The 3 Most Timeless Investment Principles

Warren Buffett is widely considered one of the greatest investors of all time, but if you were to ask him whom he thinks is the greatest investor, he would probably mention one man: his teacher, Benjamin Graham. Graham was an investor and investing mentor who is generally considered thefather of security analysis and value investing.

His ideas and methods on investing are well documented in his books, "Security Analysis" (1934), and "The Intelligent Investor" (1949), which are two of the most famous investing texts. These texts are often considered requisite reading material for any investor, but they aren't easy reads. In this article, we'll condense Graham's main investing principles and give you a head start on understanding his winning philosophy.


Principle #1: Always Invest with a Margin of Safety

Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities, but also to minimize the downside risk of an investment. In simple terms, Graham's goal was to buy assets worth $1 for 50 cents. He did this very, very well.

To Graham, these business assets may have been valuable because of their stable earning power or simply because of their liquid cash value. It wasn't uncommon, for example, for Graham to invest in stocks where the liquid assets on the balance sheet (net of all debt) were worth more than the totalmarket cap of the company (also known as "net nets" to Graham followers). This means that Graham was effectively buying businesses for nothing. While he had a number of other strategies, this was the typical investment strategy for Graham.

This concept is very important for investors to note, as value investing can provide substantial profits once the market inevitably re-evaluates the stock and ups its price to fair value. It also provides protection on the downside if things don't work out as planned and the business falters. The safety net of buying an underlying business for much less than it is worth was the central theme of Graham's success. When chosen carefully, Graham found that a further decline in these undervalued stocks occurred infrequently.

While many of Graham's students succeeded using their own strategies, they all shared the main idea of the "margin of safety."

Principle #2: Expect Volatility and Profit from It

Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. Graham illustrated this with the analogy of "Mr. Market," the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. Other times, he is depressed about the business's prospects and quotes a low price.

Because the stock market has these same emotions, the lesson here is that you shouldn't let Mr. Market's views dictate your own emotions, or worse, lead you in your investment decisions. Instead, you should form your own estimates of the business's value based on a sound and rational examination of the facts. Furthermore, you should only buy when the price offered makes sense and sell when the price becomes too high. Put another way, the market will fluctuate - sometimes wildly - but rather than fearing volatility, use it to your advantage to get bargains in the market or to sell out when your holdings become way overvalued.

Here are two strategies that Graham suggested to help mitigate the negative effects of market volatility:

Dollar-Cost Averaging

Dollar-cost averaging is achieved by buying equal dollar amounts of investments at regular intervals. It takes advantage of dips in the price and means that an investor doesn't have to be concerned about buying his or her entire position at the top of the market. Dollar-cost averaging is ideal for passive investors and alleviates them of the responsibility of choosing when and at what price to buy their positions.

Investing in Stocks and Bonds

Graham recommended distributing one's portfolio evenly between stocks and bonds as a way to preserve capital in market downturns while still achieving growth of capital through bond income. Remember, Graham's philosophy was, first and foremost, to preserve capital, and then to try to make it grow. He suggested having 25-75% of your investments in bonds, and varying this based on market conditions. This strategy had the added advantage of keeping investors from boredom, which leads to the temptation to participate in unprofitable trading (i.e. speculating).

Principle #3: Know What Kind of Investor You Are 

Graham advised that investors know their investment selves. To illustrate this, he made clear distinctions among various groups operating in the stock market.

Active Vs. Passive

Graham referred to active and passive investors as "enterprising investors" and "defensive investors."

You only have two real choices: The first choice is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn't your cup of tea, then be content to get a passive ( possibly lower) return but with much less time and work. Graham turned the academic notion of "risk = return" on its head. For him, "work = return." The more work you put into your investments, the higher your return should be.

