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.
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 2004 inception. 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 coal companies such as Arch Coal. Its shares may have blown the market away over the past five years, but it owes its run more to changes in the price of energy than to any particular improvements in its operations.
The strategy simply works
Instead, Philip has relied on companies with competitive moats, such as management consulting giant Accenture
Philip first picked Accenture in June 2005, after a decline in its operating margins spooked Wall Street. He recognized that the decline was largely temporary rather than the permanent reduction in value that the market panic had predicted. Sure enough, two and a half years later, the stock has outpaced the S&P 500 by 33 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.)
Imagine buying fast-food titan McDonald's
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. After more than doubling for subscribers between October 2004 and November 2005, Philip recommended just such a sell for pharmacy benefits provider Omnicare
Its shares had simply run past Philip's objective analysis of their true worth. Just as discount prices don't last forever, shares don't continue to trade far above their fair values forever. In Omnicare's case, in fact, its shares fell far enough following Philip's recommended sale that it once again became a bargain price -- cheap enough for value investors to buy again.
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.
At the time of publication, Fool contributor Chuck Saletta owned shares of Omnicare. Omnicare and Accenture are Inside Value selections. Chipotle has been chosen by both Motley Fool Hidden Gems and Motley Fool Rule Breakers. The Motley Fool has a disclosure policy.