2. In theory: How much to pay
When an investor strikes a deal with the owner of a business to buy a share of his company, like in Dragons Den, it's easy to see the principle of margin of safety in action. The investor haggles for a better deal, his margin of safety, and the entrepreneur compromises, or walks away.
Investing in the stockmarket is very similar. One way or another you decide whether the share price is cheap enough, whether it gives you a margin of safety, and if it is, you place an order with your broker. If it isn't, you walk away.
Shares aren't always cheap. Sometimes they're expensive, and sometimes the market price seems about right. Benjamin Graham likened the stockmarket to a hyperactive business partner, Mr Market, who would offer you his share in the business, or make an offer for yours, every day:
"Sometimes his idea of value appears plausible... Often, on the other hand Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
"You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position."
Over many years, markets accurately reflect the value of companies, but in the short term Mr Market is fickle. This gives investors an opportunity to buy shares when prices are low, and sell when they are high.
It sounds easy, but in practice people find it very hard to do. When a share price is rising it gives them confidence and they tend to buy. When it's falling they tend to lose confidence and sell. Sometimes following the crowd like this is justified, but generally you're buying high and selling low, which is not a way to make money.
Thinking like a value investor means thinking independently. Low prices are good, unless the business you're buying a share of is cruddy. That's a technical term, meaning it's got serious problems that diminish or eradicate its ability to profit in the future. The mistake many investors make is in thinking the market price tells them something about a company. It doesn't, it tells you what Mr Market thinks of the company. Value investors decide whether they agree with Mr Market or not.
There are two ways to decide. The first is to examine the company's finances, its record of profitability, and its prospects, and calculate the company's value. Graham called this ‘intrinsic value' analysis to differentiate it from the more erratic market value. By comparing the two, it's easy for an investor to see whether a company's shares are cheap or expensive.
Unfortunately, intrinsic value analysis is very difficult to do. In the early 1970s and late in his career, Graham rejected it. He doubted both the use of increasingly complex mathematics to calculate the present value of dubious profit forecasts, and whether any individual analyst could expect to produce consistently superior valuations. It just wasn't worth the effort now that everybody was doing it.
He reckoned investors could earn 15% a year in a typical year by following very basic rules identifying good companies at cheap prices. Those rules (simplified even more here) were to buy shares that cost less than about ten times earnings in companies where shareholders owned more than 50% of the company's assets, and to buy lots of them.
These two factors, the price/earnings ratio and the ratio of equity/assets, are rough and ready proxies for value and quality. They help us gauge the cheapness of the shares, and the quality of the company, without having to calculate intrinsic value. But they are fallible, which is why Graham proposed owning portfolios of 20 or 30 companies.
Sometimes the shares look cheap, but the business really is cruddy. Woolworths, which went bust in 2008, was an example. And HMV (HMV), which is in trouble right now, could be another.
On average, over long periods of time, research shows value portfolios beat the stockmarket average handsomely. Put all your money in a few companies selected this way, though, and you could lose everything if you pick the wrong ones.
More advanced books on value investing:
• The Intelligent Investor by Benjamin Graham (updated by Jason Zweig)
• The Rediscovered Benjamin Graham by Janet Lowe
• The Financial Times Guide to Value Investing by Glen Arnold