If you have neither the time nor the inclination to do quality research on your investments, then investing in an index is a good alternative. Graham said that the defensive investor could get an average return by simply buying the 30 stocks of the Dow Jones Industrial Average in equal amounts. Both Graham and Buffett said that getting even an average return - for example, equaling the return of the S&P 500 - is more of an accomplishment than it might seem. The fallacy that many people buy into, according to Graham, is that if it's so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.

In modern terms, the defensive investor would be an investor in index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to predict those areas ahead of time. In doing so, an investor is virtually guaranteed the market's return and avoids doing worse than average by just letting the stock market's overall results dictate long-term returns. According to Graham, beating the market is much easier said than done, and many investors still find they don't beat the market.

Speculator Vs. Investor

Not all people in the stock market are investors. Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple: an investor looks at a stock as part of a business and the stockholder as the owner of the business, while the speculator views himself as playing with expensive pieces of paper, with no intrinsic value. For the speculator, value is only determined by what someone will pay for the asset. To paraphrase Graham, there is intelligent speculating as well as intelligent investing - just be sure you understand which you are good at.

The Bottom Line

Graham served as the first great teacher of the investment discipline and his basic ideas are timeless and essential for long-term success. He bought into the notion of buying stocks based on the underlying value of a business and turned it into a science at a time when almost all investors viewed stocks as speculative. If you want to improve your investing skills, it doesn't hurt to learn from the best. Graham continues to prove his worth through his disciples, such as Warren Buffett, who have made a habit of beating the market.

--------------------------------------------------------------------------------------------

My Blogs:

Daily Stock Market Analysis

The Next Financial Crisis

Visit and click the links for support. Thanks!

.

Top 5 Books for Young Investors

It's imperative for young adults and professionals to start investing early. One of the main reasons for doing so is to obtain the power of compound interest; by holding long-term investments, one can allow his or her assets to generate more returns. Investing just a few years earlier could translate into tens of thousands, if not hundreds of thousands, of additional funds for your retirement nest egg.

But while it is important to invest early, it is also important to invest wisely. Let's take a look at five classic investing books that can provide indispensable business and finance insights for young investors - and they're a good read, too!

"Rich Dad, Poor Dad" (2000) by Robert Kiyosaki

This classic is a must-read for young investors. Kiyosaki's view is that the poor and middle class work for money, but the rich work to learn. He stresses the importance of financial literacy, and presents financial independence as the ultimate goal and a way to avoid the rat race of corporate America. The author points out that while accounting is important to learn, it can also be misleading. Banks label a house as an asset for the individual, but because of the required payments to keep it, it can really be a liability in terms of cash flow. Real assets add cash flow to your wallet.

Kiyosaki advocates investments that produce periodic cash flow for the investor while providingupside in terms of equity value. Real estate and stocks that provide dividends are viewed favorably. The author advises that America's educational system is designed to keep people working hard for the rest of their lives, and that the school system does a poor job of teaching people to create enough wealth so they won't have to work anymore. Kiyosaki also highlights the importance of tax planning.


"The Essays of Warren Buffett: Lessons For Corporate America" (1997) by Warren Buffett

In his essays, Warren Buffett - widely considered to be modern history's most successful investor - provides his views on a variety of topics important to corporate America and shareholders. Young investors can get a glimpse of the interface between a company's management and its shareholders, as well as the thought processes involved in enhancing a company's enterprise value.

Buffett's essays include discussions on corporate governance, finance and investing, alternatives to common stock, common stock, mergers and acquisitions, accounting and valuation and accounting policy and tax matters. Buffett outlines his basic business principles, and as the steward of Berkshire Hathaway, informs the shareholders of the company that their mutual interests are aligned. He has a philosophy of bringing in talented managers at portfolio companies and leaving them alone. He advocates purchasing shares of businesses at times when these stocks are trading at a discount from their inherent value. He opposes following investing trends.

