Warren Buffett (Trades, Portfolio) famously wrote the simplest, and perhaps best, rules for investing: “Rule No. 1: Never lose money. Rule No 2: Never forget rule No 1. “
With those words, Sven Carlin let into chapter eight of “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment,” a chapter that includes nine tools, or tactics, for avoiding losses.
Tool 16: The price you pay when you buy
Nothing matters more to your margin of safety than the price you pay. If investors pay too much, they may end up with no margin at all. He recommended buying only stocks that offer a large margin of safety because the risk-reward profile is so much better.
Carlin conceded it is difficult to accurately determine the intrinsic value of stocks, but investors can at least avoid practices that encourage them to buy at any price. Do not jump into bull markets or even passively managed index funds on the assumption prices always go up. The most infamous cases of careless enthusiasm occurred in the 1920s, the 1960s and the 1990s—they all ended badly for investors.
With that, Carlin reminded readers that individual stocks can be extremely volatile, which is good news for value investors. Further, he argued, investing risk mostly depends on the price investors pay. Low prices are not always a good reason to buy, but buying quality companies at a discount to their intrinsic value usually is. Generally speaking, “Being careful of the price you are paying means buying at a discount to the intrinsic value. The bigger the discount, the better the investment.”
To get those low prices, investors must be patient while waiting for the volatility of the market to deliver bargains to them. They can also help the process along by analyzing more stocks: Increasing the number of stocks under the microscope increases the number of opportunities.
How big should the margin be? That will depend on the risk-reward profile of each individual investor. To quantify bargain prices, he suggested this simple rule of thumb: Investors who want a 15% average annual return should look for stocks sporting a price-earnings ratio of 6.67 (15 x 6.67 = 99) or lower; those who want a average annual return of 10% will need to find stocks with a price-earnings ratio of 10 or lower (10 x 10 = 100).
Obviously, finding a quality stock with a price-earnings ratio of 6.67 or less will not be easy. It also helps explain why so few investors manage to consistently earn average annual returns of 15% or more. Investors also do not know when the market will correct its underpricing, so Carlin recommended they invest in those that are continually creating new value.
While opportunities offering 15% or 20% returns are rare, they are available to investors who exercise patience and knowledge. Again, the more stocks an investor has analyzed, the more opportunities.
Surprisingly, a stock may be undervalued even though it is trading at all-time highs. According to Carlin, the key is intrinsic value, “What is important is the discount to the intrinsic value, which means that a stock can be undervalued even if it is at all-time highs.”
He also urged investors to know the sectors in which they are investing, “There is no point in finding the best gold miner out there only to lose 80% of your portfolio in place of 90% if gold prices fall after a period of exuberance.” Carlin noted it is possible to develop a set of rules for estimating long-term development while the market focuses on the short term. For example, knowing the natural cyclicality of a sector, especially if it is in commodities.
Tool 17: Analyzing sector cyclicality
Following up, Carlin urged investors to get to know about the cyclicality of different sectors. Essentially, when prices are rising, every company will increase production. That production will outrun the rise in prices, leading to a glut of the commodity. Prices collapse, high-cost producers go out of business, leading to a shortage of supply, which begins pushing prices up again. This process is seen in many sectors beyond the mining industry.
Second, analyzing sectors also means assessing long-term supply trends. Investors who can find situations in which demand is growing while supply is constrained should be rewarded. Carlin wrote, “Think about the most beautiful real estate properties, you can’t really increase the number of penthouses around Central Park.”
Summing up, avoiding loss of capital is a critical element of investing success. By buying at a true discount and knowing the cyclicality of sectors, investors can reduce the odds that will happen.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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