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The Daily Crux Sunday Interview The three biggest risks all investors face... and the easiest ways to avoid them The Daily Crux: Dan, in your latest issue of Extreme Value, you wrote about the three biggest risks all investors face. Can you tell us what these risks are? Dan Ferris: The three big risks are pretty simple to understand, but they're probably the biggest reasons people lose big money in stocks. The first one is business, or earnings risk. This is the risk that people generally think of most often. This is the risk that the company suffers a loss in its earning power through any number of causes, like economic problems, industry changes, management missteps, or even fraud. ---------- Advertisement ---------- Little known "A.O.P." Increases Payouts 10% a year While most companies are slashing dividends at a record pace, one type of investment known as the "A.O.P." has been quietly increasing payouts by 10% a year, on average. And now, the A.O.P. is poised to issue its biggest payout to date. Click here for more information. ---------------------------------------- Now, what has become the classic way to avoid this risk is to find a business with an enormous competitive advantage. In the simplest terms, what you want to do is find a business whose earnings are extremely likely to recur again and again. A great example is a company like Wal-Mart. There's little doubt that they're going to keep making money, because they have a huge competitive advantage. They can undercut everyone on price. ExxonMobil is another great example. They're almost certain to keep making a profit, because they're highly disciplined capital allocators, and they're a low-cost provider. So that's really the best way to handle business/earnings risk. It's easy when you buy the world's best companies, like the World Dominator stocks in the Extreme Value portfolio, but it can be trickier when you're dealing with other stocks. You need to make judgments about the business, its competition, and what the future may look like... but it's important to consider this risk before buying any stock. The next big risk is balance sheet/financial risk. By far the biggest mistake most investors make here is they buy companies that use a lot of leverage. Leverage is dangerous... it goes both ways, as we saw with financial companies over the past several years. Sure, it can allow you to earn more and get higher returns on equity when things are good, but it can also cause you to go bankrupt surprisingly quick if things get bad. This one's probably the easiest to avoid... just stay away from highly-leveraged companies, especially highly-leveraged financial companies. You need to take a look at a company's balance sheet. Avoid companies with lots of debt... try to find companies that have little or no debt and plenty of cash on the balance sheet. A great example here – that we do own in the Extreme Value portfolio – is Forest Labs (NYSE: FRX). Its management has made it clear that they like to have a really strong balance sheet. They use zero leverage. They started the year with around $4 billion in cash and zero debt. They're known for carrying no debt. And it's otherwise a great business: pharmaceuticals. Finally, you've got valuation risk. This is the one risk that investors have complete control over, but it's probably the one people most often overlook. It's simply the risk that you pay too much for a stock. The price you pay plays a huge role in whether you're going to make or lose money in a stock. It could be a really great business with low earnings risk. It can have a really great balance sheet, and little to no financial risk. But if you pay 50 times earnings for it, you're basically guaranteed to lose money, because it's an extremely rare business that's worth that much. So even if you avoid the first two risks, you still have to understand what the business is worth. Now the great thing about this is if you do get the first two right, it makes this step easier... much easier. If you're looking at a great business, like a World Dominator, that's got a great balance sheet and low earnings risk, it's much easier to figure out how much it's worth. It's much more difficult to value companies that have financial or earnings risks. An example here might be an oil and gas drilling company... a company that's highly cyclical and is basically a derivative. By that I mean it's one step removed from the price of oil. So there's the price of oil, which fluctuates unpredictably, and makes it difficult to value even the oil and gas companies themselves. But with the drillers you're another step away... You're talking about the daily rates they get, which are volatile as well. So it's very difficult to tell what a driller is worth. That's not to say it can't be done, but it's much more difficult, and it helps to be intimately familiar with the business. Even then, you'll probably never avoid valuation risk to the extent you would with a business that has low earnings and financial risk. The idea behind these strategies is – if you do them right – you'll know exactly what you're buying, exactly what to pay, and what kind of risk you're taking. If you do these three things, you're chances of losing money go way, way down. Most people don't think in those terms. They want to see a lot of upside, and they want a sexy story. But investing is kind of like a seesaw... When you can dramatically lower your chances of losing money, you've dramatically raised your chances of making it. Crux: That's a great point... When you look at the most successful investors in history, they've tended to approach investing from that viewpoint. Ferris: Right. Jim Rogers always said that he looks down first. He looks down before he looks up. Warren Buffett said rule number one was “Don't lose money.” And his second rule was “See rule number one.” That's what all the successful investors do. They figure out their risk. They're obsessed with figuring out how much risk they're taking. Only then do they think about the return. Crux: Besides avoiding those three big risks, you said there's one other factor that can greatly increase your chance of investment success. Can you talk about that? Ferris: Absolutely... This one is so simple but it really is one of the most important factors for investing