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 firms like Citigroup, Morgan Stanley (NYSE:MS), and what's left of Lehman Brothers learn anything from this debacle, I hope they'll rethink the wisdom of massive debt and absurdly complex financial products.

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

It's true that, since last 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 in good enough shape to pay out billions in T-bill claims?

Coming up blank? So am I.

Talk about a dumb investment
CDSs 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 hardwired to prefer certainty over uncertainty -- even if that sometimes means taking on higher risk. This psychological fact -- known as the Ellsberg paradox -- partly explains why Wall Street would take a certain loss in return for the false sense of security that CDSs on T-bills provide.

Which 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 Paychex (NASDAQ:PAYX).
2. Distressed businesses in distressed industries, like Las Vegas Sands.
3. High-uncertainty, low-risk situations. Concern over fertilizer prices has punished potash producers like PotashCorp (NYSE:POT), Mosaic (NYSE:MOS), and Agrium (NYSE:AGU), even though they have strong balance sheets and sell a necessary product with high barriers to entry.
4. Large margins of safety. Warren Buffett's big bet on American Express in the wake of the Salad Oil Scandal -- a fiasco that battered its share price, but didn't ultimately affect its moat -- netted his company $3 billion on a $7 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 Pabrai 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.

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

Ilan Moscovitz doesn't own shares of any company mentioned in this article. American Express and Paychex are Inside Value recommendations. Paychex is an Income Investor selection. The Fool has a disclosure policy.