"Beating the Street" (1994) by Peter Lynch

Peter Lynch is one of the most successful stock market investors and hedge fund managers of the 20th century. He started out as an intern at Fidelity Investments in the mid 1960s. Nearly 11 years later, he was tasked to manage the Magellan Fund, which at the time had close to $18 million inassets. By 1990, the fund had grown to a whopping $18 billion in assets with nearly 1,000 stock positions. During this time, the fund boasted average returns of more than 29% per year.

"Beating The Street" allows the reader to peek into Lynch's mind and thought processes in terms of deciding whether to buy or sell a stock. Lynch believed that an individual investor could exploit market opportunities better than Wall Street, and encourages investors to invest in what they know.

"The Intelligent Investor" (1949) by Benjamin Graham

This book was written in 1949 and has been hailed by Warren Buffett as the best investing book ever written. Benjamin Graham is considered the "father of value investing," a paradigm that advocates the purchase of stocks that appear underpriced relative to their inherent value, which is determined through fundamental analysis.

Graham delves into the history of the stock market, and informs the reader on conducting fundamental analysis on a stock. He discusses various ways of managing your portfolio including both a positive and defensive approach. He then compares the stocks of several companies to illustrate his points.

"Think and Grow Rich" (1937) by Napoleon Hill

"Think And Grow Rich" was written by Napoleon Hill during the Great Depression, and has since sold more than 30 million copies worldwide. Hill conducted extensive research based on his associations with wealthy individuals during his lifetime. At the suggestion of Andrew Carnegie, Hill published 13 principles for success and personal achievement from his observations and research. These include desire, faith, specialized knowledge, organized planning, persistence and the "sixth sense." Hill also believed in brainstorming with like-minded people, whose efforts can create synergistic energy.

This book conveys valuable insights into the psychology of success and abundance, and should be considered a priority read given this age's emphasis on shock-value entertainment and negative news.

The Bottom Line

The best investors did not emerge overnight, but honed their skills through years of thought, research and practice. Reading these respected tomes will help you begin your journey into investing on the right foot.

--------------------------------------------------------------------------------------------

My Blogs:

Daily Stock Market Analysis

The Next Financial Crisis

Visit and click the links for support. Thanks!

.

Take On Risk With A Margin of Safety

When investing, it is well accepted that one of the main things you should focus on is risk. However, modern investment theory mainly focuses on the volatility of an asset in its treatment of risk. Themargin of safety theory is a little different - it argues that downward spikes of volatility make stocks less risky. This is an important concept to grasp in depth, because common risk theories can lead to missed opportunities. Investing gurus Benjamin Graham and Warren Buffett were instrumental in developing margin of safety. Read on to find out how this theory helped propel their portfolios to meteoric heights.

Beta's Misgivings

In general, people do not like surprises. More precisely, people do not like adverse surprises. Because investors are assumed to be more averse to losing money than gaining it, modern investment theory views the volatility of an asset, as measured by its beta, as the main component of risk. The theory implies that investors should pay less for an asset with a higher beta.

One problem with beta is that it implies that if an asset's value suddenly drops, even due to irrational market behavior, that it becomes more risky because it will have a higher beta. We'll poke some holes in this view in moment, using an example from Warren Buffett.

An Alternate Strategy of Risk

Introduced by the father of value investing, Benjamin Graham, and notably implemented by Warren Buffett, margin of safety was presented as a different view of risk and how to protect against it. Graham's concept is not new. He first presented his investing style with David Dodd in 1934's "Security Analysis" and later with his more accessible book, "The Intelligent Investor", which was first published in 1949.

Graham characterized volatility as "Mr. Market" coming each day to buy from you or sell to you. Graham hoped to buy assets that Mr. Market would sell to him with a 50% margin of safety. This, essentially, would be like trying to buy a dollar for $0.50.

Graham discussed how companies all have an intrinsic measurable value. When Graham first pitched and practiced this idea, information on companies was not nearly as easy to access. He would search through the financial statements and look for what he called net-nets, or companies trading below their liquidation values.

