When you lose money on an investment, it's natural to start wondering whether the pundits are right when they say investing has a lot in common with gambling. After all, there's a good deal of uncertainty in investing; there are absolutely no guarantees that any particular investment will make money.
It can be frustrating to put money into a stock like Doral Financial (NYSE:DRL), the largest Puerto Rican mortgage bank and a company that, by all outside appearances, was making money hand over fist, only to see things begin to unravel right before your eyes. Doral's derivative accounting turned out to be more than a bit aggressive, and as a result, what looked to be a solid and strong institution has virtually fallen apart in a matter of months. Likewise, it can be painful to see a market leader like computer networking powerhouse Cisco (NASDAQ:CSCO) struggle in the marketplace. As dominant and solid as Cisco continues to be, its shares still command less than half what they did five years ago.
As an investor, if you're looking at pages and pages of red ink on your brokerage statement, despite owning well-known brands like Cisco and Doral, you might very well think of the stock market as a casino, with the chips stacked against you and your eventual financial well-being. And with a situation like that, you might think that it makes more sense to cash in your chips and go home, rather than continue to fork over your hard-earned money to a system where the odds are not in your favor.
You're in good company
If so, you're not alone. The father of value investing, Benjamin Graham, likened the stock market to a roulette table -- a game of chance where the house has a built-in advantage. The difference, though, is that Graham's strategy stacked the odds in his favor. While nobody can guarantee a house win with every spin of the wheel, that built-in house advantage means that over time, the casino will rake in cash at the roulette wheel. Likewise, Graham's proteges know there are no certainties in the market, but there are ways to help assure that over time, value investors will come out ahead.
Graham's lessons are simple yet powerful, and generations of investors have made money over the long haul by following in his footsteps. It takes time to build wealth, though, and anyone who tells you otherwise is likely trying to speed the process along for himself or herself by confiscating your hard-earned cash. Ever wonder why state lotteries and casinos like Ameristar (NASDAQ:ASCA) and Boyd Gaming (NYSE:BYD) can practically print money, despite the fact that most rational folks know the odds are not in their favor when gambling? It's not just due to the entertainment value. It's because they offer the hope of striking it rich fast. If you can shed that irrational urge, you can build substantial wealth over time.
The master's lessons
As I said before, Graham's lessons are simple yet powerful. His key teachings can be summed up in just a few straightforward points:
- Determine what a company is really worth and buy only if its stock is trading safely below that value.
- Look for solid, sustainable dividend payouts as a sign of financial strength.
- Diversify appropriately, since not every investment will work out.
- Above all, after buying, be patient and wait for the stock to rise once others recognize its worth.
By following these simple rules, it is quite possible to beat the market. My friend and colleague Philip Durell, a longtime follower of Graham, is proof of that. His Motley FoolInsideValue newsletter has soundly outperformed the market's return since its inception last year. His selections as a whole have performed so strongly, in fact, that I'm going to do something radical: I'm going to name two of the firms that have lagged the market since their selection. Those two are cash advance company Advance America (NYSE:AEA) and First Data (NYSE:FDC), the parent company of Western Union. Both are down a bit since Philip recommended them. Both prove the value of Graham's lessons.
Learning from losses
First and foremost, both companies have illustrated the value of knowing what a company is truly worth and having the patience to wait for the market to recognize that value. This is especially clear with Advance America. Its IPO last year forced it to change its corporate structure from type "S" to type "C", a shift that dramatically increased its corporate tax burden. Because of that change, its profits so far this year seem to be well below last year's levels. This apparent decline is part of the reason its stock has stagnated. Yet if you were to look beyond the headline numbers and make an apples-to-apples comparison to the equivalent earnings from the previous year, you'd see that the business is just as strong as ever.
It's no coincidence that both First Data and Advance America are feeling the market's wrath at about the same time. Loosely speaking, both are in the business of charging people to access cash at a time where such practices are under increasing public scrutiny. Companies in similar lines of business tend to react with one another in the stock market -- when one has problems, it's simply assumed that others will as well. While both companies are likely to emerge from their current difficulties, the short-term gyrations can be painful. To minimize that pain, the best medicine is to spread your investments out -- to not concentrate too much in one company or specific industry.
If you follow Graham's wisdom, you'll know what these companies are worth and you'll be willing to buy even as others panic. The share prices of both Advance America and First Data already reflect the companies' troubles. As an investor, you need to have the patience to wait through the volatility.
Powerful profits over time
As of this writing, and despite losses by First Data and Advance America, Philip's Inside Value picks are beating the market, gaining slightly above 9.5% versus the S&P 500's approximately 5.5% return. In an industry where more than 90% of mutual fund managers cannot sustainably beat passive index trackers like Vanguard's Total Stock Market Index (FUND:VTSMX), that performance stands out as truly remarkable. As Benjamin Graham pointed out more than half a century ago and Philip Durell is demonstrating today, you as an investor cannot guarantee the profitability of any given investment. But by following the value investing rules, you can certainly stack the odds in your favor and better assure your success over time.
This article was originally published on July 20, 2005. It has been updated.
Like the idea of treating investing as though you're playing with the house's odds, rather than a gambler's? Click here for a 30-day free trial to Inside Value, and join other like-minded value investors as they seek out superior long-run investment returns.
At the time of publication, Fool contributor and Inside Value team memberChuck Salettaowned shares in Doral Financial. Ameristar is aMotley Fool Hidden Gems pick. The Fool has adisclosure policy.
