7 Key Tips to Value Investing

My early days of investing involved some speculative purchases of Priceline and Kmart.  The first one turned out great and inspired a passion for investing.  The second one?  Not so much.  Kmart was bankrupt when I bought it, and I soon learned that meant shareholders might receive absolutely nothing when the company emerges from bankruptcy.  I learned the most important lesson of all from the Kmart failure:  never lose money.  Here’s a look at why that’s important, and some other key tips I’ve mastered over the years.  If you have any other tips, leave them in the comments.

1.  Never Lose Money.

Warren Buffett’s number one rule is never to lose money.  His rule number two is to never forget rule number one.  That’s how important this is.  After all, when you lose money, you have to gain an even higher return just to return to where you began.  For example, if you invest $1000 in Company A and the investment falls to $500, at that point, you have to double your money just to get your investment back.  So the key, of course, is to avoid investing in companies that may drop in value.  That’s easier said than done, but the simplest way to do that is by only investing in companies that have strong financials.  Look at the balance sheet to review things like the company’s current ratio, amount of long-term debt, amount of intangible assets, and other key items indicating whether the company’s financial accounts are in good order (for more information about reading balance sheets, check out the ModernGraham Academy’s Intro to the Balance Sheet course).  Look also at the income statement to review whether the company has achieved a profit consistently over time, and if the net income of the company has grown over time.  Good financials don’t guarantee an investment will not lose money, but they sure help.

2.  Invest.  Don’t Speculate.

The first chapter of Benjamin Graham’s classic The Intelligent Investor deals specifically with the difference between investing and speculating.  In general, pure investing promises a safety of principal and an adequate return, and anything else is speculating.  In reality, there are no investments that completely promise a safety of principal (not even treasury bonds anymore!).  My belief is that the line should be drawn in that an investment provides a return through capital gains as well as income, so long as the investment itself does not involve so much risk that it would effectively be speculating.  Therefore, common stocks that pay dividends may qualify as investments, while common stocks that don’t pay dividends are speculative.  After all, if there is no dividend income, you are merely speculating that the company will grow in value.  If there is dividend income, you may be speculating about the growth of the company, but you are also investing in the return of your investment through the dividend payments.  Dividends are key to investing wisely.  Don’t forget that.

3.  Don’t Invest on Margin.

Graham also said that “In our conservative view every nonprofessional who operates on margin should recognize that he is ipso facto speculating…”  This is absolutely true.  Buying on margin involves speculating that your purchase will not only provide safety of principal and an adequate return, but that the return will also be greater than the cost of borrowing.  An intelligent investor does not know how soon the return will be achieved, because of the uncertainty that is inherent in the market (see the next point about Mr. Market).  Rather, the intelligent investor knows only that his investment should not decrease in value and should provide an income.  As a result, guessing about whether a return will be adequate in time to beat a given cost of capital is speculating on its face.

4.  Don’t Listen to Mr. Market.

The classic story of Mr. Market, as told by Graham in chapter 8 of The Intelligent Investor, explains in essence that the market is irrational.  The intelligent investor will do research and arrive at a given value for an investment, and the market will say the investment is worth something completely different on day one.  Then on day two, there will be a whole new value from the market.  Some days, the market will be right, but most days the market is wrong.  On the best days for intelligent investors, the market is crazy stupid, and opportunities for profit exist.  The best thing to do is to ignore the daily swings of the market, but pay attention to the trend in price of your investments.  Know how much the companies are worth, and don’t be afraid to make a move when the market is way off from where you believe the value lies.

5.  Don’t Forget a Margin of Safety.

Humans make mistakes.  All intelligent investors are human (or at least as far as I know…).  Therefore, intelligent investors will make mistakes.  By leaving yourself a margin of safety in your valuation, you can account for the inevitable mistake.  Think of your safety margin like the moat that helps protect your principal which is the castle.  For me, I use multiple safety margins.  First, the ModernGraham valuation formula estimates a growth rate based on the growth in the normalized earnings per share, then it decreases that estimate by 25% before using it in the valuation (the total possible growth rate is also capped at 15% per year).  Then, once the valuation is complete, I only will purchase a stock if it is trading at less than 75% of the value I’ve calculated.  Together, these safety margins help protect from loss of principal, thus helping to achieve Buffett’s number one rule (see above).

6.  Don’t Listen to Bad Management.

When an investor purchases common stock in a corporation, the investor becomes an owner of the company.  Many investors forget this concept, instead simply viewing the purchase of stock as a way to make a quick buck.  This attitude can lead to loss of principal if the investor is not paying attention to the performance of company management and it turns out the management makes terrible decisions.  Intelligent Investors take advantage of owning a share of the company and become involved in exercising shareholder rights.  This doesn’t necessarily mean becoming an activist, but it does mean reading the annual reports and participating in shareholder meetings either in person or via proxy ballot.  As a shareholder, your vote counts.  Use it.

7.  Don’t Stop Reading.

Always look to learn more about value investing, or any other endeavor you pursue.  Grow your understanding of what you are doing and you will become better at it.  For value investing, begin by reading Graham’s The Intelligent Investor, if you haven’t done so already.  Graham’s Security Analysis is also useful, but is a much more technical book.  After that, read some of the Berkshire Hathaway shareholder letters.  Check out more of our site here at ModernGraham, or visit other blogs such as Value Investing News, CSInvesting, or some of the others in our blogroll in the left sidebar.  There is a lot of good material out there for learning, and I hope you never stop striving to research.

What other tips do you have for value investors?

Photo Credit:  Benjamin Clark