Graham would take a company's current assets with considerable deductions, and subtract all of the liabilities on the balance sheet. At its heart, Graham's net-net investing is the most conservative value approach, and involves very little risk if done right.

Example - Finding A Company\'s Net-Net
ABC Company has the following balance sheet and market capitalization:
Cash $250
Cash Equivalents $50
Accounts Receivable (A/R) $100
Inventories $100
Total Liabilities $300
Share Price $62.50

Cash and cash equivalents are good to go, we have $300 there. Next, we turn to A/R, some of which will not be paid. Usually we have a net A/R number on the balance sheet, indicating the amount of receivables the company expects to recover. If we have it, this net number is based on the company's history of collecting receivables, and is a good indicator, but we would still discount it a little for added safety.

In this scenario, we have a gross A/R number. Again we don't expect to recover it all, but ABC is known to have a fairly reliable client base and we could easily anticipate recovering around 80% of A/R - to be even more conservative we will only factor in recovering 75%. Many investors may want to take a look at the company's allowance for doubtful accounts in their financial statements as a method for gauging an accurate recovery percentage, but in this case, we'll value A/R at $75 ($100 x 0.75). Finally, there is ABC's inventory. ABC has competitors, which we could assume, at the very least, would buy the inventory for half its value. So we take the inventory's value at $50 ($100 x 0.5).
We end up with marked down current assets of $425 ($300 + $75 + $50), and total liabilities of $300.

This net-net is worth $125 ($425 - $300), not even accounting for any real estate or other long-term assets the company might have. With the company selling at only $62.50 in the market, this is a net-net with a 50% margin of safety. Paying half of a company's net-net value was Graham's goal, and at most, he would pay two-thirds of a company's net-net value, for a 33% margin of safety. In our example, we have a 50% buffer between the market value of the company and our conservative valuation of the company's current assets. By only buying at a steep discount to our valuation, this margin of safety provides its own built-in measure against the risk of mistakes in our calculations.

Let Volatility Be Your Friend

This process of investing did not guarantee success, but with research and hard work, finding one of these scenarios was about as close to a sure thing as you could get. A lot has changed, and Graham's net-nets have essentially disappeared in the modern market. With the quick and widespread dissemination of information, markets have become somewhat more efficient.

While net-nets are disappearing, investors can see that the market provides sales on assets quite often. The concept of buying companies with an adequate margin of safety still remains, and has been practiced with great success by many value investors, most notably Warren Buffett.

Example - Taking the Value of Long-Term Assets Into Account
In the ABC example, we gave absolutely no value to the company\'s long term assets. Let\'s return to the example and suppose that that the company\'s share price is now at $200. We calculated its net-net worth at $125, so according to that it would not be a good value, but we note that ABC also has the following assets on its books:
Plant, Property, & Equipment $200
Long-Term Bonds $100

We notice from some research that the plants on the company's balance sheet have likely appreciated because property values have gone up in that area. However, we will remain very conservative in this example and still value it at $200. Next, with the company's long-term bonds, we may worry about the market value if the bonds need to be sold quickly. We will only accept 75% of the value, and value the bonds at $75 ($100 x 0.75). We end up with an asset value of $400 (net-net worth of $125 + $200 + $75). Again, we can buy the stock of this company with a 50% margin of safety at its current market price of $200.

This again seems like a home run of an investment. We are still being conservative, and we ignored any assets that could be off ABC's books, such as the appreciated value of its real estate. Other hidden assets are brands, exceptional management, competitive advantages, etc. There is much to be said about the market value of hidden assets, but the point will remain the same.

Don't Run From Beta

Now looking strictly at beta, let's say ABC had a beta of 1.5. After all of our work, we decide to go to bed and buy tomorrow. However, the next day, "Mr. Market" decides to take the price of ABC down to $150, while the rest of the market stays pretty flat. This sharp 25% decline in ABC stock makes it riskier according to beta.

