Get over it
It always amazes me when I see investors flogging themselves about making mistakes. Get over it already. That's the way this game works. No one bats 1.000. The best investors are wrong sometimes, maybe even half the time, but they persevere anyway. Why?
They plan to be wrong.
There are two ways you can minimize the risks of the mistakes you'll make when picking stocks. One is by purchasing more than one stock. (Natch.) If you're doing your homework correctly, your winners will more than outshine your losers, because winners can return a lot more than 100%, and losers -- well, even a complete loss stops at all your money. Put it this way: If, three years ago, you'd put equal amounts of money into Apple (NASDAQ:AAPL) and KrispyKreme (NYSE:KKD), you wouldn't really care that much about the money you'd wasted on that sticky doughnut situation.
The other way to make sure that mistakes don't kill your portfolio is to embrace them -- to depend on them. To make them part of every buy and sell decision. This is exactly the approach I take, along with my colleagues at Motley Fool Inside Value.
Getting it right by getting it wrong
Philip Durell, stockpicker-in-chief at Inside Value, always plans to be wrong. No, that doesn't mean he's letting chimps make his stock picks while he packs his bags and a phony passport for Parador.
What it does mean is that every valuation he makes, for every company his picks, he assumes he's not going to be completely accurate. He knows he won't be right. Not about everything. It's just not possible.
That's why stocks that meet his criteria always do so in relation to a conservative discount rate (a "safe" rate of return that the company's returns are expected to beat), as well as a healthy margin of safety -- usually 20% or more.
Contrast that with the strategy of the folks buying Google (NASDAQ:GOOG) these days. There's absolutely no room for error. They're not only paying much more than Google's worth now; they're paying a premium that depends entirely on unprecedented growth. If they're only a little bit wrong, they're going to pay in a huge way.
There's a simple reason all of us value hounds prefer to pay 80 cents on the dollar, or less, if we can get it. That means that if we're wrong by, say, 20% -- hey, we paid 80 cents for 80 cents. There are worse things you could do.
But there are also better things you could do.
My favorite mistake
Just like Philip, I plan to be wrong when I'm doing discounted cash flow valuations of stocks I consider for purchase. I often start by taking the best analysts' estimates I can get and then chop a full third off them.
In fact, this year I was way wrong, in the right way, when I tried to value my best-performing stock, Guess? (NYSE:GES). To me, this was a textbook small value: a company that most had given up for dead, improving operations and profitability under new management. The balance sheets were fine, sales were fine, yet it was completely ignored by the Street. Everyone else was paying attention to the new names, like Abercrombie & Fitch (NYSE:ANF) or Urban Outfitters (NASDAQ:URBN). No one had time for this has-been.
Mistake No. 1
Writing off a company without checking the books is just plain silly, but I almost did this, too. Heck, the only reason I bought shares was because my wife took a macabre interest in the Guess? store near our home -- one that always seemed empty. In trying to discover whether Guess? might be a good short, she instead found a classic turnaround that was still cheap even though it was already turned around! She turned the ball over to me, and it turned out to look even better than she'd thought.
Mistake No. 2
Back then, I decided that the jeanswear firm was worth as much as three times the then-going price of around $14 a share. But my models of the firm's growing profitability were based on very conservative estimates of sales and earnings growth, in the range of 10% to 15%.
And I was dead wrong. Since sales have actually been growing at more of a 25% clip and earnings much more quickly than that, at an 80% rate, Guess? has turned out to be a triple, all right. It's almost tripled for us (returning 170% so far) since just March of last year. And if recent sales figures are any indication, it's got plenty of room left to keep rolling.
Vive la mistake, I say. And vive la value.
Foolish bottom line
Mistakes don't have to put a kink in your portfolio. Not if you assume you're going to make them, and you make your buys accordingly. By planning for mistakes and buying stocks that are already valued below your most conservative estimates of their worth, you'll end up with fewer losers and smaller losses on your losers.
When you're wrong to the right side, like I was with Guess?, or like Inside Value was with Intuit (NASDAQ:INTU) or Omnicare, you'll see some amazing returns, even over short periods. Intuit has returned 41% since March of 2005, and Omnicare doubled from its original recommendation in November of 2004. Both of those have risen more quickly than anyone expected, but I'm sure these are the kinds of mistakes that are easy to forgive.
If you want more details on how learning to be wrong can make you wealthy anyway, a free trial of Inside Value is just a click away. An easy sign-up will let you peruse the old editions, check the full-disclosure scorecard that details mistakes that weren't for the better, and take a look at another retail turnaround story that happens to be told in the latest issue.
Seth Jayson assumes everyone is wrong. It drives his wife nuts. But he assumes he's wrong, too, so it all smoothes out, right? At the time of publication, he had shares of Guess? View his stock holdings and Fool profile here . Intuit is a Motley Fool Inside Value recommendation. Krispy Kreme is a Stock Advisor pick. Fool rules arehere.
