Years ago, long before I became a Fool, I got into the habit of listening to David Gardner and his brother, Tom (the brains behind The Motley Fool's successful Hidden Gems investing newsletter), host their Motley Fool Radio Show every Saturday. I'll never forget one sunny afternoon, when a guy -- let's call him "Mr. Lucky" -- called in.
The topic that day was investing strategies, and Mr. Lucky had a real simple plan. When asked how long he held his stocks, Mr. Lucky answered matter-of-factly: "When I buy a stock, I hold on to it until it's gone up about 5%, and then I sell." The brothers Gardner were dumbfounded, and asked Mr. Lucky to clarify. But they'd heard it right the first time. Mr. Lucky's plan for "investing" was to buy a stock and basically hope it went up. If it did, as soon as it did, he sold out immediately to lock in his gain, fearful of waiting "too long" and seeing his profits vanish.
Even as a novice investor at the time, I, too, knew that something sounded wrong with Mr. Lucky's answer. For one thing, he didn't talk much about how he researched his "investments" before buying them. He didn't seem to really know all that much about what the companies, whose shares he was buying, did.
By now, you've probably noticed that I'm putting all the various derivations of the word "invest" in quotes here. Why? Because Mr. Lucky wasn't "investing" at all. He was gambling. Betting on one stock, getting lucky, and taking his winnings to another table to spin the roulette wheel once more. To use the parlance of the day, he was "playing the market" -- except that I'm willing to wager that, around about March 2000, it looked more like the market played him.
Because Mr. Lucky didn't really understand the companies whose shares he was buying, he had no sense of security in his investing decisions. That's why he never stuck around to see whether a stock would rise more than 5%. That's why he treated investing as if it were a game of chance. To him, it was.
Investing and gambling don't mix
But at its most basic level, investing doesn't depend on luck. True investors understand that, yes, luck can drive a stock up or down in the short term. But over the long term, it's fundamentals that determine whether a stock rewards you or takes all your money and slips out of town in the dark of night. Yes, you can analyze the heck out of such a great company as Merck (NYSE:MRK), decide to buy it at $45 a share on Sept. 29, 2004, and then have the bad luck to see your investment plunge 27% the next day.
But by the same token, you can invest in the likes of Ballard Power (NASDAQ:BLDP), one with no prospect for profits in the near term, only a potential for profits if hydrogen power takes off in the future. And one day, out of the blue, a president generally believed to be beholden to the oil companies up and promises to invest in fuel cell research. And Ballard's stock rockets. There's luck at work again. But it's just as unpredictable.
In the end, to maximize your chances of success, you need to focus on what you can control -- and trust that the good and bad luck will cancel each other out. Which is precisely why our crack team of analysts at Hidden Gems spends more time reviewing SEC filings and calculating owner earnings than nailing up horseshoes and stroking rabbits' feet.
Control the variables
So let's get right down to it. What can you control? What can you insist upon in an investment, in order to maximize the likelihood that it will reward you (luck permitting)?
1. Limit downside risk
First and foremost, we think it's smart to limit the ability of bad luck to hurt you. For instance, it's exceedingly rare for a company to fall in value below the cash it has in the bank, minus its long-term debt -- its "net cash." Long before Apple (NASDAQ:AAPL) became synonymous with both iPod and profits, it was considered a safe stock, cash-rich, and unlikely to ever trade below its net cash. Investors in Apple three years ago may not have suspected that the iPod would transform their company into a cash printing press, but they knew for darn sure that with the amount of green stuff that Apple had in hand, the company was a veritable four-leaf clover, protecting them from downside risk.
2. Less cash bad, more cash good
Cash in the bank is great. Cash in the bank that is growing is better. So you also want to ensure that your cash-rich company generates more and more cash as time progresses. That's why, at Hidden Gems, we seek out companies that have not just strong balance sheets but copious free cash flow to boot.
We would not, for example, recommend that our members buy into a company like Gateway (NYSE:GTW). The reason being that, while the company has nearly $300 million in cash against a market cap of just $1.7 billion, it's also bleeding cash at an annual rate of nearly $400 million per year. Such a negative rate of cash flow means that today's cash surplus may not last.
Rather, if its size were not an issue (Hidden Gems focuses on small caps), we'd much prefer to own a company with traits like those Oracle (NASDAQ:ORCL) possesses: $9 billion worth of cash in the bank, increasing by another $3 billion every year.
3. Bet with the house
There's an old saying that you should never "bet against the house." I suspect the saying's been preserved because gamblers know that, when the house sets the rules, more often than not, the house wins. In investing, a more positive piece of advice would be to bet with the house.
When a company's own management and insiders own a significant stake in their own company, their interests are the same as yours -- they'll maximize shareholder value because they're shareholders too. That's why we actively seek out companies where the house in on our side. Companies such as Adobe (NASDAQ:ADBE) or Apollo Group (NASDAQ:APOL), where the people in charge also own significant stakes in the company.
Conversely, when you see insiders selling in droves, insiders who own only a tiny portion of their company's stock, you need to ask yourself whether they perhaps know something you don't. And if they don't entrust their money to the company, perhaps you shouldn't either.
So there you have it, folks. Three easy ways to minimize your investment risks, each based on easily accessed public information. Find a company with lots of cash, with more cash coming in every day, and with management dedicated to keeping things that way. If you can build yourself a portfolio of businesses with those traits, luck should be the last thing you need to build lasting wealth.
And, gee, as luck would have it, we've got a portfolio of 31 select companies that meet all three of those requirements right here for your perusal! Take a free trial of Motley Fool Hidden Gems, and find out how we've managed to rack up 30% returns since inception, versus a market return of just 8%, crushing the market by nearly four to one.
Fool contributor Rich Smith has no position in any companies mentioned in this article. The Motley Fool's disclosure policy leaves nothing to chance.
