Every day the market opens, we get a new chance to make a million dollars.
We search. We scour. We consult the charts and the stars, trying to find stocks that will give us that million-dollar payoff.
Unfortunately, we're looking in all the wrong places. How else can we explain the people willing to buy Equinix (NASDAQ:EQIX) at nearly 3,700 times trailing earnings? Or that Pep Boys (NYSE:PBY) remains on anyone's radar screen, even with a P/E greater than 650?
By looking at stocks with sky-high valuations, we've cut out the legs from our margin of safety. If anything unexpected goes awry, those shares stand a good chance of falling sharply from their lofty valuations.
Profits in the margins
Ah, margin of safety. We've all heard about it, but what does it really mean to us? Simply put, it means buying stocks at a discount -- a hefty discount -- to what we think they're really worth.
It's a common enough concept these days, but when investing legend Benjamin Graham first penned those thoughts in his classic investing book The Intelligent Investor, it was a groundbreaking idea. In fact, Graham's ideas were so well-received that they have become a part of our everyday investing lexicon. Yet despite their ubiquity, their real meaning often gets overlooked.
We can probably boil down the essence of The Intelligent Investor into three concepts. This Fool believes they're the only three concepts any investor needs to be able to profit handsomely. Forget them at your peril.
- Pick investments with a margin of safety.
- Take advantage of Mr. Market. He's quoting stock prices to you every day. Sometimes he's up, others he's down. As Graham's protege Warren Buffett likes to say, you can look at the pitches every day without swinging at any of them, because there are no called strikes.
- Consider a stock a piece of a business, not just a piece of paper. Think of yourself as a part owner of that business when you buy into it.
Using just those three concepts, we can increase our profits. Graham's rules compel us to consider the risks involved in investing -- and to try to minimize them, while maximizing our profits.
Dumpster diving for fun and profit
Instead of buying insanely valued stocks at a premium, we should be looking at deeply discounted stocks that the market has tossed aside. That might lead us to Wal-Mart (NYSE:WMT), which is trading at a little more than three times book value. The last time it traded this cheaply was back in 1996, just before it began its march toward four-bagger status over the next three years. Or we might look at pharmaceutical giant Pfizer (NYSE:PFE), with an enterprise value-to-operating earnings multiple of about 10. That figure is around a third of its historical average. For a company that still has a strong pipeline of drugs, its valuation of less than 2.5 times book value is its lowest in the past 15 years.
Warren Buffett bought his stakes in American Express (NYSE:AXP) and Washington Post (NYSE:WPO) when they were in the market's trash bin. These stocks were trading at pennies on the dollar, at huge discounts to their intrinsic value. It shouldn't be surprising, then, that they have been two of his most rewarding investments.
Buffett's held onto those winning stocks for the long term. He's owned his interest in Washington Post for over three decades, earning considerably more than 100 times his original value. That's because a manic Mr. Market offered Buffett a deeply discounted price to the company's intrinsic value, one which gave him a very large margin of safety. The company performed well, and Buffett therefore held on to it, like any good business owner would.
Choose your pitches carefully
Sure, we could buy the latest hot stock an exuberant Mr. Market is offering, but there'd be little room for error in such valuations. In our quest for those million-dollar payoffs, it's better to avoid overhyped stocks. Instead, consider at what price a quality stock like Oracle (NASDAQ:ORCL), for example, might become a compelling investment again -- and then be patient until the opportunity comes to swing at a home-run pitch.
Every day, Motley Fool Inside Value scours the market's trash bin, looking for the discounted values nobody else wants. You'll find both Wal-Mart and Pfizer among its recommendations. Join in the scavenger hunt with a 30-day free trial subscription.
Fool contributor Rich Duprey owns shares of Wal-Mart, but does not have a financial position in any of the other stocks mentioned in this article. You can see his holdings here. The Motley Fool's disclosure policy enjoys Benjamin Graham and graham crackers in equal measure.
