All investors face an unfortunate conundrum. We all want to make money, but in order to build real wealth, we have to put our cash at risk. With our cash at risk, there's the very real chance that we'll lose money on our investments. It's a risk/reward trade-off, and it is a very real part of every investor's decision-making process.
Value investors are constantly looking to find the market's "sweet spot" -- where it's possible to maximize your returns based on your risk tolerance. We're not expecting to crush the market with every investment, but we are looking to build portfolios that can beat the market with less total risk of losing our capital.
The wrong insurance
The key point for building a successful value portfolio is determining how to reduce your risk without reducing your expected return along the way. If risk reduction were all it took, it would be trivially simple to invest in money market funds and take on virtually no risk at all. Yet doing so would reduce your expected returns, as well. After all, just how much is a money market fund really returning, after taxes and inflation?
Likewise, commission-hungry brokers often sell a strategy known as portfolio insurance, the purchase of derivative securities called "put options," to reduce an investor's risk of loss. Yet that sort of insurance comes with its own set of costs. For instance, as of this writing, near-the-money June 2006 put options on industrial conglomerate General Electric (NYSE:GE) have a time-value component of more than $1.22 per share, which is nearly 4% of the company's current market value. If you buy the put option as "insurance," the company needs to fall at least that much between now and June before the insurance really kicks in. On the opposite side of things, should General Electric's shares advance, the value of your put options would decrease, lowering your overall return.
In essence, by taking out that insurance, you may be capping your risk of catastrophic loss, but you're also giving up a significant chunk of your expected gain. You're giving up so much of your gain, in fact, that you're likely to find a better expected return for less total risk elsewhere, such as in the iShares Lehman TIPS Bond Fund (NYSE:TIP), an exchange-traded fund that invests exclusively in inflation-protected U.S. Treasury securities.
The right margin
If you want real protection for your portfolio -- protection that doesn't cost an arm and a leg -- you need a good dose of margin in your portfolio. No, I don't mean "financial margin," as in debt. I'm talking about a healthy dose of value investing pioneer Benjamin Graham's margin of safety.
Here's how it works: Every company has a fair value that represents its true worth to its owners. Generally speaking, most companies trade pretty close to their fair value. Occasionally, however, something comes along to spook the market into throwing a tremendous fire sale on a firm. When that happens, the company's market price no longer reflects what the underlying business can do. Say, for example, you come across a company whose business is worth $50 a share, but that is trading for $35 a share. In that case, you have a 30% margin of safety -- the market price is 30% below what the company is truly worth. If you buy at that discounted price, the margin of safety protects you in two ways. First, since the company is already trading for less than what it is really worth, there is that much less room for it to fall further. Second, not only does the company have the chance to grow over time as its business improves, but it also has the chance to catapult its way back up to fair value, giving a tremendous bonus return to investors who bought it on sale.
For instance, in the spring of last year, housing-related stocks like homebuilder Pulte (NYSE:PHM) and title insurer LandAmerica (NYSE:LFG) were trading dramatically below their true worth. Fears of rapidly rising interest rates and heated talk of a nationwide housing bubble were providing the one-two panic punch needed to artificially depress the prices of these great businesses. Yet Alan Greenspan and the Federal Reserve had clearly signaled their intention to gradually raise rates, making it that much less likely that rapid-fire rate hikes would decimate the housing market. As a result, the panic never materialized, and investors in these and other housing-related firms have easily eclipsed the general stock market. It's exactly these types of situations that Motley Fool Inside Value lead analyst Philip Durell seeks out every month for subscribers.
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Of course, just by finding stocks that appear to be on sale, we're not guaranteed to profit from each of our investments. Something unexpected could still cause a company to legitimately stumble further. I myself have owned shares of drug company Merck (NYSE:MRK) since before it pulled former blockbuster drug Vioxx from the shelves because of its link to serious cardiovascular problems. That dramatic reduction of anticipated profits lowered Merck's true value, and the resulting lawsuits have knocked the firm down even further.
As a result of those unexpected stumbles, the margin of safety provides a tremendous benefit, but its strongest power comes when it's applied across an entire portfolio of unrelated companies, each trading below its true worth. While any given enterprise can stumble, it's unlikely to take down firms in a completely different business line. As an investor, if you originally purchased those other companies with their own margins of safety intact, then your overall portfolio can still be ahead of the game -- despite the occasional (and inevitable) slip.
It's by adhering to Graham's margin of safety that Inside Value has been able to stay ahead of the market, leading the S&P 500 by a hair more than four percentage points over the life of the service (about 14 months). The tremendous portfolio protection provided by the margin of safety has worked for generations, and it continues to work today.
The latest issue of Inside Value released on Wednesday at market close. If you'd like a free peek at the two newest value picks,click hereto try the service for free for 30 days. You'll have full access to everything we've ever published, and you can learn all about putting Benjamin Graham'smargin of safety to work in your portfolio.
At the time of publication, Fool contributor and Inside Value team memberChuck Salettaowned shares of General Electric and Merck. Merck is a Motley Fool Income Investor recommendation. The Fool has adisclosure policy.
