I love to play golf. I wish I could play more, but it's not a priority right now.
But I remember vividly when Peter Jacobsen seemed to be in contention every week a while back, sitting high up on the money list. His secret? He aimed to eliminate one mistake per round, in order to save one stroke per round -- four strokes per tournament, assuming he made the cut.
Again, his goal was not to go out and win every tournament, although I'm sure he didn't show up shooting for 10th place, either. He just intended to minimize his number of mistakes, increasing his probability of winning or placing high on the leaderboard. That simple approach helped him shoot lower scores and win more tournaments.
Free your mind
So here's my hypothesis: As investors, if we work to minimize our mistakes, not only will we limit our chances of a blowup, but we'll also see our overall returns increase.
How do we do this? By learning from investing greats like Marty Whitman, Warren Buffett, and Bill Miller -- and making the right kinds of errors. I know it sounds backward; as investors, we want to find high returns. But there's a method to this madness.
The types of errors
When making decisions, we can make two types of errors: Type I and Type II. (Who said statisticians aren't creative?)
We'll start with the Type II error, also known as the false-negative. There is a capital murder trial in a state that has the death penalty. The defendant is innocent until proven guilty. If the evidence shows that the defendant is guilty, but the jury finds him innocent, the jury committed a Type II error by letting a guilty man go free.
While this is egregious, it is not as bad as a Type I error, the false-positive. In another trial, the evidence shows the defendant is innocent, but the jury finds him guilty. A Type I error is far worse; not only will an innocent man die, but the guilty person is still out in society.
A powerful mental model
To illustrate how this principle applies to investment decisions, let's take a cue from master fund manager Marty Whitman -- who has earned greater than 12% annualized five-year returns on undervalued stocks like Brookfield Asset Management (NYSE:BAM), Legg Mason (NYSE:LM), and Posco (NYSE:PKX) -- and look for what is "safe and cheap." Here's the decision tree we should use.
|
Invest |
Pass | |
|---|---|---|
|
Safe and Cheap |
Correct |
Type II Error |
|
Not Safe or Cheap |
Type I Error |
Correct |
Type I errors should be avoided at all costs; not only do they put our capital at risk, but they also take capital away from "safe and cheap" investments that are still available. Since capital is scarce, we may feel forced to make up any losses by making even riskier investments. That's not very Foolish.
In investing, Type II errors aren't anywhere near as damaging as Type I errors. We may miss out on some returns, but we aren't putting our capital at risk. When you're harnessing the power of compounding returns, that can be huge.
Standing on the shoulders of giants
Warren Buffett's purchase of Coca-Cola (NYSE:KO) stock is a great example. After studying the business for years, he determined that the brand could carry the company through the "New Coke" debacle, making it a safe investment. The stock was cheap at the time, but it still had plenty of room to grow. I know it's been said before, but that's like stepping over a 3-inch-high bar rather than trying to set a high-jump record.
Bill Miller's Dell (NASDAQ:DELL) purchase is another example. According to his account in The Man Who Beats the S&P, Miller started buying Dell when it traded for five times next year's earnings and was earning 35% returns on capital. Not only that, but the company also had plenty of room to grow as the industry expanded and Dell increased its market share. Talk about safe and cheap; I'm still trying to figure out how I missed this one.
I recently wrote that I am more than happy to live with the "shame" associated with making a Type II error by not having Google (NASDAQ:GOOG) in my portfolio. But I think Bill Miller recently conveyed the point much better. Miller, who has owned shares of Google since its IPO, thinks that Google's theoretical price could be significantly higher than its current one. But he says that "the margin of safety is much less at [a price of $400 per share] than it was [at a price of $85 per share]." To me, that means Google was safe and cheap to Miller at $85. At $400, it might not fit that bill.
Whitman, Buffett, and Miller are great decision makers. By studying them, we can learn how to make lots of money by finding investments that are safe and cheap.
The Foolish bottom line
"Safe and cheap" is precisely how Fool value guru Philip Durell finds stocks for Motley Fool Inside Value subscribers. One of his most recent recommendations is Microsoft; he likes its cash position and its moat in operating systems and desktop software.
Philip has 30 more safe and cheap ideas as well. Click here to see them all for free for a limited time. That's got to be the easiest decision you'll ever make.
David Meier does not own shares in any of the companies mentioned. Microsoft and Coca-Cola are Motley Fool Inside Value picks. Posco is an Income Investor recommendation. Dell is a Stock Advisor pick. The Motley Fool has adisclosure policy.