However, according to Warren Buffett in his 1993 letter to shareholders this altered perception of risk is misleading:

"Under beta-based theory, a stock that has dropped very sharply compared to the market - as hadWashington Post when we bought it in 1973 - becomes "riskier" at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?"

What this means is that volatility is our friend in this scenario. We did the work to value the company, and now Mr. Market is just offering it to us at a steeper discount and a higher margin of safety. If we had already made the purchase before the decline, we might kick ourselves for bad timing, but according to our research, an investment in ABC is still worth much more than what we paid.


Take a Page From the Masters

The concept of margin of safety as practiced by Warren Buffett is not that complicated. These are fairly simple ideas, and should teach us all not to rely simply on volatility as a judge of risk. Many common theories of risk make volatility out to be a bad thing, and if a stock's sea becomes choppy, some investors may sail for calmer waters. But take a cue from Warren Buffett. He, and other value investors, get excited in volatile and down markets. If you invest carefully, and with an adequate margin of safety, Mr. Market's mood swings can lead to great opportunities.

--------------------------------------------------------------------------------------------

My Blogs:

Daily Stock Market Analysis

The Next Financial Crisis

Visit and click the links for support. Thanks!

.

The Value Investor's Handbook

Value investing, and any type of investing for that matter, varies in execution with each person. There are, however, some general principles that are shared by all value investors. These principles have been spelled out by famed investors like Peter Lynch, Kenneth Fisher, Warren Buffet, John Templeton and many others. In this article, we will look at these principles in the form of a value investor's handbook.


Buy Businesses

If there is one thing that all value investors can agree on, it's that investors should buy businesses, not stocks. This means ignoring trends in stock prices and other market noise. Instead, investors should look at the fundamentals of the company that the stock represents. Investors can make money following trending stocks, but it involves a lot more activity than value investing. Searching for good businesses selling at a good price based on probable future performance requires a larger time commitment for research, but the payoffs include less time spent buying and selling and fewer commission payments.

Love the Business You Buy

You wouldn't pick a spouse based solely on his or her shoes, and you shouldn't pick a stock based on cursory research. You have to love the business you are buying, and that means being passionate about knowing everything about that company. You need to strip the attractive covering from a company's financials and get down to the naked truth. Many companies look far better when you judge them on basic price to earnings (P/E), price to book (P/B) and earnings per share (EPS) ratios than they do when you look into the quality of the numbers that make up those figures.

If you keep your standards high and make sure the company's financials look as good naked as they do dressed up, you're much more likely to keep it in your portfolio for a long time. If things change, you'll notice it early. If you like the business you buy, paying attention to its ongoing trials and successes becomes more of a hobby than a chore.

Simple Is Best

If you don't understand what a company does or how, then you probably shouldn't be buying shares. Critics of value investing like to focus on this main limitation. You are stuck looking for businesses that you can easily understand because you have to be able to make an educated guess about the future earnings of the business. The more complex a business is, the more uncertain your projections will necessarily be. This moves the emphasis from "educated" to "guess."

You can buy businesses you like but don't completely understand, but you have to factor in uncertainty as added risk. Any time a value investor has to factor in more risk, he has to look for a larger margin of safety - that is, more of a discount from the calculated true value of the company. There can be no margin of safety if the company is already trading at many multiples of its earnings, which is a strong sign that, however exciting and new the idea is, the business is not a value play. Simple businesses also have an advantage, as it's harder for incompetent management to hurt the company.


Look for Owners, Not Managers

Management can make a huge difference in a company. Good management adds value beyond a company's hard assets. Bad management can destroy even the most solid financials. There have been investors who have based their entire investing strategies on finding managers that are honest and able. To quote Buffett, "look for three qualities: integrity, intelligence, and energy. And if they don't have the first, the other two will kill you." You can get a sense of management's honesty through reading several years' worth of financials. How well did they deliver on past promises? If they failed, did they take responsibility, or gloss it over? (Find out more about Buffett's investing inWarren Buffett: How He Does It.)

