Avoiding Blow-Ups

Everyone loves a big winner. The problem is: most don’t focus enough on the odds of winning big.  

In baseball, a batter who swings from his heels and knocks it out of the park is considered a hero. In football, a 50 yard Hail-Mary pass that ends in a touchdown is called miraculous.  In basketball, a wild three-point shot that wins the game is considered stellar. But, what are the odds of those outcomes? Sport statisticians know the numbers, and most complain about the show-boats who pull such stunts. Why? Because they know that the odds are terrible, and that it doesn’t consistently win games.

Why do people dwell on big wins? Because huge victories are vivid–everyone can imagine themselves as the star. And, big wins seem much easier than hard work over many years.  Who wants to slog away in obscurity for years hitting singles? Most people don’t–they want home-runs!

When it comes to investing, this attitude is extremely unproductive. Instead of trying to get steady returns over time, investors eagerly gamble their hard-earned savings hoping they can score a big win. 

With investing, as with many other things, this just doesn’t work. If you don’t beleive me, examine the record of Warren Buffett, or almost any other billionaire. You won’t find that they “invested” in a lottery ticket or bought Apple stock.  

Most investors, unfortunately, seem to think that swinging from their heels is how you win, and they invest accordingly. Their results illustrate the failure of such an approach.

As contrast, look at Buffett’s two rules of investing:

  • Rule #1: don’t lose money
  • Rule #2: never forget rule #1

Anything in there about making a big gamble and aiming for a big score? Nope.

Why the boring approach of avoiding losses? Because it works. Show-boating doesn’t win in sports, buying lottery tickets doesn’t lead to happiness, and investing in “winners” that are “certain” to go up a lot doesn’t generate enviable investment results.

Why not pick winners? Because that’s what tons of other people are trying to do, and companies perceived as winners have stock prices that reflect investors’ generally high opinion. The high competition in picking winners makes it a losers game.

There’s not a lot of competition, however, in picking companies that are considered losers. Not surprisingly, this means the odds of good outcomes from investing in supposed “losers” are much better. There is a risk, of course, of investing in the unloved: they may turn out to really be losers.  

And that is why Buffett and so many other value investors focus on avoiding blow-ups. If you buy something that tanks, it will pull you down more than your winners will pull you up. If you can do everything in your power to avoid such blow-ups, your returns will be good–perhaps very good.

How can you minimize the risk of blow-ups? I’ve found there are two keys:

  1. Avoid blow-up situations
  2. Don’t pay too much for a company

Blow-up situations can be due to financial problems. If a company finances its operations with too much debt, it can go bankrupt and its stock can get wiped out. If a company needs funding and it can’t get it–even temporarily–lenders may end up owning the company and you’ll own a worthless stock. This means avoid companies that may have leverage or liquidity problems.

Blow-ups situations also occur for business reasons. Most buggy whip makers were toast as soon as Ford’s cars were a success.  Technological obsolescence can kill a business seemingly overnight. A major change in end markets, like people getting their information from the Internet instead of newspapers, can kill a business, too. Supply can dry up. Regulations can alter the landscape forever. Competition can steam-roll weak players. Business risk is the hardest to assess, but one of the most frequent causes of blow-ups. You have to do a lot of research to assess this risk.

Management is another cause of blow-ups. They can do it with fraud, like Enron or Worldcom; or they can do it with incompetence, like Kodak; or they can do it with bad capital allocation, like Tyco. Management risk may seem harder to judge than business risk, but I find it’s much easier to detect. Evasive management is one thing to look for. Another is inconsistency in measuring their own performance: one quarter it’s sales, then next its market share, the next its customer satisfaction.

Doing everything you can to avoid blow-ups is crucial, but not enough. Sometimes, unpredictable things happen: hurricanes hit, earthquakes occur, sound businesses turn out to be unsound because of new technology that no one saw coming.  If you invest assuming you know everything, you’ll get burned. Acknowledge, from the get-go, that you’re not omniscient, and pay a low price for your investments.

Paying a low price protects you in two ways. First, if a company turns out to be a blow up, you’ll do less damage if you paid a low price. Second, you’ll earn much better returns on the companies that don’t blow up–because you paid a lower price–and that will allow your winners to make up for your infrequent and low-loss losers.

Investing success comes from putting the odds in your favor, and using the right approach. Don’t try to swing for the fences. Instead, avoid picking losers and don’t pay too high a price.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Avoiding Blow-Ups