- Money Morning Australia

Value Investing – Three Simple Rules for Picking Stocks


Written on 13 February 2012 by Aaron Tyrrell

On Friday, one of our colleagues mentioned he’d re-read Ben Graham’s value investing bible, The Intelligent Investor.

It got us thinking about the timeless principles of value investing again. And marvelling at how you can adapt them to suit any market.

Which is just as well…


Because from around 9:45 this morning, we watched the Greeks vote for austerity. Again.

They had to. Otherwise, Greek default.

But in case you missed it, the price of the bailout has jumped from $130 billion to $210 billion, too. Where did that extra $80 billion come from? Check out Zerohedge.com for the answer.

A few of our friends are turning away from stocks and moving into fixed-income investments. They’d rather miss out on share price gains than risk losing what they’ve already got.

Whether that mirrors your own investing strategy or not, we don’t know. (Like to let us know what you think/how you’re investing in this market? Email letters@moneymorning.com.au … put ‘My Strategy’ in the subject line.)

But deserting the stock market just because things look scary isn’t always the best idea. Because that’s when the savviest investors find some of the stock market’s best valued stocks. All you have to do is follow these 3 timeless value investing principles. After all, they’ve worked for Warren Buffett.

Rule #1: Value the business, not the share


This is the number one rule of value investing. Focus on the company, not the stock.

That is, don’t worry about who is buying what – or how much a stock is climbing, or falling. It’s just noise.

You really need to look to invest in strong businesses that have sound fundamentals…

  • A solid business plan that brings in money
  • A product/service that is in demand today and probably still will be tomorrow
  • A manager that knows how to spend money the right way – that is, a manager who invests a lot of money in resources that will bring in more money rather than a reckless spender

Rule #2: Always invest with a margin of safety


If you want to make money on stocks, the simplest way is to pay LESS than what a share is worth… like buying a share worth $1 for 80 cents.

This is where good old-fashioned balance sheet analysis comes in.

The market capitalisation of a company is the value the market puts on a company. That is the number of shares on issue multiplied by the share price.

In an ideal world, a business that earns profits of $1 million a year and has $1 million in assets would have a market cap of $2 million.

But in reality, this never happens.

Earnings estimates, bullish stock price predictions cause people to buy and sell shares for almost no other reason than the hope that the stock will go up or down.

And that makes it possible for you to find ‘unpopular’ stocks that the market undervalues. I.e. a company with assets and earnings equal to, say, $20 million, but a market cap of $16 million.

That gap between the real value of the company and its perceived value is your margin of safety. And you often find it when people are feeling negative about stocks in a certain sector. (Like retail stocks before Christmas, for example.)

Rule #3: Focus on ‘fair range’ not precise value


You really only need basic math skills to work out a company’s intrinsic value… As long as you know which figures to look at…

But you need to accept you’ll probably NEVER estimate the ‘intrinsic value’ of a company to the exact cent.

No matter how much data you have about a company’s profitability and the macro outlook, you’ll probably NEVER get the intrinsic value spot on…

But you can do the next best thing…

And that is estimate a precise range of fair value… 20% above and below your best, most accurate estimate.

Once you pinpoint that ‘fair range’, you’re almost mathematically guaranteed your investments will make gains and avoid losses. Because it gives you the margin of safety that can help ensure you’re buying quality stocks at sensible prices.

Follow these simple rules and you’re on your way to almost mathematically guaranteed gains.

To find out more about how value investors are playing this market, click here.

Aaron Tyrrell
Editor, Money Morning

strong>From the Archives…

Picking the Big Investment Story for 2012
2012-02-10 – Kris Sayce

Attention: If You Have Australian Bank Stocks – Sell Them Now
2012-02-09 – Kris Sayce

Why This Bearish Indicator Means it’s Time to BUY Stocks
2012-02-08 – Kris Sayce

Why The RBA Uses The Terms of Trade Indicator… And Why You Should Too
2012-02-07 – Greg Canavan

Why the US Unemployment Rate is a Slippery Statistic
2012-02-06 – Dr. Alex Cowie


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21 Comments For This Post

  1. M&M Says:

    “In an ideal world, a business that earns profits of $1 million a year and has $1 million in assets would have a market cap of $2 million.”

    I’ve never heard of this. Well not when it comes to public companies.

    Safe secure well differentiated company with good management earning $1m per year would have to be worth between $5m to $8m. Earning between 12.5% and 20%.

    It has to earn more than the risk free rate otherwise why invest at risk. Every company has inherent risk.

    If its completely risky (like a snack bar) then yes it would be worth $1m – $2m to buy that sort of income plus stock. Note you wouldn’t buy cash holdings of a snack bar. That would be weird.

    Your assertion about valuations in a real world seem bizarre to me.

