Early last week, I saw an article in the New York Times  that really concerned me. The headline tells you everything you need to know: “Public Pension Funds Are Adding Risk to Raise Returns.”
I can’t even begin to tell you what a bad idea this is … but I’ll try.
As a value investor, it pains me when anyone —in this case, entities responsible for the retirement income of potentially millions of individuals —foolishly ignores one of the most basic rules of successful investing: You should invest only in what you know.
And I can guarantee you that the people running these pension funds have no idea what they’re getting themselves into. Here’s more from the New York Times article:
States and other bodies of government are seeking higher returns for their pension funds, to make up for ground lost in the last couple of years and to pay all the benefits promised to present and future retirees. Higher returns come with more risk. In effect, they’re going to Las Vegas … double up to catch up.
Public pension funds are trying a wide range of investments: commodity futures, junk bonds, deeply discounted mortgage-backed securities and margin investing. And some states that previously shunned hedge funds are trying them now.
Junk bonds? Mortgage-backed securities? Margin investing? Listen … I realize there’s some pressure on these pension funds because of the losses they’ve likely incurred in the last few years. But let’s be honest —they’re just throwing good money after bad here.
Would you feel comfortable with funds for your future pension being invested in junk bonds or mortgage-backed securities … especially now? I didn’t think so.
Peter Lynch once advised that one should “never invest in any idea you can’t illustrate with a crayon.” And I think this is a prime example of a group of people —in this case, pension fund managers —who can’t find their Crayolas.
How You Can Avoid Making This Same Mistake:
Always Understand What You’re Investing In
Each time you make a buying decision, you should be able to understand how the business makes money and what products or services the company sells.
I’m not saying that you need to become an expert and understand everything about the company. I realize that you are not running the business on a daily basis and that you can’t possibly have the knowledge a middle manager who works within the company has, but you should have a working knowledge of how the company makes and spends its money.
The important things to understand about the business are the factors that will affect sales, earnings, and cash flow, all of which are very knowable. If you don’t understand these factors, it will often be too late before you realize that the company is on the way down.
Now let’s think back to the people running those pension funds for states and other government agencies … Do you really think they understand all the factors involved in how the junk bonds, foreign stocks, or mortgage-backed securities go up or down?
Of course they don’t.
Not unlike a gambler on a losing streak, they’re simply looking to make back all their losses with one big bet. And make no mistake —gambling is exactly what you’re doing when you invest in something you don’t understand.
Here’s a simple rule: If after five minutes you can’t figure out what the company does, move on. Warren Buffett had this to say when encountering a business that is too difficult to understand:
Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree of difficulty doesn’t count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.
Know What You Don’t Know —and Stick to What You Do Know
After doing research on a company, make a purchase only if you are highly confident that its earnings and sales will be as consistent and predictable over the next five years as they have been in the past five years.
Certain industries have very consistent and predictable operating histories. One example of an industry to avoid is the airline industry, which has proven to be very inconsistent and unpredictable. The price of fuel and the threat of terrorism can put a big damper on earnings and sales for long periods of time.
A consistent operating history is very important when you are trying to predict future growth rates. If the past operating history is erratic, how can you project the future? Finding those companies that have a consistent long-term operating history is not such a daunting task. Out of a universe of all stocks traded on the U.S. exchanges, fewer than 200 have long-term (10 years), consistent, and predictable operating (sales and earnings) histories.
I especially like what Larry Coats, Jr., Co-Manager of Oak Value Fund has to say about predictability:
Predictability is a key part of valuing a company, with value determined by the amount of cash an enterprise can generate over time. If you can’t understand the business, you can’t value it. If you can’t value it, you shouldn’t own it.
Sticking with companies that consistently increase sales and earnings greatly minimizes your risk of permanent capital loss on your investment.
Knowing what companies to avoid is just as important as knowing what companies to focus on. By sticking with companies that have understandable businesses, a consistent operating history, and an enduring competitive advantage, you put the laws of probability in your favor.
Like Warren Buffett, the next time you are searching for investments, have three boxes on your desk marked IN, OUT, and TOO HARD. Put anything you can’t easily figure out in the TOO HARD box. By knowing what you don’t know —and sticking to what you do know —you will already be way ahead of the crowd.
That’s a “rule” I follow very closely when identifying opportunities for the Prime Time and Special Situation portfolios.
Every single company I’ve recommended to my subscribers has three essential components:
1. The company’s shares are trading at a discount.
2. The company offers tremendous long-term profit potential.
3. The company has a business I can clearly understand.
This month’s selections —Harry Schein, Inc. (NASDAQ:HSIC), and Deckers Outdoor Corp. (NYSE:DECK) —have the three essential components I look for. Their shares are trading at a discount to my estimate of the worth of their underlying businesses, they both have favorable market positions in their industries, and their businesses are easy to understand.
Hopefully they will trade lower over the next few weeks and give us an opportunity to add these two fine businesses to our portfolios.
About the author:
Hidden Values Alert has been named one of Marketwatch.com’s 10 Best Advisors from October 2007 to January 2015…a period that included the Financial Crisis of 2008 and the subsequent bull market that began March 2009.
While many gurus boast of astronomical rates of returns over very short time spans, their claims don’t stand up to scrutiny. Instead, their “returns,” when reviewed by an independent third party, melt away faster than ice cream on a hot summer day.
The returns that Charles has racked up are certified by Hulbert Financial Digest – the fiercely independent rating service that tracks the performance of financial newsletters.
Charles is also the author of the highly acclaimed book, Getting Started in Value Investing (Wiley).