Principles for Intelligent Investing

Tiger Woods hits about 500 golf balls a day when he's practicing. With each practice shot, he has a very specific target in mind.

The same approach holds true for a good investor. Successful investing is, by definition, a methodology. And just as in any other trade or profession, there are methods and techniques you need to apply, regularly and intensely, if you want to come out on top. After all, investing, like golf, is a game between you and all of the other competitors out there. If you can't bring anything to the game, you shouldn't be playing.

In the investing world, there are six investing principles you need to apply if you want to succeed in the long term. These are principles that the world's greatest investors are constantly dispensing. Just pick up a copy of a Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) annual report or a Longleaf investment report, and you'll see them on display. Every investor will apply them differently, but they all infuse the activities and methods of the most successful investors on the planet.

These principles all build on each other, in that you cannot apply a subsequent principle until you understand the one before it. In this article, we'll consider the first three.

Principle No. 1: Have a sound investment philosophy.
Without a logical approach to allocating capital, you're doomed right from the start. You must have a sound philosophy on which all of your investing activities are based, and this philosophy must, first and foremost, protect you from permanent loss of capital.

The smartest investment philosophy I have come across was one the late Ben Graham spelled out in The Intelligent Investor: "Investment is most prudent when it is most businesslike." In other words, always view investing as an opportunity to acquire ownership stakes in businesses.

Graham also offers us the three most underrated words in all of investing: margin of safety. When you acquire shares in a business, make sure you do it at attractive prices, to protect your downside. Graham's teachings and philosophies ultimately served as the foundation for value investing, and his most famous student, Warren Buffett, has shown you what you can accomplish when you have a sound investment philosophy. It comes down to value investing, and as Charlie Munger aptly says, "All intelligent investing is value investing."

Principle No. 2: Develop a good search strategy.
Once you understand and appreciate the soundness of a value-investing approach, you need to develop a good search strategy. There are tens of thousands of stocks out there, so knowing where to look is more important than knowing how to look.

When Buffett was starting out as an investor in his early 20s, he literally read through every page of the Moody's stock manuals -- all 10,000 pages per volume -- looking for ideas. Those manuals were the best source of investing information available back then. Fortunately for us, the Internet has opened up many more wonderful investment resources. (Of course, it's also given us a fair share of not-so-good investment resources, so tread carefully.)

A great way to start your online investing search is with stock screening, which allows you to define your investing parameters. There are some amazing screens out there. One of the best I've found is Joel Greenblatt's Magic Formula screen. Each day, this site provides you the names of the 100 businesses that earn the highest return on invested capital and earnings yield. All levels of investors can use the site. Even superinvestor Mohnish Pabrai used it to discover an eventual multibagger investment, Pinnacle Airlines (Nasdaq: PNCL  ) .

Some other fantastic places to start online are the Value Line reports, for a good overview of businesses, and the SEC website, where company filings can reveal what the world's best money managers are buying and selling. Thankfully, in investing, no one penalizes you for using someone else's ideas to make you rich!

Principle No. 3: Know how to value a business and assess management quality.
Once you use the value approach to search for good companies, you then need to know whether the businesses you're considering are suitable for investment. First, you must understand the business, the industry, and the competition. Once you understand a business and its operation -- and you must be able to understand the business; if you don't, you can't properly value it -- you then need to determine its intrinsic value, so you can figure out whether Mr. Market is offering you an attractive price.

Even if a business passes these tests, quality of management is still crucial, because an attractively priced business can be a terrible investment if management is making bad decisions. You need the company's assets working as well as they can to make your investment appreciate in value.

As Buffett has said: "Investing is simple, but it's not easy. You don't need an IQ of 160 to be a great investor." Those are valuable words for any investor. Buffett himself has enjoyed enormous success putting that philosophy to use -- he has bought stakes in easy-to-understand businesses at attractive prices, and then he holds them for a really long time. Through my years of studying the investing greats, I've come to realize that they share a set of similar characteristics that make them so successful. And those characteristics have arisen from following principles such as the three we've discussed today. In a future column, we'll look at three more.  

Berkshire Hathaway is a recommendation of Motley Fool Inside Value and Motley Fool Stock Advisor. Try out either service free for 30 days.

Fool contributor Sham Gad is the managing partner of the Gad Partners Fund, a value-centric private investment partnership modeled after the 1950s Buffett Partnerships. He has no positions in the companies mentioned. Reach him at sham@gadcapital.com. The Fool has an intelligent disclosure policy.


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