Value Investing – Three Simple Rules for Picking Stocks

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

 

Money Morning Australia