I'm not going to get political today, but I do want to talk about our defense secretary. Whatever your opinion of Donald Rumsfeld, no one can deny that he's got some interesting things to say.
One of the most profound statements he's ever uttered has also been the one most often ridiculed. Here's what he said (or as close as I can find on the Internet):
"As we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say, we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know."
To those who see trouble in all overly nuanced statements, this humdinger no doubt has your eyeballs rolling as far back in your head as when Bill Clinton gave us his reflections on what the meaning of is is.
But investors would do well to take a closer look at what Rumsfeld said, because he summarizes, in a nutshell, the opportunities and risks in any investment thesis.
Known knowns
There are things we know. And we know we know them. Things like this: Apple (NASDAQ:AAPL) sells a ton of iPods these days, and that has caused its revenues and earnings to skyrocket; Mittal Steel (NYSE:MT) made a bid for Arcelor, which would make the company the world's biggest steel producer (it will also cheese off the Europeans, especially the French); Transocean (NYSE:RIG) is renting deepwater oil rigs as quickly as it can get its hands on them, and dayrates are blazing upward all the time.
Known knowns are usually not much of a challenge for investors. The information is all out there, either in the filings or in the media. As a result, most of the value of known knowns is already priced into a stock.
Known unknowns
There are things we don't know, and we know we don't know them. This is where investors begin to get into trouble. For instance, I can crunch all the data I want regarding Pfizer (NYSE:PFE), but historical multiples, returns on capital, and free cash flow won't give me a clue as to the stock's real value. That's because I know that there's a lot about Pfizer I don't know. What's its current drug portfolio doing? When do its blockbusters go off patent? These issues could make or break an investing thesis, whereas a company like Starbucks (NASDAQ:SBUX) that sells the same thing, day in and day out, has a lot fewer known unknowns.
In the case of Pfizer, we're lucky enough to be able to look up the known unknowns. But there are other known unknowns that we will never ... um ... know. Mostly, these involve the future.
For instance, Apple investors should know that they don't know what Apple's future earnings growth will look like. Unfortunately, most assume it will be 20% a year or more, which is why the stock carries a nosebleed valuation. Google (NASDAQ:GOOG) investors have it even worse. There, analysts are predicting greater than 30% earnings growth for the next five years. Once again, we know that number is, in reality, something we don't know -- a known unknown. But Wall Street is in a faithful mood with Google, or was until recently. That expectation, along with ridiculous analyst price targets ("make mine the biggest!"), have propelled the stock upward, until the recent slide made hash of investors who were hoping to get from $470 to $500.
Unknown unknowns
These are the situations that can really turn your investment dreams into nightmares. Anyone remember the fate of Iomega as the Zip drive gave way to other forms of data storage? Pondering Eastman-Kodak's (NYSE:EK) demise because it couldn't foresee the rise of digital film? Do you think that GM and Ford had any idea that upstarts like Honda and Toyota would not only outsell them on the cheap end, but also rise to become the paragons of automotive quality? Nope.
Those are but a few examples of unknown unknowns, and particularly nasty ones at that.
A modest proposal
What's an investor to do? There's a solution to the dangers of known unknowns and unknown unknowns. It's called a margin of safety. Simply put, every time you buy a stock, you need to build a valuation based on the best information you've got (your known knowns and your known unknowns), and then you refuse to pay that price. That's right. You say "This is worth $20, but I'm not going to pay a penny over $16."
That's the secret that value investors like Whitman, Munger, Buffett, Neff, Davis, and others have used to earn millions, all the while stomaching less risk than you get from the average stock. (It's also the path we follow at Motley Fool Inside Value, which has recommended both Pfizer and Mittal.)
In closing, let's reflect on a few more words from Rumsfeld. He has also been known to say, "Learn to say, 'I don't know.' If used when appropriate, it will be often."
Investing means paying for "I don't know" every single day. Make sure you're getting a discount.
To check out the write-ups on Mittal, Pfizer, and more than 30 other stocks the Inside Value team believes are currently undervalued, click here for a totally free month-long trial.
Seth Jayson wants to know whether there's something out there beyond unknown unknowns. At the time of publication, he had shares of Transocean but no positions in any other company mentioned. View his stock holdings and Fool profile here. Fool rules are here.
