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Leave a margin of safety

Benjamin Graham, father of modern security analysis, taught that building a margin of safety into your investments is the single most important thing you can do to protect your portfolio. There are two ways you can incorporate this principle into your investment selection process. 1. Be conservative in your valuation assumptions As a class, investors have a peculiar habit of extrapolating recent events into the future. When times are good, they become overly optimistic about the prospects of their enterprises; as Graham pointed out in his treatise The Intelligent Investor, the chief risk is not overpaying for excellent businesses, but rather, paying too much for mediocre businesses during generally prosperous times. To avoid this sorry situation, it is important that you err on the side of caution, especially in the area of estimating future growth rates when valuing a business to determine the potential return. For an investor with a 15 percent required rate of return, a business that generates $1 per share in profit is worth $14.29 if the business is expected to grow at 8 percent; with expected growth of 14 percent, however, the estimated intrinsic value per share is $100, or seven times as much! 2. Only purchase assets trading at substantial discounts to your conservative estimate of intrinsic value Once youve conservatively estimated the intrinsic value of a stock, you should insist upon an additional margin of safety. Going with our prior example of a company with an estimated intrinsic value of $14.29; you wouldnt want to purchase the stock if it was trading at $12.86; thats only a 10 percent margin of safety. Instead, youd want to wait for it to fall to around 2/3 of your estimate of intrinsic value, or $9.57. This isnt bound to happen often, but if you monitor enough companies and have patience, the securities markets do extraordinary things. In the 1970s, for example, there was a period of several years where you could buy top-quality insurance companies at 2 or 3 times earnings!

2. Only purchase businesses you understand (recognize your own limitations)

How can you estimate the future earnings per share of a company? In the case of CocaCola or Hershey, you could look at per-capita product consumption by various countries in the world, input costs such as sugar prices, managements history for allocating capital, and a whole list of things. You understand how these businesses make their money, the corollary being that you are able to make reasonable assumptions about future performance. Yet, many investors ignore this common sense and invest in companies that manufacture products outside of their knowledge base. Unless you truly understand the economics of an industry and are able to forecast where a business will be within five to ten years with reasonable certainty, do not purchase the stock. In most cases, your actions are driven by a fear of being left out of a sure thing or forgoing a huge fortune. If that describes you,

youll take comfort to know that following the invention of the car, television, computer, and Internet, there were thousands of companies that came into existence, only to go bust in the end. From a societal standpoint, these technological advances were major accomplishments; as investments, a vast majority fizzled. The key is to avoid seduction by a sexy industry; the money spends the same, regardless of whether you are selling hotdogs or microchips. To be a successful investor, you dont have to understand convertible arbitrage, esoteric fixed-income trading strategies, stock option valuation, or even advanced accounting. These things merely expand the potential area of investment available to you; valuable, yet not critical to achieving your financial dreams. Yet, many investors are unwilling to put some opportunities under the too difficult pile; a reluctance that is part pride and part unfounded optimism. Even billionaire Warren Buffett, renowned for his vast knowledge of business, finance, accounting, tax law, and management, admits his shortcomings. At the 2003 Berkshire Hathaway stockholder meeting, Buffett, responding to a question about the telecom industry, said: I know people will be drinking Coke, using Gillette blades and eating Snickers bars in 10-20 years, and have a rough idea of how much profit theyll be making. But I dont know anything about telecom. It doesnt bother me. Somebody will make money on coca beans, but not me. I dont worry about what I dont know I worry about being sure about what I do know. This ability to realistically examine his strengths and weaknesses is one way Buffett has managed to avoid making major mistakes over his considerable investing career.

. Measure your success by the underlying operating performance of the business

You should hold small pieces of excellent businesses with the same tenacity you would if you owned the entire company. Over time, the operating results and the share price are inextricably linked. Years ago, at the height of the dot-com bubble, a reader of this column, angered by my insistence that fundamentals mattered, posed a question in a missive, Dont you know that the stock price has nothing to do with the underlying business? he asked. He was serious. This sort of absolute mental absurdity is what causes asset pricing bubbles. Common sense tells you that if a company cannot continue to exist as a viable entity, the investors will eventually lose everything. How many grocery stores and small retailers have been crushed by Wal-Mart due to its superior operating skills? Were you a shareholder in those businesses, the fundamentals supplier cost, profit margin, volume were all extremely important. Without the ability to compete, you eventually closed your doors. For further proof, look at the venerable behemoths of the past that now lie in the junkyard of financial history: Pan Am, the Pennsylvania Railroad. K-Mart and Sears were headed in the same direction until the former was saved as a result of the involvement of famed hedge fund manager Eddie Lampert of ESL Investments and distressed-debt guru Marty Whitman at Third Avenue Funds.

