Here's a new definition for you:
Academics (n): those who are (painfully) adept at creating theories that are scientifically supported, sensible, creative, and completely useless in the real world.
To illustrate my point, let's look at the academic perspective on the correlation between risk and return in the stock market. The egghead's point of view is this: The higher the risk, the greater the return. But that doesn't translate logically to an investor. I mean, "To outperform the market, buy the riskiest stocks!" does not a motto make.
So, how do the bookworms arrive at this conclusion? They use back-testing, which means they take all of the stocks in the universe, divide them into groups based on risk, and see which group did the best.
Now, call me a Fool, but that sounds like the way a computer -- not a person -- would manage a portfolio. Why arbitrarily buy a fifth of the stocks in the entire market when you can cherry-pick the best? (There's no need to answer that. I was simply proving my point.)
A simple principle
With individual stocks, low risk can equal high return. This is because each stock has an intrinsic value. The more a stock descends below its fair value, the less likely it is to fall further. And the upside will be far greater when it bounces back to what it's actually worth.
Monsanto (NYSE:MON), a leading company in agricultural biotechnology, had a terrible 2002, even beyond the genetically modified food controversy. For Monsanto, it started with Solutia -- which was spun off by Monsanto's parent company, Pharmacia, in 1997 -- losing a lawsuit for dumping PCBs. That left Monsanto potentially liable. Then, in the summer of 2002, Monsanto missed earnings because of bad weather and difficulty collecting some Latin American receivables. At that point, the market decided to react to the not-so-new news that Round-Up, the herbicide that had historically driven Monsanto's growth, went off patent in 2000. The stock cratered, driving the company to a single-digit price-to-free-cash-flow ratio.
But Monsanto was still a leading company in an exciting -- though controversial -- industry. After all, the problems it had suffered were only temporary. It looked incredibly cheap. And during the next few years, Monsanto became one of the top-performing stocks in the S&P 500, as shareholders quintupled their investments!
The truly great investors are able to take advantage of short-term market irrationality. They see the reward, even in times of risk. I'm thinking of Warren Buffett with Coca-Cola (NYSE:KO) and USG (NYSE:USG); Bill Miller with Amazon.com (NASDAQ:AMZN) and Capital One Financial (NYSE:COF); and Marty Whitman with Nabors Industries (NYSE:NBR) and St. Joe (NYSE:JOE). In each case, the managers were able to purchase stocks when temporary bad news or market sentiment had driven down prices, and they thereby achieved excellent returns.
If you're looking for the sweet spot -- where you get lower risk and higher returns -- look for stocks trading at a discount to their fair value. Motley FoolInsideValue can help you find them. Simply click here to learn more.
This article was originally published on Jan. 17, 2006. It has been updated.
Fool contributor Richard Gibbons, a member of the Inside Value team, considers it risky to go anywhere without an umbrella. He does not have a position in any of the stocks mentioned in this article. Coca-Cola is an Inside Value recommendation. Amazon is a Stock Advisor pick. The Motley Fool has adisclosure policy.
