings. It's even worse when that one customer is the government.

The aforementioned Force Protection was a small but growing company that was depending largely on government contracts to fuel its growth. When those contracts continually went to competitors such as Navistar and Oshkosh (NYSE: OSK), there was little recourse for Force Protection or its shareholders.

A somewhat similar fate faced Headwaters, a company that used coal byproducts to make synthetic fuels. At the time, if you were using synthetic fuel that Headwaters provided, you received a sizable tax credit from the government . If the price of oil went above a certain price, the synthetic gas would become cheaper than regular unleaded, and the government money disappeared.

In theory, the cheaper price of synthetic fuel should have made it more appealing. In practice, however, this simply wasn't the case. And as it turned out, when government assistance dried up, so did demand for the synthetic fuel.

David's weakness is also his greatest strength
It would be easy to take most of this out of context and wonder why anyone would ever listen to what David Gardner has to say. He's even gone on the record saying he's not very good at knowing when to sell a stock.

In truth, the fact that David holds on to companies as long as he does is both his greatest weakness and his greatest strength. But two crucial factors tip the scales in his favor.

• First, he has found far more winners than losers.
• Second, a stock can only go down 100%, while it can go up a whole lot more.

Listening to David discuss how he goes about picking stocks is one of the great benefits to a membership in both Stock Advisor and Rule Breakers. You can try either one out for a free 30-day trial. Though joining the discussion won't make you an instant millionaire, it's the first step toward your financial freedom.