1. Leave a margin of safetyBenjamin Graham, father of modern security analysis, taught that building a margin of safety into your investments is the single most important thing you can do to protect your portfolio. There are two ways you can incorporate this principle into your investment selection process.
- Be conservative in your valuation assumptions
As a class, investors have a peculiar habit of extrapolating recent events into the future. When times are good, they become overly optimistic about the prospects of their enterprises; as Graham pointed out in his treatise The Intelligent Investor, the chief risk is not overpaying for excellent businesses, but rather, paying too much for mediocre businesses during generally prosperous times.
To avoid this sorry situation, it is important that you err on the side of caution, especially in the area of estimating future growth rates when valuing a business to determine the potential return. For an investor with a 15 percent required rate of return, a business that generates $1 per share in profit is worth $14.29 if the business is expected to grow at 8 percent; with expected growth of 14 percent, however, the estimated intrinsic value per share is $100, or seven times as much!
- Only purchase assets trading at substantial discounts to your conservative estimate of intrinsic value
Once youve conservatively estimated the intrinsic value of a stock, you should insist upon an additional margin of safety. Going with our prior example of a company with an estimated intrinsic value of $14.29; you wouldnt want to purchase the stock if it was trading at $12.86; thats only a 10 percent margin of safety. Instead, youd want to wait for it to fall to around 2/3 of your estimate of intrinsic value, or $9.57. This isnt bound to happen often, but if you monitor enough companies and have patience, the securities markets do extraordinary things. In the 1970s, for example, there was a period of several years where you could buy top-quality insurance companies at 2 or 3 times earnings!
2. Only purchase businesses you understand (recognize your own limitations)How can you estimate the future earnings per share of a company? In the case of Coca-Cola or Hershey, you could look at per-capita product consumption by various countries in the world, input costs such as sugar prices, managements history for allocating capital, and a whole list of things. You understand how these businesses make their money, the corollary being that you are able to make reasonable assumptions about future performance.
Yet, many investors ignore this common sense and invest in companies that manufacture products outside of their knowledge base. Unless you truly understand the economics of an industry and are able to forecast where a business will be within five to ten years with reasonable certainty, do not purchase the stock. In most cases, your actions are driven by a fear of being left out of a sure thing or forgoing a huge fortune. If that describes you, youll take comfort to know that following the invention of the car, television, computer, and Internet, there were thousands of companies that came into existence, only to go bust in the end. From a societal standpoint, these technological advances were major accomplishments; as investments, a vast majority fizzled. The key is to avoid seduction by a sexy industry; the money spends the same, regardless of whether you are selling hotdogs or microchips.
To be a successful investor, you dont have to understand convertible arbitrage, esoteric fixed-income trading strategies, stock option valuation, or even advanced accounting. These things merely expand the potential area of investment available to you; valuable, yet not critical to achieving your financial dreams. Yet, many investors are unwilling to put some opportunities under the too difficult pile; a reluctance that is part pride and part unfounded optimism. Even billionaire Warren Buffett, renowned for his vast knowledge of business, finance, accounting, tax law, and management, admits his shortcomings. At the 2003 Berkshire Hathaway stockholder meeting, Buffett, responding to a question about the telecom industry, said: I know people will be drinking Coke, using Gillette blades and eating Snickers bars in 10-20 years, and have a rough idea of how much profit theyll be making. But I dont know anything about telecom. It doesnt bother me. Somebody will make money on coca beans, but not me. I dont worry about what I dont know I worry about being sure about what I do know. This ability to realistically examine his strengths and weaknesses is one way Buffett has managed to avoid making major mistakes over his considerable investing career.