Charlie Munger, vice chairman of Berkshire Hathaway
Back it up
Backup systems can often be the difference between life and death.
For example, would you rather be on:
• Plane A, which needs 10 critical parts to function in order to stay in the air, but where each part works correctly 99% of the time, or:
• Helicopter B, which only has one critical part that correctly functions 90% of the time, but has two backup systems that also work 90% of the time (assume under both scenarios that the probability of failures are all independent).
(For those interested, I will put my calculations below in italics.)
Helicopter B, even with seemingly lower accuracy, proves to be safer nevertheless. Even though Plane A's parts work 99% of the time, it only takes one failure to sink the whole thing, which by probability will happen nearly 10% of the time.
(calculated as a joint probability, or 0.99^10 = 90.4%)
On the other hand, Helicopter B, thanks to its backup systems, works 99.9% of the time. How can this be? Plane A requires numerous things to simultaneously work in order to function properly -- a single breakage leads to failure. Plane B requires numerous things to go wrong to break -- only one of the backup systems has to work for success.
(the probability of failure = 10% (100%-90%). The probability of three failures = 10%^3 = 0.001, or 0.1%).
Real world applications
Intelligent investors discriminate between investment theses that require numerous things to be right (as with integrated systems), versus investments that only fail if multiple things go wrong and have built-in backup systems, or margins of safety.
For example, back in the dot-com boom, momentum investor pushed Stock Advisor pick Amazon's
However, after shares plummeted more than 90% in 2000, expectations got so low that the investment thesis morphed from an integrated system, where everything had to go right to justify the lofty share price, to a backup system, where everything had to go wrong to justify the low stock price. If Amazon showed any signs of life in sales growth or margin expansion, shares would skyrocket. Indeed, shares are up over 10 times their 2000-2001 lows.
I think Inside Value recommendation USG
A lot of things have to go wrong for USG, whose shares have fallen 70% from their peak in 2006, to fail as an investment candidate. Housing would have to continue to slump in the many local markets that USG serves. Instead of continuing to build intrinsic value by building new, efficient plants or repurchasing shares, management would have to waste away USG's future free cash flows.
If, in the long run, America's population constantly grows and needs more homes, and USG's management sports a solid capital-allocation policy, I estimate a high probability that USG will rebound in the next couple of years.
Do your own research. Osmium Partners, a hedge fund whose flagship fund boasts 23% annual net returns since inception, requires that its investments pass a rigorous gauntlet in order to be considered a candidate. You should have your own process as well. Put together an investment thesis for yourself.
Need some ideas? Osmium's criteria include substantial net cash on the balance sheet, owner-oriented management, a dominant market share in a niche industry, and extremely low multiples of cash flow. Each additional criterion puts in place another backup system to ensure positive returns, helping to explain Osmium's ability to find multibagger opportunities in small-cap stocks. Put together an investment thesis of your own, and you'll be a better investor in the long run.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.