Value investors want managers who act like owners. The best managers ignore the market value of the company and focus on growing the business, thus creating long-term shareholder value. Managers who act like employees often focus on short-term earnings in order to secure a bonus or other performance perk, sometimes to the long-term detriment of the company. Again, there are many ways to judge this, but the size and reporting of compensation is often a dead give away. If you're thinking like an owner, you pay yourself a reasonable wage and depend on gains in your stock holdings for a bonus. At the very least, you want a company that expenses its stock options.

When You Find a Good Thing, Buy a Lot

One of the areas where value investing runs contrary to commonly accepted investing principles is on the issue of diversification. There are long stretches where a value investor will be idle. This is because of the exacting standards of value investing as well as overall market forces. Toward the end of a bull market, everything gets expensive, even the dogs, so a value investor may have to sit on the sidelines waiting for the inevitable correction. Time, an important factor in compounding, is lost while waiting, so when you do find undervalued stocks, you should buy as much as you can. Be warned, this will lead to a portfolio that is high-risk according to traditional measures like beta. Investors are encouraged to avoid concentrating on only a few stocks, but value investors generally feel that they can only keep proper track of a few stocks at a time.

One obvious exception is Peter Lynch, who kept almost all of his funds in stocks at all times. Lynch broke stocks into categories and then cycled his funds through companies in each category. He also spent upwards of 12 hours every day checking and rechecking the many stocks held by his fund. As an individual value investor with a different day job, however, it's better to go with a few stocks for which you've done the homework and feel good about holding long term.

Measure Against Your Best Investment

Anytime you have more investment capital, your aim for investing should not be diversity, but finding an investment that is better than the ones you already own. If the opportunities don't beat what you already have in your portfolio, you may as well buy more of the companies you know and love, or simply wait for better times. During idle times, a value investor can identify the stocks he or she wants and the price at which they'll be worth buying. By keeping a wish list like this, you'll be able to make decisions quickly in a correction.

Ignore the Market 99% of the Time

The market only matters when you enter or exit a position; the rest of the time, it should be ignored. If you approach buying stocks like buying a business, you'll want to hold onto them as long as the fundamentals are strong. During the time you hold an investment, there will be spots where you could sell for a large profit and others were you're holding an unrealized loss. This is the nature of market volatility.

The reasons for selling a stock are numerous, but a value investor should be as slow to sell as he or she is to buy. When you sell an investment, you expose your portfolio to capital gains and usually have to sell a loser to balance it out. Both of these sales come with transaction costs that make the loss deeper and the gain smaller. By holding investments with unrealized gains for a long time, you forestall capital gains on your portfolio. The longer you avoid capital gains and transaction costs, the more you benefit from compounding.


The Bottom Line

Value investing is a strange mix of common sense and contrarian thinking. While most investors can agree that a detailed examination of a company is important, the idea of sitting out on a bull market goes against the grain. It's undeniable that funds held constantly in the market have outperformed cash held outside the market, waiting for a down market. This is a fact, but a deceiving one. The data is derived from following the performance of indexes like the S&P 500 over a number of years. This is where passive investing and value investing get confused.

In both types of investing, the investor avoids unnecessary trading and has a long-term holding period. The difference is that passive investing relies on average returns from an index fund or other diversified instrument. A value investor seeks out above-average companies and invests in them. Therefore, the probable range of return for value investing is much higher. In other words, if you want the average performance of the market, you're better off buying an index fund right now and piling money into it over time. If you want to outperform the market, however, you need a concentrated portfolio of outstanding companies. When you find them, the superior compounding will make up for the time you spent waiting in a cash position. Value investing demands a lot of discipline on the part of the investor, but in return offers a large potential payoff.

--------------------------------------------------------------------------------------------

My Blogs:

Daily Stock Market Analysis

The Next Financial Crisis

Visit and click the links for support. Thanks!

.