WS: BUY STOCKS LIKE STEAKS, III (06 Oct 2006)

BUY STOCKS LIKE STEAKS, III
Belts and Suspenders for Stocks

Benjamin Graham was a cautious investor who took a "belts and suspenders" approach to stock picking. Once he had accepted the concept of intrinsic value as a method of determining what a company was worth, he applied it to the field of investing to get an edge over the market. He had to buy stocks selling for less than intrinsic value. He was first a credit analyst: If a company was worth X, he wanted to invest in it at less than X. Like a banker, he looked for his margin of safety, his "collateral." If he was wrong, or if some unforeseen event reduced his estimate of a company's value, he wanted a cushion. He wanted belts and suspenders for his stocks.

Think about it-- before Graham, the world of investing was composed mostly of speculators and stock manipulators. But anyone who had followed his principles would have avoided most of the financial carnage of the crash of 1929 just as true value investors avoided the bursting of the technology bubble in 2000. As Warren Buffett has advised, the first rule of investing is, don't lose money. The second rule is, don't forget rule number one.

Basically, Graham wanted to buy stocks selling at two-thirds or less of their intrinsic value. This was his margin of safety, the belt for his stocks. It is a margin of safety for a couple of reasons. First, if he was correct in his estimate of intrinsic value, the stock could rise 50% and still not be overvalued. Second, if the stock market hit a rough patch, he had the comfort of knowing that what he owned was ultimately worth more than he paid for it.

A margin of safety gives you an edge over just blindly buying stocks or an index fund. Over the years, our margin of safety in the stocks we buy has provided more of our overall gain than the underlying growth in the value of the business. If we buy the stock of ABC Ice Cream Corp for $6.50 and we believe it is worth $10, we have a potential gain of $3.50. If during the period we own the stock, the company can grow its business by 10% so that the stock becomes worth $11, we have a larger potential gain. However, the greatest part of that gain has come from buying the stock cheaply in the first place. If an investor had bought the same stock for $10, his potential gain might only be $1. Buying for 66 cents has provided market-beating returns.

Buying stocks at a discount to their intrinsic value not only is the best for stocks, but also serves as a set of suspenders for what it prevents investors from doing. We have generally avoided investing in companies that have a lot of debt relative to their net worth. This margin of safety provides assurance that the company will survive during poor economic times such as recessions. A company with a lot of debt where earnings barely cover the interest expense is a far riskier investment than a company with some extra cash on its balance sheet. It is about having a cushion-- a margin of safety-- to get you through the bad times that companies inevitably encounter.

Another principle of margin of safety is diversification. Like Graham, I want to have a broadly diversified portfolio both in terms of the number of stocks we own, and in terms of spreading those investments over different industries. Individual stocks and particular industries can have the wind in their face from time to time. Such adverse conditions are difficult to predict. They just happen. We call them negative event surprises. In any given year, every stock portfolio will hold winners and losers, and it's virutally impossible to sidestep every loser. The point is to hold more winners than losers.

How much diversification should you have? Certainly, 10 stocks in a portfolio is a minimum. Other investors like to own as many as 50 or even 100 if they can find that many meeting their criteria. You should ask yourself: If one of my stocks went bankrupt could I just slough it off.

The last and perhaps greatest benefit of margin of safety investing is that it allows you to be a contrarian. Investing counter to the herd is not easy. We are all influenced by what we read in newspapers, see on TV, or hear from friends or people we consider experts. The best time to buy stocks is when they are cheap. However, when stocks are at their cheapest, there are usually a whole host of reasons not to buy them.

Following the principles of value investing, if stocks are cheap, you buy them. You forget all the noise that is swirling around you and take advantage of stocks on sale. The reverse is also true. If stocks are dear, if valuations are reaching or exceeding intrinsic value and there is no margin of safety, you sell. More than likely, you will be selling when every one else is buying. Not to worry. That is what a successful investor is supposed to do. These two simple investment principles, intrinsic value and margin of safety, provide the courage and the reassurance that buying in bad times and selling in good times is the better course to follow.

To be continued...




Credits: Much of this article, with modification, is extracted from The Little Book Of Value Investing by Christopher Browne, 2007.



POSTED :06 Oct 2006