We all invest for the same reason: to make money. And to make money in investing, we need to know two key things: when to buy and when to sell.
If you can buy something for $1 and turn around and sell it for $2, then you've made money. If, on the other hand, you buy something for a buck and can't find someone willing to take it off your hands for more than $0.50, you've lost money. Clearly, to make money at investing, the goal is to buy low and sell high. More than half a century ago, Benjamin Graham, the pioneer of value investing, came up with a simple way to do just that -- a concept known as the "margin of safety." By employing this technique, investors greatly decrease the chance that they'll lose their hats and increase the likelihood that they'll trounce other investors.
Following in Graham's footsteps, Bill Miller, who runs Legg Mason Value Trust (LMVTX), has beaten the market for 15 consecutive years -- something that's practically unheard of in the mutual fund industry. And Miller's long-run performance pales in comparison with that of Warren Buffett, a former pupil of Graham's. What's more, Graham's margin of safety is something we put to good use here at the Motley Fool Inside Value investing service.
Know a company's true worth
The key to success is a clear understanding of a company's true worth. With that knowledge in hand, buying low and selling high becomes a simple matter of waiting to buy a stock only when it falls below the company's true worth by a tempting margin. Once you own it, you need to keep tracking the company's value. When the stock rises to an uncomfortably high premium to its true worth, sell it.
This method allowed me to triple my investment in specialty chemical company KMG Chemicals
The method works
My friend and colleague Philip Durell follows that philosophy as chief analyst at Inside Value. His selections as a whole are beating the market's return since the service's inception in 2004. His record is added proof that using a margin of safety truly does work.
Philip has beaten the market without depending on the likes of on-again, off-again technology company Apple Computer
Philip reasoned that Coke, with its solid and growing dividend, large share buyback program, and inexpensive price tag, was simply too good an opportunity to pass up. Sure enough, he was right. Since his recommendation, Coke's shares have risen nicely. Just as importantly, it has raised its dividend a whopping 24% while continuing to repurchase its own shares. These moves showcase Coke's tremendous financial strength and long run potential.
Buying low with the margin of safety
Every company has what Graham calls an "intrinsic value," a measure of what that company is really worth. Finding that value is part art and part analysis. One of the most powerful tools in a value investor's tool kit is a discounted cash flow calculator, into which you put your estimate of how much cash the company will generate in the ensuing years. The calculator then tells you how much the company is worth today. Inside Value has just such a calculator available to subscribers. If you're already a subscriber, you have access any time. If not, you can get access by taking a free 30-day trial to the newsletter. Then you can play with the calculator to your heart's content.
Once you've figured out what the company is worth, you can use that information to help you determine whether it has enough of Graham's margin of safety to be worth buying. For example, in June of last year, Philip put cash advance company Advance America
Selling high with the margin of safety
Logically, if a company trading below its intrinsic value is worth buying, then a company trading at or above its intrinsic value might be a candidate for selling. Take former Inside Value selection and long-distance giant MCI, for instance. Philip recommended the stock in August 2004. After MCI agreed to be purchased by fellow telecommunications company Verizon
Once you've figured out what a company is really worth, its margin of safety will tell you when it's time to buy and when it's time to sell. The lower a company's price with respect to that intrinsic value, the stronger the margin of safety, and the better the chance that buying that company will lead to a profitable investment. The higher a company's price with respect to that intrinsic value, the more that margin of safety has been reversed, and the better the chance that it's time to sell your position and take the extra profits from your bargain-hunting trip.
Like the idea of knowing how to buy low and sell high? Want more value investing tips and techniques? Start a free 30-day trial of Inside Value, The Motley Fool's home of the margin of safety.
This article was originally published on July 13, 2005. It has been updated.
At the time of publication, Fool contributor and Inside Value team memberChuck Salettaowned none of the companies mentioned in this article. Advance America and Coke are current Inside Value selections. The Fool has adisclosure policy.