Jason Zweig, who did a bang-up job updating Benjamin Graham's investing classic, The Intelligent Investor, recently conducted an interview with another investing legend, 85-year-old Peter Bernstein. Bernstein has his own contributions to the investing pantheon, the most well-known being his book on the history of financial risk, Against the Gods.
As great a student as Bernstein is in the art of security analysis, where his insights really shine is in the arena of human psychology as it relates to investing. As I was reading the interview, I was reminded once again about what impresses me so much about Peter Bernstein. It's not his intellect, nor is it his discipline -- both of which are considerable. It's his self-awareness. Bernstein knows what he doesn't know. It makes him a much better investor.
But one thing that Bernstein said in this interview struck me as being especially profound. He noted that investors (and I'm paraphrasing) must remember that they don't know the future. We don't really know what's going to happen with something. We never do.
Naturally, this seems like a fairly obvious observation. Few of us claim to know the future. But how many people make investments as if they do, as if things that they believe are going to happen have already happened? And -- this is what's most important -- they do not consider the probabilities that they are wrong, or the consequences of being wrong.
Put this into the context of the most recent boom and you can see how damaging this can be. B2B e-commerce was supposed to be anywhere from $1 trillion to $3 trillion in size by 2005, depending on which forecasting service you referenced. Merrill Lynch (NYSE:MER) made a B2B Internet HOLDR (AMEX:BHH) in 2000, on the theory that investors unable to discern the eventual winner in this exciting sector could own a basket of companies. The assumption was, of course, that any of these companies would win, when in fact, none did. B2B e-commerce has grown, but not in a way that allowed such former titans in the wings like Verticalnet (NASDAQ:VERT) to control these markets. Of course, Verticalnet has the benefit of still being in business, unlike other original BHH components Scient and PurchasePro.com.
Perhaps as importantly, of the 17 HOLDR products that Merrill put together from 1999 to 2001, four of them have Internet themes. Merrill's reasoning for doing so was simple -- it was reacting to the demands of customers, who looked into the future and saw the Internet at the center of everything. Newspapers? Dead. Middlemen? Dead. It was going to destroy whole sectors of business as we know it. Everything was going to change.
And it did, sort of. E-commerce is a massive component of the American economy. But what none of the investors, institutional or individual, who bought into these pipe-dream companies got right was predicting how things would change and who would benefit. In short, they didn't take into account the risk of being wrong. What destroyed investors' portfolios wasn't being wrong about one stock; rather it was holding a series of companies that had great hopes but minuscule presents and being wrong about the whole lot of them. Picking among Ariba, Commerce One, and i2 for a winner didn't yield any winner at all. They all lost. So did their investors.
I've been thinking about this to some extent because I've been receiving some very nice, if misguided, questions about how I "knew" that oil was going to take off when I started writing about Ultramar Diamond Shamrock and its successor, refining giant Valero (NYSE:VLO), a little more than two years ago, in greatest detail in the Motley Fool Hidden Gems predecessor TMF Select. This is a stock that has much more than doubled in this short period of time, a fairly staggering return for an industry that had languished for more than a decade. How did I know that oil was going to take off?
It's pretty simple, actually. I didn't. What I did know was that refining was a business priced at a level that had enormous margins of error built in. Further, I knew that refining was a business that would remain in high demand and had a fairly fixed base of supply. And finally, this was a sector that investors had totally abandoned. They were sick of waiting. I, of course, don't mind waiting, if the price is right, which for Valero it was. What's not to like about that?
Each time that I wrote about Valero's business, some roughneck let me know that it would require a very, very large vessel to hold all of the information that I don't know about the refining business. He is, of course, correct. There is plenty about this business I don't know. We're never going to have perfect information as investors. What I did need to know about was the thing that so many investors forget: I had a pretty substantial margin of not being massacred if I was wrong. It's hard for companies to let investors down when no one expects much from them anyway. Further, I had good probability of success on my side. Refining was a nasty but very necessary business, and it has huge operating leverage. When the economics change in refining's favor, as they have of late, its marginal product is massive. That's why Valero has sailed from being a $16 stock to one that exceeds $40 today, and that's why it still only boasts a price-to-earnings ratio of 9.
What if I were wrong? Well, what about it? The only people in investing who are right 100% of the time are liars, marketers, and freaks, and yes, these lists are decidedly co-extensive. Everyone is wrong sometimes. On Monday I laid out a scenario that showed how Marsh & McLennan's (NYSE:MMC) ongoing bid-rigging scandal could doom it to share Arthur Andersen's fate -- a total ignominious collapse. Naturally, this view assumes an awful lot, including and perhaps most importantly that the New York attorney general will not only refuse to allow Marsh to settle out of court without admitting any fraud, but also that a vigorous pursuit of the case will come out favorably for the state. (By the way, New York isn't the only state in the union -- already the attorneys general of Connecticut and Pennsylvania are preparing their own cases against Marsh. I expect more to come.) Should Marsh be found to have committed fraud, then the customer cases against it are eligible for treble damages. Would this take down Marsh? I don't know, but its equity account certainly wouldn't last very long at that rate.
All of these things are suppositions. I don't know what the future holds, and neither does anyone else. What's crucial is to note that the probability of such an outcome is much, much higher than zero. Is such a possibility priced into the stock? I'd suggest the fact that we're dealing with imperfect information demands that such a scenario be considered highly. What we have to deal with in investing are probabilities. Give me a game where an opponent continually takes bets with a 5% probability of succeeding with 10% of his assets and I figure that I'll win almost every time. Those are risks for which the chance of appropriate compensation is very slim -- even if they work out, the payoff profile is exceedingly low. Such is the recipe of all bubbles -- the Japanese stock market, the American stock market, Chinese Internet stocks, and more recently Travelzoo (NASDAQ:TZOO) and Google (NASDAQ:GOOG). It's not enough to be right -- you must also make sure that the pain of being wrong is not too great to bear.
Those who count on the future to bail them out too many times in investing (and in other endeavors as well) are courting almost certain mathematical failure over the long term. Risk is part and parcel of investing, and so is the occasional failure. Bad decision-making needn't be. There's no way to predict the future with certitude. There are plenty of ways to make sure that when you're wrong, the damage isn't mortal to your financial future. That doesn't mean fearing risk -- it does mean understanding it, and doing your best to quantify it in every security you own.
Fool on!
Bill Mann, TMFOtter on the Fool discussion boards
Interested in the quest of companies with large margins for error? Take a free trial to Philip Durell's Inside Value newsletter. Each month Philip offers up two deep value stock ideas.
ESPN recently put together its Top 100 sports moments from the last 25 years. Should the Boston Red Sox win over the Yankees tonight, we will have just witnessed what should have been No. 2. If they lose, it's still top 20. Bill Mann does not own shares in any company mentioned in this story.