    Has anyone heard of this ideal world where risk is ignored and every business earning the same income is valued the same?

    Even a commercial property earning $1m can be worth $11-12m.

    You must mean “in an ideal world where everything is considered risky” and so should be cheap. In which case a commercial property earning $1m should be worth $1m.

  2. M&M Says:

    Make that ” In which case a business earning $1m should be worth $1m”.

    Anyway, the problem of value investing is that you have to have patience because as I’ve learned its a beauty contest and company prices can often far exceed value.

  3. Peter Fraser Says:

    Fly Me, Drood, TRB, M&M et al – read Robert Gottleibsens post at Business Spectator today re Aussie Dollar and bank funding.

    http://www.businessspectator.com.au/bs.nsf/Article/Swan-interest-rates-RBA-banks-job-cuts-AUD-pd20120214-RFSBN?OpenDocument&src=sph&src=rot

  4. M&M Says:

    Thanks Peter.

    I always thought the govt would scheme something.

    Hope it isn’t what Gottleibsen suggests nor what amounts to a MacAussie.

    This sort of interference signals a race to the bottom….. who will have the lower interest rate. Again causing malinvestment.

    Personally I want house prices to (really) slowly melt so the economy can adjust normally, and that savers can benefit.

    If inflation is low then wage growth will be low and we can then compete again.

    Anything else is surely a cocaine hit, followed by the inevitable downer.

  5. Peter Fraser Says:

    “slowly melt”

    Obviously you read at MB.

  6. M&M Says:

    I read all that I can. ;-)

    It seams to fit what should happen. What would be safest. Don’t want a crash and burn.

    What should happen and what will happen are two different things.

    I’ve been looking at Commercial Properties of late and I see the yeilds are around 7-9% net.

    What a bonanza if rates come down. I can’t remeber your take on Commercial Properties. Do you have any insights?

    Might be worth a sneeking investment if you can find a property with 9% return & mutiple tenancies to spread the risk of default.

  7. DM Says:

    M&M. May I suggest you be very careful with commercial property. The returns are always 7-12% with tenants paying outgoings it sounds pretty good.
    However, with the tough retail world and increasing difficulty in many businesses, I expect to see commercial property go backwards over the next few years.
    When there’s no tenant you are getting 0% and commercial properties can be hard to let. Banks are unlikely to lend more than 50-60% becaus of the higher risk and then they want the property revalued regularly to ensure you don’t exceed your LVR.
    I’m the executor of an estate that has a few investments in supposedly good quality commercial property trusts and the noises coming from those are not good – no redemptions, no dividends. Some are looking at bailing out of a few properties to payout their investors.
    Good luck.

  8. M&M Says:

    DM – I was thinking of looking around and waiting (could be 6 months to a year) before they’re priced back at 12%.

    I think they were priced at around 7-9% when interest rates were dropping (and depending on length of contract and tenant worthiness (if that makes sense)).

    I did see a property at circa $1.6m returning net $110k with 4 tenants, but that’s a net return of 6.9% – they’re dreaming – they’d expect a lower offer.

    Because the tenancies are quite cheep, they would be easy to fill if one or two left. But you’re right, the rent will drop when negotiating with a new tenant.

    I’ll try a sneeky bid when things deteriorate in about 12 mths. I’m sure they’d tell me to get nicked right now. But I like the idea of multiple tenancies.

    I’ll call the bank about the LVR – sounds about right.

    So for $110k you’d want to pay $1.05m (maximum right now with risk of a drop later).

    Dunno – kinda new for me.

  9. Peter Fraser Says:

    DM is correct. Actually the LVR is about 65% but close enough in my opinion.

    returns are good but tenuous as per DM’s advice.

    It’s a good time to think about commercial property if you are well cashed up and can travel without a tenant, but a bad time to think about commercial property if you don’t have the ready cash to get you through without a tenant for maybe 12 months, depending on the area.

    Retail property is risky. Many retailers are finding conditions difficult – but high risk brings high reward for those who have strength and intelligence.

  10. TRB Says:

    Well PF I did read your article good example of this was when Macqaurie Bank was toasted and Wayne Swan gave Macqaurie Bank a government funded gaurantee bond to survive the meltdown of 2008.
    Macqaurie went on a shopping spree overseas and brought many assets cheap and used taxpayers money to get a better return on interest rates overeseas.
    Wayne Swan was very angry and piss off about that so he may think twice about allowing investment bankers a free taxpayer funded ride.
    Do you really think PF the power elite in business and shareholders are going to let Wayne Swan take the cream of their profits and give it to some whingering over indebt spoil Australain?
    Lets be frank PF you cannot afford a 1% hike in interest rates then you are not living within your means.

