A dictionary will tell you that investing involves putting money into assets with the intent of making a profit. But that's not the whole story. Speculating, for example, involves the very same process.
The legendary "Dean of Wall Street," Benjamin Graham, differentiates the two approaches in his seminal work, Security Analysis, and in the process, he offers the best definition of investing I've come across. Graham says an investment is something that " upon thorough analysis, promises safety of principal and a satisfactory return. [Emphasis mine.] Operations not meeting these requirements are speculative." Given that definition, a lot of us who think we are investing may come to discover that we're engaging in what I would call intelligent speculation.
So let's briefly review Graham's three criteria for an investment. I'll conclude with two securities that I think would meet his test over the next several years.
Thorough analysis
: Do your homework
Warren Buffett used to write down why he was making an investment. If what he wrote wasn't crystal clear, he either did more research, or he'd decide that he simply could not understand the business well enough to make an investment.
Imagine you're buying a house. You would make sure it's a nice, safe neighborhood with a good school system before you put down your money. Buffett puts that kind of prudent diligence into his stock research, and so should you. Really good investments are really hard to find. So when you find one that looks interesting, do your homework. Study the industry. Examine the competition. Find out everything that could possibly go wrong through boom and bust cycles.
Safety of principal:
Never lose money
Buffett says he has two goals when making an investment. Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.
There are three types of stocks: the overvalued type, the fairly valued type, and the undervalued type. Your goal is to avoid the first, ignore the second, and buy the third. One way to keep attuned to that goal is to focus on value over price. Google (NASDAQ:GOOG), for example, is a fantastic business that is doing all the right things to ensure its long-term success. Yet at more than $500 a share, Google trades for better than 40 times earnings. If Google has a bad quarter or year and you've bought in at $500, you don't have much safety of principal. But if the stock suddenly shot down to $100 after a bad reporting period and the economic characteristics of the business remained intact, your investment thesis is entirely different. The one variable is the price. As Buffett once said, "Price is what you pay. Value is what you get."
Satisfactory return
: Risk versus reward
Any time you commit capital to one business, you are forgoing the opportunity to commit that capital to any other business. But that's OK, because if you are rational, the investment you choose will be better than all other alternatives.
So what should you be looking for? Well, you can always invest in the market through index funds and earn, on average, about 10% a year without exerting any effort. Whatever you do, you should at least expect a higher rate of return than U.S. Treasury Notes, commonly referred to as the risk-free rate, which currently stands at around 5%. I like to make investments that I think can exceed the market rate of return by 3% over the long run. John Bogle once stated that more than 85% of active money managers fail to beat the stock market by 3%, so making investments that can yield you 13%-15% a year is a satisfactory return, given your alternatives.
Meeting the Graham threshold
Over the weekend, I came up with two businesses that I think could pass Graham's test of an investment operation. I'll offer some general information and leave the deep analysis for you and other fellow Fools to tackle.
The power of the Trinity
Trinity Industries (NYSE:TRN) is the largest manufacturer of railcars, with more than 31% of all railcar shipments in 2006. It also makes barges for marine transports of bulk goods and commodities, as well as propane tanks for utilities and industrial companies. And it's the largest manufacturer of wind towers in the United States, too. Plus, anytime you drive down a highway and notice those long stretches of guardrails on each side, you're seeing a Trinity product -- no other company makes them. Oh, and it's also a major supplier of ready-mix concrete in Texas.
Trinity generated about $3.2 billion in sales in 2006 and posted a net profit of $230 million, or $2.99 a share, equating to a P/E of 15. Return on equity was a respectable 18%. At the end of 2006, the company had a backlog for new railcars of about $2.9 billion and $464 million of inland barge products. Trinity does generate about 50% of its revenues from railcars, but as we've seen, it has leading positions in several other stable businesses. No less than Legg Mason legend Bill Miller recently disclosed a new position in Trinity.
Thirsty, anyone?
Mueller Water Products (NYSE:MWA) (NYSE:MWA-B) is a recent spin-off of Walter Industries (NYSE:WLT). In a more detailed piece I wrote for the Fool, I go into detail about what this company does and why it looks like a long-term winner in my book. The short version: The U.S. water infrastructure desperately needs upgrades to the tune of tens of billions of dollars, and Mueller has the broadest base of existing above-ground and underground infrastructure components. So it's in the best position to make those improvements, and it's getting its ship in order. Most of Mueller's products already occupy the No. 1 or No. 2 spot in their market. Meanwhile, management is shutting down inefficient plants and combining locations to increase margins, and the company recently refinanced its debt to take advantage of lower costs of capital.
The company trades at 17 times earnings, with a market cap of $1.8 billion. So, while it might not seem cheap now, that just means you have time to study Mueller to determine just how cheap it actually is if you look ahead.
For other great investing ideas, see "The Best Stocks Right Now." And keep Benjamin Graham's lessons in mind when you're ready to make your next investment.
Walter Industries is a Motley Fool Hidden Gems pick. To see more small-cap stock picks, treat yourself to a free 30-day trial today.
Sham Gad owns shares in Mueller and Walter Industries. He is currently launching Gad Investment Funds, a value-focused investment partnership modeled after the Buffett Partnerships. You can reach Sham at [email protected]. The Fool has a disclosure policy.
