There's one investment strategy that, if you master it, will prove to be a fabulous moneymaking tool regardless of whether you're a growth investor or you lean more toward value. It's a simple rule that anyone can understand, but when applied consistently over the course of a lifetime, it can lead to incredible wealth.
The strategy is the most important concept from the finest book on investing ever written, Benjamin Graham's The Intelligent Investor. This book contains key ideas that top investors apply to outperform the market year after year, but its central concept is that investors should buy stocks with a margin of safety.
Margin of safety
The idea is that investors can profit handsomely by buying stocks for significantly less than their fair value, conservatively calculated. The fair value of a stock can be determined in a number of ways -- it can be based on the company's net assets, its normalized earnings, or its future cash flows.
Buying with a margin of safety is effective because it offers high profit potential with low risk. The low risk stems from purchasing something for less than it's worth. Remember: If a stock is undervalued now, it's less likely to become even more undervalued later.
The high profit potential is the result of two factors. First, stocks tend to return to their fair value over the long term. So even if a company posts average results, its stock can become a profitable investment simply by returning to its fair value. Second, companies tend to improve their positions and profits over time. Thus, even if the stock remains undervalued, investors can potentially make money from the company's growth. When these two effects happen simultaneously -- the company's profits grow and the stock returns to fair value -- investors' returns can become significant.
Some examples
As an asset play, Graham cites Great Atlantic & Pacific Tea (NYSE: GAP), when the retailer was an outstanding business, trading at prices below its net current assets. In other words, if you liquidated the company, the shareholders would make a profit just from the assets -- yet the business was actually profitable. Investors tripled their money within a year.
The same thing happens with growth stocks. Warren Buffett, a Graham disciple, bought shares of Washington Post (NYSE: WPO) in 1973 and Coca-Cola (NYSE: KO) in 1988 because he was able to determine, based on his estimates of these companies' future growth, that that they were trading at a discount. In 1964, he was willing to invest 40% of his assets in American Express (NYSE: AXP) because he was confident of his margin of safety.
However, the key with growth stocks, according to Graham, is to use conservative calculations when working out fair value. By absolute standards, Juniper Networks (Nasdaq: JNPR), Qualcomm (Nasdaq: QCOM), and EMC (NYSE: EMC) are three of the most successful companies in exploiting the tech boom at the turn of the century. All of them capitalized on huge growth trends in technology -- Juniper in networking, Qualcomm in wireless communications, and EMC in networked storage. Yet investors who bought in 2000 have lost money. They correctly identified great companies, but they bought with an insufficient margin of safety because they failed to be conservative enough in estimating these companies' growth.
The upshot
Buying with a margin of safety is just one of several important ideas in a book that even Buffett calls "By far, the best book on investing ever written." Because the strategies described in the book really work, we constantly use such techniques in our Motley Fool Inside Value newsletter. For example, we calculate the fair value of every pick so that subscribers can see which recommendations offer the greatest margins of safety.
This article was originally published on April 7, 2006. It has since been updated.
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