4. Have a rational disposition toward price

There is one rule of mathematics that is unavoidable: the higher a price you pay for an asset in relation to its earnings, the lower your return. Its that simple. The same stock that was a terrible

investment at $40 per share may be a wonderful investment at $20 per share. In the hustle and bustle of Wall Street, many people forget this basic premise and, sadly, pay for it with their pocketbooks. Imagine you purchased a new home for $500,000 in an excellent neighborhood. A week later, someone knocks on your door and offers you $300,000 for the house. You would laugh in their face. Yet, in the stock market, you may be likely to panic and sell your proportional interest in the business simply because other people think it is worth less than you paid for it. If youve done your homework, provided an ample margin of safety, and are encouraged about the long-term economics of the business, you should view price declines as a wonderful opportunity to acquire more of a good thing. If those statements arent true, then you shouldnt have purchased the stock in the first place. Instead, people tend to get excited about stocks that rapidly increase in price; a completely irrational position for those that were hoping to build a large position in the business. Would you have a proclivity to purchase more cars if Ford and General Motors increased prices by 20 percent? Would you want to buy more gas if per-gallon prices doubled? Absolutely not! Why, then, should you view equity in a company differently?

5. Minimize frictional expenses

In the article Frictional Expense: The Hidden Investment Tax, you learned how frequent trading can substantially lower your long-term results due to commissions, fees, ask / bid spreads, and taxes. Combined with the knowledge that comes from understanding the time value of money, you realize that the results can be staggering. Imagine that you are 21 years old. You plan on retiring on your 65th birthday, giving you 44 financially productive years. Each year, you invest $10,000 for your future. If you managed to earn at 10 percent return, by the time you retired, you would have $6,526,408; certainly not chump change by anyones standards! Yet, if you had controlled frictional expenses, adding a mere 2 percent per annum, the resulting 12 percent return would have generated $12,118,125 by retirement. Thats nearly twice as much capital! Although it seems counterintuitive, frequent activity is often the enemy of long-term superior results. As one great analyst once told me, sometimes the client is paying us to tell them not to do anything.

6. Keep your eyes open at all times

Like all great investors, famed mutual fund manager Peter Lynch was always on the lookout for the next opportunity. During his tenure at Fidelity, he made no secret of his investigative homework: traveling the country, examining companies, testing products, visiting management, and quizzing his family about their shopping trips. This led him to discover some of the greatest growth stories of his day long before Wall Street became aware they existed. The same holds true for your portfolio. By simply keeping your eyes open, you can stumble onto a profitable enterprise far easier than scanning the pages of Barrons or Fortune. Need help

getting started? Check out Finding Investing Ideas: Practical Places to Discover Profitable Opportunities.

. Allocate capital by opportunity cost

Should you pay off your debt or invest? Buy government bonds or common stock? Go with a fixed rate or interest-only mortgage? The answer to financial questions such as these should always be made based upon your expected opportunity cost. Heres how it works: an investor looking to acquire real estate in an urban area could ask themselves several questions such as, is the average home price for the area increasing at a rate faster than average household income? If so, are there demographic changes taking place such as a rapidly expanding, educated population base that will make it possible for the local economy to sustain higher asset prices? Will the property be cash-flow positive in the event of a substantial increase in interest rates? What is my expected return on a rental-income basis, aside from anticipated price appreciation? If the result of this self-subjected inquiry results in an expected return of 8 percent, yet you calculate the return available on U.S. Bank stock to be 13 percent, you should go with the latter. Likewise, if none of your potential investments seem to beat some sort of arbitrary threshold, say a real return of 10 percent or more, you should simply park your excess cash in U.S. Treasuries. (Note: This approach is only appropriate for an entrepreneurial investor who manages his or her own capital. For a vast majority of investors, simply buying index funds through a dollar cost averaging plan is going to result in superior