Friday, August 5, 2016

3 Timeless Investment Principles

In his well known investment book "The Intelligent Investor", Benjamin Graham has explained several investment principles that have withstood the test of time.

If you haven't heard of Graham, he is considered the 'guru' of value investing and was a teacher of Warren Buffett. Graham's book is recommended reading for all small investors.

To appreciate and understand Graham's value investing principles, here are three time-tested ones:

1) Margin of Safety

It means buying a stock  at a price below its intrinsic value. What is intrinsic value? defines it as the true value of a company's stock based on all aspects of the company's business, including qualitative and quantitative factors. That means putting a value to the company's reputation, business model, competitive advantage, as well as calculating its financial ratios to assess profitability, sustainability, financial prudence.

A DCF (Discounted Cash Flow) method that takes into account a company's free cash flow and weighted average cost of capital is often used to calculate intrinsic value. But even such a calculation is subjective, as it requires certain assumptions to be made about future earnings that may or may not turn out to be accurate.

Is there an easy way to figure out 'Margin of Safety'? One way is to compare the average 'earnings yield' of a company (inverse of the P/E ratio) over a period of 5 to 10 years with the fixed deposit rates of banks. If the average E/P is more than the current FD rate, you have some 'Margin of Safety'. (Otherwise, you may be better off investing in a bank FD.)

Note that higher E/P means lower P/E, which usually happens in bear markets or when a company is not performing well. A company with strong fundamentals in a bull market is likely to have a high P/E ratio and hence low E/P - not leaving much 'Margin of Safety'.

'Margin of Safety' can also be thought of as 'buy low and sell high'.

2) Profit from Volatility

A young investor had once asked John Pierpont Morgan, the famous American financier, banker and art collector, what the stock market will do on that particular day. Morgan had responded: It will fluctuate.

Warren Buffett had said: Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.

Volatility is an integral part of stock market movements. Sometimes a market fluctuates so rapidly and wildly that it scares off most investors. But irrational market movements can be your friend, because it allows you to avail of sudden extremes of low or high prices.

If you are a long-term investor and not a day trader, there can be a couple of ways you can benefit from market fluctuations. First is 'Rupee Cost Averaging' (or, SIP), where you invest a fixed amount of money at regular intervals, which smooths out day-to-day fluctuations. Second is investing in a balanced fund, which has a mix of stocks and fixed income instruments; stock price fluctuations are 'balanced' by steady returns of fixed income instruments.

For novice investors, or, for those who don't have the time or inclination for detailed fundamental and technical analysis before buying a stock, regular investment of monthly savings in a good balanced fund is an excellent way to build wealth for the long-term without much effort.

3) Know Thyself

You know yourself better than anyone else. At least, you definitely should. Your investment style and strategy should depend on your personality. Otherwise your market returns will not be up to the mark.

Are you an active and enterprising investor, who loves nothing better than to dig out less-known small-cap or mid-cap companies and then do detailed analysis of their annual reports for selecting future multibaggers? Or, do you prefer to be a passive and defensive investor, who hates bothering about the economy, inflation rate, currency fluctuations, price chart patterns?

Do you enjoy the adrenaline rush of picking an unknown stock based on a friend's recommendation and seeing it rise into the stratosphere, or, would you rather make a detailed financial plan and asset allocation plan and then regularly invest according to your plans to achieve your investment goals?

Only you have answers to such questions. And there are no right or wrong answers. The bottomline is that your personality should match your investment strategy. 

However, remember that wealth can not be built by constant activity of buying and selling. It is built by buying with a 'Margin of Safety', using volatility to book part profits and re-entering at lower levels, and holding on for the long-term to get the benefit of dividends, rights issues, bonus issues and stock splits. 

Read more about the three timeless principles.

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What exactly is the Margin of Safety?

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