  11. Peter Fraser Says:

    TRB – the banks only hiked about 0.10% but the media have overplayed it, and people get excited. Bank bashing is one of our national sports – that and whinging.

    A couple of points – Mac Bank is now an ADI so it has the same support any bank has, no more and no less.

    TRB – that article pointed out what they can do. All of the bank debts are in $AUD not $USD or any other currency. I don’t know why it has taken them so long to work it out, that the commonwealth can replace those foreign loans with excel spreadsheet money, make a healthy return on the money, reduce the exposure of Aussie Banks to foreign investors, and reduce the value of the $AUD in one movement.

    It just doesn’t matter what you and I think, what matters is what politicians think once this has been explained to them.

    So ask yourself – how is Gillard looking in the polls, and does she need a political masterstroke that brings 35% of the population lower cost home loans, would she stoop to buying votes?

    What is your answer to that question?

    What would Abbot do in the same circumstance?

    Voila……..

    NB. – that the $AUD may not reduce that much as the foreign debts would reduce by the same amount that the government deficit increased, so forex markets may see it as much positive as it is negative – who knows.

    Not so much different in essence as Steve Keens idea to just print and give money to everyone to repay debts. This would be better targeted for the economy.

    Macrobusiness have an article on it if you want more info.

  12. TRB Says:

    PF looking at one side of the story that is the whingers in big debt?

    What about savers and productive people they vote too PF?

    USA the investment banks took control of the government and got their way, do you really think Gillard government is going to stand up to big powerful business interests?

    Has this hubris government learnt it’s lesson on the mining and carbon tax yet?

    Does this government want a third lesson now on trying to reduce interest rates and take the big banks profits away?

    It’s interesting you quote Steven Keen the fruit loop economist his idea of Japan getting out of deflation is to double the wages of everyone as any small business person with some common sense will tell you wages are a real cost and must be pass on to the customer.

    So Australian products and services become too expensive!

    Already we are losing jobs to Asia our steel industry and manufacturing wages are too high, so we will have higher unemployment and greater pain under Steve Keen crazy, stupid policies.

  13. Peter Fraser Says:

    TRB – I’m not a disciple of Steve Keen – I only made a reference.

    Would you rather that I hadn’t mentioned the possibility of an excel rebalance?

    Not all swans are white. Where is JC when you need him?

  14. TRB Says:

    PF I’m please your not a disciple of Steven Keen he has gone to the extreme left of politics and will do anything to keep the extreme left in power.

    PF as JC will tell you from his own experience in Japan the grey power older generation want to save and get a return on their investments this is where the real political power and votes come from not whingering first home buyers in big debt.

    American has much lower interest rates than Australain but the older generation (savers) want a decent return on their savings, zero interest rates in USA will cost Obama the election, do not underestimate the older frugal voters.

  15. Peter Fraser Says:

    TRB – it may not change rates very much. Hopefully a blogger called bb will write on this over at the APM forum. I’ll link when he does, although links to the APM are banned by this site, even though they post over there – wierd.

    Most bloggers just don’t understand the implications of this, but he usually has a good handle on this subject.

    This is an important development.

  16. Drood Says:

    Suddenly everyone here is in favour of government meddling ( TRB excepted ) LMFAO

    Thanks for the link Mr Fraser.

  17. Peter Fraser Says:

    Drood – it doesn’t matter what any of us want – what matters is what happens and how we handle that.

    We are irrelevant.

    PS – have you got my mars bar on ice – I don’t want one that has melted.

  18. TRB Says:

    TRB excepted damn right their Drood!

    I don’t need the ponzi scheme to survive and I don’t have any debt, not like most bloggers who need the debt game to continue to make more money and survive.

    Usually when I stand alone a change is happening when I mention the market was turning down in March/April 2011 everyone was screaming hyperinflation I was called shit$4brains.

    When I mention the China story is flawed last year everyone again thought I was shit$4brains.

    Back to my hole in the ground atleast I can think independently away from the herd traders.

  19. Peter Fraser Says:

    Well I never called you that TRB, as you will know – what is your call for the market right now?

  20. TRB Says:

    PF I know do have a sense of humour!

    Actually MMR did have a sense of humour as you know TRB stands for Triune Rational Brain, theory the brain has three compartments the first brain is the primitive lizard food,sex,herding,territory (war)
    The second brain is the limbic system emotions of greed,love and fear .
    Third brain is neo cortex rational planning and critical thought.

    Fourth brain is shit$4brain!

    So I can only make a call on the markets when I see the first primitive lizard brain working hard and number three and four brains are seen as fools?

    I can’t make a call at the moment because the lizard brain and limbic system is not working hard enough?

  21. Peter Fraser Says:

    Better get in touch with your emotional side TRB.

    http://www.youtube.com/watch?v=1wup_K2WN0I

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