We all invest for the same reason -- to make money. And to make money investing, we need to know two key things: when to buy and when to sell.
If you can buy something for $1 and turn around and sell it for $2, you've made money. If, on the other hand, you buy something for a buck and can't find someone willing to take it off your hands for more than $0.50, you've lost money. Clearly, to make money at investing, the goal is to buy low and sell high. More than half a century ago, Benjamin Graham, the pioneer of value investing, came up with a simple way to do just that -- a concept known as the margin of safety. By employing this technique, investors greatly decrease the chance that they'll lose their hats, and increase the likelihood that they'll trounce other investors.
Following in Graham's footsteps, Bill Miller, who runs Legg Mason Value Trust (LMVTX), beat the market for 15 consecutive years. That's a record practically unheard of in the mutual fund industry. Even so, Miller's long-run performance pales in comparison to that of Warren Buffett, a former pupil of Graham's. What's more, Graham's margin of safety is something we put to good use at our Motley Fool Inside Value investing service.
Know a company's true worth
The key to success is a clear understanding of a company's true worth. With that knowledge in hand, buying low and selling high becomes a simple matter of waiting -- buying a stock only when it falls below the company's true worth by a tempting margin. Once you own it, you need to keep tracking the company's value. When the stock rises to an uncomfortably high premium to its true worth, sell it.
My friend and colleague Philip Durell follows that philosophy as the chief analyst at Inside Value. His selections as a whole are beating the market's return since the newsletter's 2004 inception. His record is added proof that using a margin of safety truly does work. For instance, in the time auto-parts giant AutoZone (NYSE: AZO ) was an active recommendation, its shares easily outpaced the market, in spite of stagnating revenue and profits. You simply don't get a 45% leap in a stagnant company's stock in less than two years unless you're starting from a deep value price.
The strategy simply works
Philip has beaten the market without depending on the likes of on-again, off-again technology company Apple, which has experienced a tremendous run since the iPod and iPhone helped bring the company back from the brink. Instead, he relies on stalwarts such as beverage giant Coca-Cola (NYSE: KO ) . Philip recommended Coke in December 2004, when comparisons with archrival PepsiCo (NYSE: PEP ) seemed to indicate that Coke was losing ground to its far more diversified competitor.
Philip reasoned that Coke, with its solid and growing dividend, large share buyback program, and inexpensive price tag, was simply too good an opportunity to pass up. He was right. Coke's shares have risen nicely, and its total return has bested the market by about 35 percentage points since then. Just as important, it has raised its dividend a whopping 36% while continuing to repurchase its own shares. These moves showcase Coke's tremendous financial strength and long-run potential.
Buying low with the margin of safety
Every company has what Graham calls an intrinsic value -- a measure of what that company is really worth. Finding that value is part art and part analysis. One of the most powerful tools in a value investor's toolkit is a discounted cash flow calculator, into which you put your estimate of how much cash the company will generate in the ensuing years. The calculator then tells you how much the company is worth today. (Inside Value has such a calculator available to subscribers. If you're already a subscriber, you can access it here. If not, you can get access by taking a free 30-day trial of the newsletter.)
Once you've figured out what the company is worth, you can use that information to determine whether it has enough of Graham's margin of safety to be worth buying. For example, in June of last year, Philip put cash advance company Advance America (NYSE: AEA ) on his watch list. He reasoned that the company's stock had fallen far enough to potentially be attractive after changes to federal guidelines for the banks that lend it money. It remained on the watch list until Philip was convinced it could adapt to the new guidelines and continue to thrive. Then, it graduated to the status of official pick. Simply put -- a low price is not enough to be a real value. It takes a low price coupled with a discernable true worth.
Selling high with the margin of safety
Logically, if a company trading below its intrinsic value is worth buying, then a company trading at or above its intrinsic value just might be a candidate for selling. Take former Inside Value selection and long-distance giant MCI, for instance. Philip recommended the stock in August 2004. Amidst a later bidding war for MCI waged by fellow telecommunications companies Verizon (NYSE: VZ ) and Qwest (NYSE: Q ) , Philip reasoned that the firm's value had been realized and that there would be little left to gain by continuing to hold. Subscribers enjoyed a gain of approximately 52% for MCI in about six months, a classic example of buying low and selling high.
Follow the formula
Once you've figured out what a company is really worth, its margin of safety will tell you when it's time to buy and when it's time to sell. The lower a company's price with respect to that intrinsic value, the stronger the margin of safety, and the better the chance that buying that company will lead to a profitable investment. The higher a company's price with respect to intrinsic value, the more that margin of safety has been reversed, and the better the chance that it's time to sell your position and take the extra profits from your bargain-hunting trip.
Like the idea of knowing how to buy low and sell high? Want more value investing tips and techniques? Start with a free 30-day trial of Inside Value, The Motley Fool's home of the margin of safety.
This article was originally published July 13, 2005. It has been updated.
At the time of publication, Fool contributor and Inside Value team member Chuck Saletta did not own shares of any company mentioned in this article. Advance America and Coca-Cola are Inside Value picks. The Fool has a disclosure policy.