How to Be Exactly Wrong

My 6-year-old daughter loves tagging along with me to the hardware store. I'd like to think it's because she enjoys hanging out with Daddy, but truth be told, she's more excited about picking out Mickey Mouse-shaped paint samples.

Recently, we were on our way to the store when she asked the timeless question, "How much longer, Daddy?" I answered, "Honey, that depends." For those of you who spend time around 6-year-olds, you know how deeply unsatisfactory that answer is. When you're 6, everything has an answer, and that answer must be exact. "Why don't you know how long it takes, Daddy? Does anybody know?" That seemed like a thoughtful question.

Who knows for sure?
"Well, sweetheart, it's about 4 miles to the store, but we'll pass through more than 10 stoplights from here. If we get all green lights, it'll take us about eight minutes to get there. But if we hit every red light, it could take us 30 minutes. Chances are, we'll catch some green lights and some red lights, and it'll take us between eight and 30 minutes. But we can't know exactly what time we'll get there."

I then proceeded to not miss a single green light and arrived in fewer than 10 minutes. We got our widgets and whozits, and then on the way home, held back by loads of traffic, we managed to hit every single red light. This was neither a necessary nor a welcome demonstration of the concept, as far as I was concerned. And in the end, I have no idea how long it took us.

Beware false precision
Little did I know how this quotidian experience would reflect our investment philosophy and approach to valuation in our Motley Fool Hidden Gems small-cap service. Valuing businesses is an exercise in false precision for the same reason that you can't determine exactly how long it'll take to get across town. You will never have information accurate and complete enough to let you precisely divine the future. In our work, we simply want to put the probabilities of success in our favor.

For example, when I recommended Fairmont Hotels & Resorts to Hidden Gems members, I'd assessed its competitive position against other hotel giants. I also had a good idea of where the company's real estate should be valued, and that number was well higher than its market capitalization. I thought that at $33.50, the stock was undervalued. But did this mean it would be worth $40, $50, or $60 soon? I didn't know. The answer depended on how Fairmont's executives managed the process of extracting value from the company's assets, among loads of other variables.

Should we not invest, then, until we have a tidy target price? Well, that usually doesn't work so well. Some months back, I gathered a few old research reports from around March 2006, curious as to how close some Wall Street analysts came with their price targets:

Let me say straight up that I'm not out to make any of the analysts look bad. It's just that they have an impossible task in trying to consistently nail a price target like that, and frankly, I don't think they should be trying. Sometimes they'll be close; sometimes they won't.

A better way
Instead, in Fairmont's case, I came up with a range of fair prices between $38 and $76, based on assumptions tapped into the valuation tools at my disposal.

Of course, that's a huge disparity -- a difference between Fairmont having a market cap of $2.6 billion and $5.5 billion. But what it did tell me was that Fairmont would not have been attractive if its shares were priced at, say, $51. With my fair value of $38 to $76 per share, that would open up the possibility of anywhere from a 25% loss to a 40% gain.

I don't like those situations. If you're 15 minutes away from a critical meeting and the drive could take from eight to 30 minutes, you'll be driving with anxiety. I don't like to drive, or invest, anxiously. Fortunately, Fairmont's stock was trading at $33.50, below my fair-price window of $38 to $76 per share. I recommended it, and we enjoyed a 34% gain before the company was acquired by Kingdom Hotels and Colony Capital in May 2006.

Stacking the odds
This is how Tom Gardner and I approach our recommendations in Hidden Gems. We create a range of potential fair values and then compare that with the shares' present value. Once we have that, we never stop re-evaluating.

While we were in the hardware store, for instance, the city may have erected a new stoplight, or an accident may have occurred. The same is true in investing. As I look over our list of Hidden Gems, I see how many of them have had events with big impacts in just the past few months. Each time anything substantial happens, we re-evaluate by developing a new range of possibilities, not by coming up with a specific target price.

Thus far, our results are extremely satisfying. Our recommendations have returned an average of 56% since the service began, versus 20% for equal amounts invested in the S&P 500.

We don't know what lies on the road ahead. Sometimes, we'll glide through an unending sweep of green lights en route to a market-smashing romp. Other times, a downed tree in our path will force us to sit patiently for an hour.

Rest assured, though, that we have every intention of getting you that Mickey Mouse-shaped paint sample as quickly and as often as we can. Want to try Hidden Gems for free? We're offering a special 30-day, no-obligation trial.

This article was originally published on Oct. 3, 2006. It has been updated.

Bill Mann co-pilots the Hidden Gems newsletter with Tom Gardner. He owns no companies mentioned in this story. Tyco, Pfizer, and Microsoft are Inside Value picks. The Motley Fool has a disclosure policy.