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:

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.