I’ve spent the past 30 years studying the world’s greatest investors.
I’m talking about the top hedge fund managers and billionaires who have outperformed the market for decades.
I have become a better investor by rooting out and adopting the best parts of their investment processes.
In doing so, I have found that a large percentage of these investors share a similar mindset in regard to building a portfolio…
They seek out stocks that represent attractive asymmetric investment opportunities.
These exceptional stocks come with two characteristics:
- They have very little downside if the investment thesis fizzles.
- They have enormous upside if the investment thesis pans out as expected.
Hedge fund manager Mohnish Pabrai likens this investment approach to a coin flip.
If the coin comes up heads and the investment doesn’t quite work out, Pabrai doesn’t lose much.
If the coin comes up tails and the investment works out perfectly, Pabrai has a home run on his hands.
He sums up his approach like this: “Heads I win big; tails I don’t lose much.”
Another hedge fund manager, Mark Sellers, says that if you focus on the downside first, the upside will take care of itself.
The great Warren Buffett even uses this approach to investing.
Buffett’s first rule of investing is, “Don’t lose money.”
His second rule of investing is, “Don’t forget rule No. 1!”
So How Do You Asymmetrically Invest?
Understanding asymmetric investing as a concept isn’t difficult.
The hard part is finding the right stocks to own so that you can put it into practice.
Step No. 1 is finding companies that offer the downside protection we’re looking for.
That downside protection can come from a huge cash balance on the balance sheet, cash flow from a legacy business unit or real estate value that supports the current value of the stock in the market.
Once you find a stock with solid downside protection, you want to seek out the big upside. Your pick should have huge potential that the market isn’t pricing in.
I like to think of this approach as finding solid companies with free lottery tickets attached to them.
Only, in this case, unlike with a lottery ticket, the odds of success aren’t one in a million. They’re more like 1 in 5, or even better.
Here are some examples of lottery ticket-level upside:
- A new business line with exploding growth that lies within an existing company
- A hidden asset that the market doesn’t know the company has that will soon be monetized
- A blockbuster announcement on a new product, discovery or business practice that is a game changer.
In early 2008, I was able to piggyback on an asymmetric opportunity that I found in the portfolio of Mohnish Pabrai.
The company was Fairfax Financial Holdings (OTC: FRFHF), a company that quietly held a huge position in credit default swaps tied to financial institutions.
That meant Fairfax was positioned for a windfall profit from the ensuing global financial crisis.
No value was assigned to these credit default swaps in Fairfax’s share price. The reinsurance business provided the downside protection.
When Fairfax revealed in the fall of 2008 that it had made more than $2.1 billion from its credit default swaps, the company’s stock price soared while the rest of the market melted down.
From September 2008 through February 2009, Fairfax shares were up 75% while the S&P 500 crashed by 33%.
It was asymmetric investing at its finest.
Certain industries are perfect for this type of investing approach.
The best example I can think of is biotech, where potential blockbuster drugs undergoing trials can be attached to companies with massive amounts of cash in the bank or existing cash-flowing operations from drugs already in production.
If the blockbuster new drug realizes its potential, the stock is a home run.
If the drug fizzles, it isn’t a problem. The stock price is supported by cash that the company holds or cash flow that it generates from the rest of its business.
In my experience, the key to successfully deploying this strategy is patience.
Great asymmetric opportunities rarely come around, but when they do, they can produce exceptional results.
You have to turn over a lot of rocks to find a gem.