One of my favorite sayings from Warren Buffett is, "It is not necessary to do extraordinary things to get extraordinary results." I like this idea, not just because it's observant, witty, and true, but also because it conveys Foolish philosophy. It is possible for small investors to achieve extraordinary results without extraordinary effort. This isn't the same as saying no effort is required -- although being lazy really appeals to me -- but rather that investors can outperform by following a simple set of rules. With that in mind, I propose five rules to help you achieve extraordinary results in 2005.
1. Calculate valuations
Valuation is the key to most successful investing strategies. It makes sense. You're buying a stock because you think that it will be worth more in the future than right now. This is the case whether you're buying Sears
Calculating valuations is a reasonable exercise for almost any security, even shares of companies without revenues. Take a company like stem-cell researcher Aastrom Biosciences
2. Examine moats
A moat is more than just an attractive accessory to a castle. When it comes to business, a moat is a barrier to competition, serving both to protect the profit margins and to help expansion. For instance, eBay's
In general, you should be looking for companies that have strong barriers to competition and be willing to pay more for such companies. It doesn't matter whether a company looks 30% undervalued if it cannot successfully fight off competition. The key is finding companies with sustainable competitive advantages.
3. Buy with a margin of safety
Margin of safety is a critical concept proposed by Benjamin Graham in The Intelligent Investor. The idea is a simple one: Investors should attempt to purchase securities at a significant discount to fair value. Such a strategy is prudent for several reasons.
First, it allows an investor to make significant errors in their calculation of fair value, but still make money. If an investor buys a stock at a 50% discount, the calculations of fair value could be off by 50% and there would still be a reasonable chance for the investor to profit. Second, it reduces the downside risk. If bad news hits, the fair value may fall, but there's a decent chance it will remain significantly above the price the investor paid for the security.
For example, consider McDonald's
McDonald's is also an example of the third advantage of a margin of safety: the potentially huge upside. If an investor buys at a 50% discount to fair value, then even if fundamentals of the business don't improve at all, it's quite possible for that investor to make a 100% profit. And if the fundamentals improve at the same time as the stock returns to fair value, then the potential return is huge. Just look at Coke's performance from the early '80s to the late '90s.
4. Be Patient
It's important to be patient in most aspects of stock market investing. First, it's important to wait for companies to be undervalued before you buy them. After all, if you aren't buying a company that's undervalued, then why would you expect your investment to outperform in the future?
Then, if an event causes a stock to fall, it's important to patiently analyze the importance of the event, calculate the valuation, and examine the moat before buying. For instance, in Merck's
Finally, it's important to be patient after buying, because not every stock reaches its fair value in days or even months. The real money is made over the course of years by owning undervalued companies with strong competitive advantages. Warren Buffett didn't make his billions by trading stocks, but rather by buying companies and patiently holding them, potentially forever. As Buffett says, "Buy a business, don't rent stocks."
Inside Value helps individuals gain the large profits that any investor can achieve by following these rules. Every month, expert value investor Philip Durell identifies undervalued stocks with strong competitive advantages. He tracks the performance of these picks and provides advice when significant news events occur. For instance, when Kohlberg, Kravis and Roberts recently made an offer for door manufacturer Masonite
Inside Value is an excellent tool for experienced investors to find investment ideas and for less experienced investors to learn how to identify undervalued stocks. Plus, the free trial makes checking out Inside Value a risk-free way to find stocks that have the potential to achieve extraordinary returns in 2005.
Richard Gibbons wishes that he had a little moat around his townhouse and wonders whether Masonite would consider a drawbridge a door, or just a bridge. He does not own any securities mentioned here.