Fool.com: A Cautious Investor's Credo [Special] September 3, 2002

Congratulations, class! You've been back to school with us for one week, and think of all you've learned. We trust you enjoyed a little rest and relaxation this Labor Day Weekend, because now it's time to get back on the horse; back to the basics; Back in Black -- you get the point.

Last week, Matt Richey recommended the "index investing plus a few" strategy, while Jeff Fischer reminded about the importance of understanding what you own. Let's finish our review of the fundamentals of investing with a look at the four principles that guide a cautious investor's thinking. 

The painful Nasdaq slide has helped shape my thinking about investing and structure my priorities. You may say it's too late for such a list, but here's a look at what I've learned, not just from watching high-quality technology stocks tumble, but from reading the lessons of successful investors, such as Ben Graham, John Neff, Ralph Wanger, and Bill Ruane. This may not be the only strategy that works, but it's the approach I'm comfortable taking.

Investing in high-quality companies is a given
Too much focus on quality leads to bad decisions, if, for example, it means paying any price for a quality business. Of course, investors should concentrate on companies with competitive advantages, such as pharmaceutical company Pfizer's (NYSE: PFE) renowned sales force, and on companies that generate solid returns on capital. But other investors are doing the same thing. Focusing on quality companies is like putting in the proper training for a marathon. It's required if you plan to compete, but you still have to run the race and make good decisions on the road.

Now, you can't have investment success without understanding the importance of quality. This is a key lesson, more so when you realize the number of investors who still put money in penny stocks or pricey initial public offerings hoping to beat the odds. This strategy is a bad bet, and almost without exception, should be avoided.

Don't invest in unprofitable companies
It never surprises me to read that the number of start-up businesses that fail ranges from 50% to as high as 80%. These aren't good odds, and I wouldn't invest a dime if I had a 50% chance of losing my money. (You can put your funds in a money market account and earn 5%.)

Yet the number of high-profile, unprofitable companies is still high, fed by the hungry bull markets of the 1990s, the sirens song of brilliant technology, and the star power of talking heads on CNBC. As an investor, I stay away from them all.

This means I will likely miss the next big thing. I'm not invested, for example, in any biotechnology stocks. They may have proprietary technology, teams of bright scientists, and capable managers. Some investors, by dint of temperament and training, are in a position to bet on that. I won't go near a stock until I get a sense what kind of cash the company is reasonably expected to produce in the future. You can't do that with an unprofitable enterprise.

This goes hand in hand with the notion of preservation of capital, a phrase I'd like to read a lot more often in the investing press. It may sound like a dusty, old economy practice, and it certainly can be taken too far: If you're age 25 and 70% in bonds, then your money's on the couch eating Pringles. Still, the preservation of capital is the investor's equivalent of the Hippocratic Oath: First do no harm.

Margin of safety
Ben Graham said it, and it's been practiced over the last seven decades by hundreds of successful investors. At root, margin of safety means buying stocks selling at a steep enough discount to intrinsic value that it provides a cushion against unforeseen events. Calculating intrinsic value isn't easy and isn't exact, but it's part of the due diligence investors must perform to invest safely. Columnist Whitney Tilson wrote about margin of safety and how he applies it in "Trembling With Greed."

It is this concept that must be married to the high-quality standard to invest successfully. It means I may never get to invest in Microsoft (Nasdaq: MSFT) or Home Depot (NYSE: HD). Maybe, maybe not. The market provides many opportunities.

Investing in stocks isn't easy
Knowing this going in reminds me that it takes work to identify the right kind of high-quality company, get an understanding of its profitability potential, and get a rough idea of its intrinsic value. You don't have to be able to discount cash flows in your head, but it takes elbow grease, and an interest in business.

Also, you might have to wait a long time before a company you like is selling at a price you're comfortable paying. I watched Dell (Nasdaq: DELL) for two years before it became available at a price that made sense to me. It might never have happened at all. I have to be patient enough to wait, or move on.

No, it's not easy. In life, as in investing, knowing when and where to get help is key. Our Choosing Stocks With The Motley Fool online seminar can help you develop an investing strategy that's right for you. The next session starts Sept. 19.

Richard McCaffery is a former Fool who owned shares in Dell when he wrote this article last year. We like its timeless lesson so much that we updated it this week. The Motley Fool is investors writing for investors.