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Low Risk, High Potential

By Sham Gad – Updated Nov 14, 2016 at 11:23PM

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Focus on both, and you can separate values from value traps.

It's OK to make mistakes. They help you learn valuable lessons. However, you don't want to make too many mistakes when it comes to investing. Too many can eventually kill your returns.

To minimize your risk for making big blunders as an investor, and to invest successfully over the long term in general, your first goal should be to always seek a margin of safety. The key is to remember that return of capital is of paramount importance. Any percentage loss of capital requires a greater percentage gain on capital just to get back to par. For example, if an investment declines by 20%, that investment has to appreciate by 25% just to get back where you started.

So what does this mean?
It means that before you can focus on return on capital, which is important, your investing analysis should first begin by concentrating on return of capital. In other words, before allocating capital to an investment, ensure that your probability of permanent loss of capital -- in other words, your risk -- is very low, and that your potential gains are very high. If you look at some of the greatest investments ever made -- Warren Buffett with GEICO in the 1970s, Mohnish Pabrai with Satyam Computer (NYSE:SAY) in his early days, or my friend Jeff Cole with Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) back in the early 1990s -- you'll see this principle at work.

Low risk means return of capital
Mr. Market hates uncertainty, and he will punish a stock if that uncertainty continues to attach itself to a company. But given the right company and opportunity, the elimination of that uncertainty can result in triple-digit returns in a relatively short period of time. However, uncertainty usually accompanies risk, so couple just a small bit of uncertainty with a low risk proposition, and you might just have the next Pinnacle Airlines (NASDAQ:PNCL), which rocketed from $5 a share to more than $17 once the uncertainty surrounding the bankruptcy of its only customer, Northwest Airlines, was resolved. Pinnacle was a very low-risk investment -- it was trading at less than 3 times free cash flow and had cash on the balance sheet. So while there was always a possibility -- albeit a small one -- that the relationship with Northwest would not be reinstated, the then-current price of Pinnacle virtually assured your return of capital. If nothing happened with Northwest, odds were that you would have close to 100% of your invested capital ready for the next opportunity.

When asbestos was profitable
A similar opportunity occurred with USG (NYSE:USG) several years ago. Earlier this decade, the building-material company was mired in the asbestos mess and ultimately filed for bankruptcy protection, essentially to protect itself and its shareholders. At the time, the ultimate fallout from the asbestos litigation was anyone's guess, so there was a huge cloud of uncertainty hanging over the company. The stock cratered to $2 a share on the expectation that equity holders would be wiped out. Yet USG had a Fort Knox-like balance sheet at the time. The company had no debt, cash per share exceeded the stock price several times over, and business was booming -- USG was earning about $3 in free cash flow per share. With USG's stock price hovering around $2, investors were effectively being paid to own shares. Sure, USG could have been forced to pay a horrific punitive settlement that would have rendered these numbers useless, but some diligent research would have shown that the odds didn't tilt in that direction.

First, USG's asbestos claims, on close analysis, were not that large relative to the overall industry's claims. Second, company leaders' activities suggested that they were very intent on keeping shareholders solvent. They were being very careful with the company's cash and were cooperating fully with the asbestos litigation. In the end, USG emerged as one of the most successful bankruptcy recovery stories in corporate America -- it had all of its equity intact. Investors who had the conviction and patience to take advantage of Mr. Market's nervous mood bought shares in the single digits that are now changing hands at around $36 a share. Even at the current price, USG is still a compelling investment with huge upside potential, but you will have to be patient. It could be years before the housing market again experiences the type of demand that occurred over the past few years.

Time to go bargain-hunting
The current state of the market has the potential to offer some bargain opportunities. It's times like this when the enterprising investor can take advantage of Mr. Market's erratic behavior. After all, your best opportunities come when good businesses suffer from temporary setbacks that cause a cloud of uncertainty to loom above. If your initial approach is to focus on return of capital, you are a lot less likely to confuse a true bargain with a value trap.

For the Filene's Basement of true bargain stocks, come and join us over at Motley Fool Inside Value. It's free for the first 30 days

USG and Berkshire Hathaway are Inside Value recommendations. Satyam and Berkshire Hathaway are Stock Advisor picks.

Fool contributor Sham Gad is the managing partner of the Gad Partners Fund, a newly launched value-focused investment partnership modeled after the 1950s Buffett Partnerships. He has no positions in the companies mentioned. The Fool has a disclosure policy.

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Stocks Mentioned

Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
BRK.A
$406,470.00 (-0.06%) $-230.00
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
BRK.B
$267.02 (-0.95%) $-2.56
USG Corporation Stock Quote
USG Corporation
USG

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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