We all invest for the same reason -- to make money. And to make money 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, 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), beat the market for 15 consecutive years. That's a record practically unheard of in the mutual fund industry. Even so, Miller's long-run performance pales in comparison to 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 at our 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 -- buying 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.
Using this method, I managed to earn more than 31% in just over a year on an investment in the real estate firm AmREIT
Before I sold, the dividends had stopped rising and the shares had leaped well beyond their book value. With my two buy criteria gone, there was no reason to hold. Two and a half years after I sold it, its shares recently changed hands some 5% below my sell price. The central lesson: All buying and selling decisions should be guided by comparing a company's stock price to its true worth, not by some vague notion of what the hot stock of the moment is.
My friend and colleague Philip Durell follows that philosophy as the chief analyst at Inside Value. His selections as a whole are beating the market's return since the newsletter's inception in 2004. His record is added proof that using a margin of safety truly does work.
Philip has beaten the market without help from the likes of oil giants like Sunoco
Instead, Philip looks for companies with competitive moats, such as financial software firm Intuit
Philip recommended Intuit in February 2005, after the company's stock had taken a nosedive during one of the market's periodic panic fits. And sure enough, between the time he picked it and the time it reached a high enough valuation to warrant a sell, Intuit rose an astounding 88% in a mere 20 months. That easily outpaced the S&P 500 -- by around 70 percentage points.
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 toolkit 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 such a calculator available to subscribers. If you're already a subscriber, you can access it here. If not, you can get access by taking a free 30-day trial of the newsletter.)
Once you've figured out what the company is worth, you can use that information to determine whether it has enough of Graham's margin of safety to be worth buying. In December 2004, for example, using just such a cash flow calculation told me that employment and income verifier TALX was significantly undervalued. Less than three years later, TALX was acquired by credit reporting giant Equifax
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 just might be a candidate for selling. Take the case of a former Inside Value watch-list firm, health-care services company Cardinal Health
Follow the formula
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 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 with a free 30-day trial of Inside Value, The Motley Fool's home of the margin of safety.
This article was originally published July 13, 2005. It has been updated.