The Dumbest Investment I've Ever Seen

While 2008 was a bad year for us individual investors, it was downright nasty for the Wall Street smarty-pantses who started this mess.

If "sophisticated" traders at companies such as JPMorgan Chase (NYSE:JPM), Morgan Stanley, and what's left of Lehman Brothers learn anything from this debacle, we can hope it will be that they need to rethink the wisdom of massive debt and absurdly complex financial products.

They clearly haven't learned it yet
Take credit default swaps (CDSes) on U.S. government bonds, for example. They're essentially insurance policies. If the U.S. Treasury defaults on its loans, credit default swaps guarantee that other Wall Street firms will pay those claims.

It's true that, since October, the Treasury's balance sheet has taken on additional risk in the form of TARP and other bailout-related obligations.

But wait: What scenario can you imagine that would wipe out the U.S. Treasury yet leave AIG or even Goldman Sachs (NYSE:GS) in good enough shape to pay out billions in T-bill claims?

Coming up blank? Me, too.

Talk about a dumb investment
CDSes on U.S. government bonds are like insurance policies on a Monopoly game: Either you win and didn't need the policy, or you lose and get an IOU for money that's not worth the paper it's printed on. In other words, whatever happens, you're now down by whatever amount you paid for that policy.

So, why would some of the smartest minds in finance buy them?

Strangely, our brains are hard-wired to prefer perceived certainty over uncertainty -- even if it sometimes means taking on higher risk. This psychological fact -- which is known as the Ellsberg paradox -- partly explains why Wall Street would take a certain loss in return for the false sense of security that credit default swaps on T-bills provide.

That got me thinking ...
If the dumbest investment around amounts to one with all downside and no upside, then the smartest would be the investment with almost no downside but tremendous upside.

And in fact, that's exactly what the best investors look for. Mohnish Pabrai, whose Pabrai Investments has managed 12.7% annualized returns since its inception almost a decade ago, compared with negative 0.3% returns for the Dow, explains his market-beating strategy as "heads, I win; tails, I don't lose much."

That is to say, he looks for:

1. Simple, stable businesses with moats and high returns on capital -- think PepsiCo (NYSE:PEP).
2. Distressed businesses in distressed industries, such as Starbucks (NYSE:SBUX).
3. High-uncertainty, low-risk situations. He cites Microsoft as an example, which in 1980 bought QDOS for $50,000 and sold a modified version -- MS-DOS -- to IBM. One year later, Bill Gates took a sneak peek at a Macintosh mockup and got the idea of a mouse and graphical user interface for free. It wasn't clear if either MS-DOS or the graphical user interface would work. If they didn't, it wouldn't much matter to the bottom line. But if they did, it'd make quite a difference indeed.
4. Large margins of safety. Warren Buffett's big bet on The Washington Post in the early 1970s for less than one-quarter its estimated intrinsic value netted his company $800 million on a $10.6 million investment.

Together, these criteria

1. Limit your risk.
2. Maximize your upside.

In other words, they're exactly the kind of smart investments we're looking for.

What does Pabrai like today?
Environments like this one are ripe for Pabrai's strategy because the market is full of stocks that Wall Street won't touch because it confuses uncertainty with risk.

As he recently told my Foolish colleague Morgan Housel, "Because of all the recent turmoil we've seen, there are some incredible opportunities outside the financial-services space. Right now, that's really the place to make some hay!"

Specifically, Pabrai says he's looking for companies trading at a discount to their future cash flows. Who fits those criteria right now? I ran a screen to find stocks that are highly profitable, enjoy increasing sales, and are trading at low free cash flow multiples:

Data from Capital IQ (a division of Standard & Poor's).

None of these are official recommendations, but they could be interesting starting places for further research.

What you should do
Right now, the market is clearly pricing some bad news into stocks, which means that just like Buffett, Gates, and Pabrai, you can make a lot of money if you're willing to put in the work to separate the value traps from the tremendous bargains that are out there. To do that, you'll want to make sure your investments have:

• Strong moats.
• Limited or unlikely worst-case scenarios.
• Honest and capable management.
• Significant margins of safety to their book values or discounted cash flows.

These are just some of the criteria we, like Pabrai, look for when we evaluate investment opportunities at Motley Fool Inside Value. If you're interested, you can access all of our analysis, research reports, and best ideas for new money now. Click here to get started -- there's no obligation to subscribe.

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This article was originally published Jan. 29, 2009. It has been updated.

Ilan Moscovitz doesn't own shares of any company mentioned. Medco, National Oilwell, and Starbucks are Motley Fool Stock Advisor picks. Microsoft and Starbucks are Inside Value recommendations. PepsiCo is an Income Investor pick. The Motley Fool owns shares of Starbucks and has a disclosure policy.