success: it's time. Time is why value investing will always work. It's why there will always be an advantage available to anyone who wants it, because it's the one advantage nobody wants. Nobody wants the advantage of waiting [laughs]. Everybody wants to get rich overnight, and they think the stock market is about playing a game where you make a million dollars overnight, but it's not. It's about ignoring everybody else, finding out what the good businesses are, and holding them for 20 years. In Charlie Ellis' book, Winning the Loser's Game, he cites research that says the S&P 500 has had no losses over any 20-year period from 1900 to 2000. Not a single loss over any 20-year year period. When you've got no losses, your certainty of making money has just gone to 100%... And your certainty that you're not going to lose money has gone to 100%. All you have to do is wait. And you're not just waiting for 2% a year, either. You're waiting for 7% or 8% a year, which is enough. If you can make 8% a year for 20 years, that's five times your money. That's pretty darn good for doing absolutely nothing... almost for being completely passive. And the best part is, it's right there for everyone. It's an easy, obvious, competitive advantage that anyone can get. Just like Wal-Mart has a competitive advantage, just like Intel has a competitive advantage, you can dominate the stock market like a world dominating business. You can do it by simply mastering time and having patience and understanding that, when the stock market falls, that's your opportunity to buy more. And if it goes up and gets really crazy, that's your opportunity to maybe collect some profits. But in between, you know, unless it does get really crazy, the smart thing to do is to stay in for a long, long time. Now, the easiest way to get the certainty of time on your side is to simply put a portion of your investment money into an index fund. That's the no-brainer, completely passive way to do it, and you'll get that 7% or 8% return over a long period of time. But I also love the idea of taking advantage of time with the world's best businesses. You could build a 20 or 30 stock portfolio with a core position in World Dominator-type franchises, and then fill it out with some second-tier stocks – you know, other quality businesses that don't quite qualify as true World Dominators and are a little more speculative. You could hold that portfolio for 20 years, and very likely, what will happen is you'll get nice gains out of the World Dominators. They'll compound your money at a good rate over a long time, and will likely outperform the market. The rest of the stocks – the second-tier ones – will compound your money pretty well, too, but you'll likely have a few stocks make big moves. You might even have one that goes to zero, but you'll probably also have one that returns 20 or 30 times your money. Over time, you could expect a really nice return. Crux: For readers who may not be familiar with your arguments about World Dominator stocks, can you explain why you think they're great stocks to hold for the longterm? Ferris: It's simple... World Dominators are the best ones to hold for a long, long time because they're likely to look about the same many years from now. To refer to the risks we discussed before, they've got the lowest business and financial risk. They're most likely to keep doing what they do... and keep getting good, high returns on capital. They're number one now, and it's logical they could remain number one for some time, because so many of them have remained number one for such a long time already. Crux: We know you can't reveal all your World Dominator picks, but could you leave us with one more that you really like? Ferris: Actually, one that we've had in the portfolio in the past, which I wish we had hung onto is UPS (NYSE: UPS). When it gets cheap enough again, I'll be really, really happy to buy it and hold it for a long, long time. One of the best competitive advantages any company can have is to own the distribution system. That's what Coca-Cola does. It's got that worldwide distribution system. If it comes up with a product this month, next month that product can be selling everywhere – much faster than the competition. And the competition can't use its distribution system, so they don't have that advantage. The big pharmaceutical companies have a similar advantage. They have 20,000 reps in the field that get new drugs in every doctor's office as soon as it's available. That's a huge advantage. Wal-Mart has a big distribution advantage too, by the way. But if you just take a step back from that, with UPS you've essentially got the leading distribution system in the world. They go to every address in the United States. They go all over the world. It's the biggest package delivery service in the world. And I don't think FedEx has a chance of really catching up to them. If you go back and look historically, UPS has earned consistently thicker margins and higher returns on capital. And unlike FedEx, UPS drivers are unionized. UPS has dealt with that its whole life, and it knows how to operate in that situation. Sooner or later, FedEx drivers are going to want more security. There have been stirrings that they're unhappy already. If you read FedEx's 10-K, it warns you right in there how Congress is thinking about making changes that would make it easier for smaller groups of FedEx employees to unionize. So this could become a problem sooner rather than later. That could be really bad for FedEx. FedEx doesn't have that extra expense now, and they already get lower returns on capital and have thinner margins. If the employees decide to unionize, the added expense could really hurt them. The other thing I like about UPS is that it's a hard-asset business. You know, it's trucks. It's the ninth-largest airline in the world. It's distribution facilities, real estate. And that's worth a lot. So it's not just an intellectual property company. I don't think the need to send packages worldwide is going to do anything but grow over the next 20 years. And UPS has a huge advantage over everybody. Crux: Good stuff. Thanks for talking with us, Dan. Ferris: My pleasure. Thank you. Editor's Note: You can gain instant access to Dan's list of World Dominators – and the full list of super-safe Extreme Value stocks – by clicking here.