It's Time to Play Roulette

In The Intelligent Investor, the book that Warren Buffett called "by far the best book on investing ever written," Benjamin Graham likened the stock market to a roulette table. In roulette, nobody knows exactly what number will come up with every spin, but thanks to its built-in advantage, the house will win money over time.

Likewise, in the stock market, you can't be 100% certain of what the future will bring for any given company you may choose to invest in. But if you follow a solid investment strategy like the value-focused one that Graham pioneered -- more on that in a minute -- you can wind up with the investing equivalent of the house's edge.

Think like the casino
Graham's philosophy was centered on two key principles. The first, which he called "Margin of Safety," can be summed up in a few simple sentences:

  • Almost every company is worth something.
  • That something may not have any connection with the company's stock price.
  • When there's a significant difference between price and worth, invest accordingly.

It sounds simple, and on paper, it is. Out in the real world, however, it can be gut-wrenchingly difficult to invest according to those principles. As amazing an opportunity as the market may be handing us right now, it's hard to justify investing when we've seen so many formerly seemingly invincible titans like Fannie Mae and AIG going belly-up or requiring rescue.

That's why it's important to remember that even though the casino occasionally pays out to the gamblers at its roulette wheel, the house has a significant long-term edge. Successful value investing -- like successful casino management -- isn't about making sure every spin is a win. Instead, it's about making sure you have the right strategy to ensure your long-run profitability.

Cover your bases
Graham's second key principle was smart diversification. In Graham's view -- which differs from Wall Street's Efficient Market mumbo-jumbo -- that doesn't mean you should go out and buy a bit of every company, willy-nilly. Instead, you should find and buy undervalued companies in a variety of industries, to protect yourself from slip-ups by one particular company or industry.

After all, did you predict that the subprime mortgage bubble would take down all of Wall Street? And if you happened to get that one right, did you invest accordingly before the meltdown? Spreading your cash around solid companies in a variety of industries will help to protect you from surprises.

A good way to think about Graham-style diversification is to focus on companies that are:

  • Making money now.
  • Expected to keep making money in the future.
  • Trading at a reasonable to cheap valuation.
  • Operating in different, largely unrelated business areas.

I've selected a group of companies for you that fit the above criteria. Since the market's median price-to-earnings ratio from 1871 to 2003 was about 14, and its median forward P/E was 11, I also made sure these companies are trading below 11 times both last year's normalized and next year's expected earnings:

Company

Industry
Classification

Normalized
Trailing P/E Ratio

Forward
P/E Ratio

Chevron (NYSE: CVX  )

Energy

5.7

10.3

Merck (NYSE: MRK  )

Health care

9.6

9.5

Time Warner (NYSE: TWX  )

Consumer Discretionary

9.0

10.1

Caterpillar (NYSE CAT)

Industrials

8.7

10.8

Travelers (NYSE: TRV  )

Financials

10.4

8.0

Dell (Nasdaq: DELL  )

Information Technology

8.9

7.8

Archer Daniels Midland (NYSE: ADM  )

Consumer Staples

8.6

8.5

Of course, these stocks aren't formal recommendations, but if any of them catch your eye, they could serve you as starting points for further research.

Own your own roulette wheel
By building your portfolio based on both value and smart diversification, you can make yourself the stock market equivalent of a casino running a roulette wheel. While you still have no guarantee of winning on every investment, you do stack the odds in your favor -- so overall, you wind up ahead.

At Motley Fool Inside Value, we're seeing high-quality companies trading at fire-sale prices. If you'd like to take a look at the entire diversified collection of undervalued companies our team of analysts have hand-picked for our members, simply click here to start your 30-day free trial.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Merck. Dell is an Inside Value selection. The Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 06, 2009, at 6:10 PM, dividendgrowth wrote:

    If forward P/E is a lot higher than trailing P/E, it means serious earning contraction down the road.

    Why should you buy cyclical companies at beginning of cyclical downturns? Shouldn't you be buying them at the cyclical bottom?

  • Report this Comment On January 06, 2009, at 6:47 PM, termin8r03 wrote:

    One thing you're forgetting about Graham's valuation strategy is that P/E is not the sole representation of a company's value.

    I'm looking more at Book Value than P/E or forward P/E

  • Report this Comment On January 06, 2009, at 9:29 PM, TMFBigFrog wrote:

    Hi Fools,

    Yes -- Graham looked at a wide variety of metrics when determining value. He is of course well known for his "Cigar Butt" approach that used balance sheet measures like net tangible assets, but in The Intelligent Investor, he also talked about dividends, PE ratios, and other measures as well.

    Graham had the space available in an entire book to work with. While I would have loved to tackle more of the concepts he discussed at one time, we have to strike a balance between completeness and readability in these articles...

    Also -- yes, a higher leading PE vs. trailing PE is a sign of expected earnings contraction. The questions you need to ask yourself, though, are:

    1) Is the company still cheap, even though its earnings will be dropping in the near future?

    2) Is the drop in earnings a permanent shift in the business or an artifact of cyclicality?

    3) Can you really time that "cyclical bottom" well enough to buy there?

    Best regards,

    -Chuck

  • Report this Comment On January 10, 2009, at 2:07 PM, Dadw5boys wrote:

    Look at the 20 charts.

    Stock prices are returning to that level !!!!!

    Don't be suckered into believing they are worth more that that.

    If you can make a profit good luck the fools may drive the stock price up but that won't make the company more valuable.

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