Value-based Investment: The Rules


 

The rules here are simple. They follow common, yet clear, sense.

Warren Buffett [1], the great investor of all times says: Rule number One: Never lose money! And rule number Two: Never forget Rule number One.

Sounds easy? Not always. But keeping those tow rules in mind helps you say no to a bad investment, while cheering a big yes to a wonderful investment. The first opportunity has the potential to make you lose money. The second has the potential to make you profit.

The intelligent investor buys wonderful businesses at attractive prices, that’s how he/she adheres to the two rules above.

After the IV discussion few days ago, we can guess what an attractive price is. It’s buying a dollar worth of the stock IV for 50 cents! weird? difficult? Not really.

Everyday, stock markets all over the world, list businesses selling at such discounts. Remember, Mr. Market is not logical, it doesn’t care what the IV is. It follows its fluctuating mood. A wonderful business may go down to an attractive price. But we need to be patient and ready. We must be sure that this is the business we want to add to our portfolios.

So, what we do is the following:

  1. Make a list of businesses you like. By that I mean, you’d love to own. You’re interested in their products or services. You know the management, or the owners, and you want to be part of the game. Something in every entry on that list has attracted your attention
  2. One by one, find out the IV of each business
  3. Divide that IV by 2. That is your attractive price. You keep the stock on your radar screen till it hits that price. Why do we discount the price that much? first, it’s very possible that the business would fall to that price. Second, we all like to sleep well at night, don’t we? In order to sleep well, not worrying about your stock picks, Ben Graham introduced another term he referred to as Margin Of Safety (MOS). When you divide the intrinsic value of a stock by two, you introduce the right MOS into the process. Even if Mr. Market becomes so angry at that business and yanks its price way down, you’re still much better off than someone who bought at the IV or even higher!
  4. Decide whether the business is a wonderful business or not. Is it going to grow your money, or is it going to send you to the cleaners? You shouldn’t buy such a loser even at 10% of the IV.

But how would you know that the businesses on your list deserve your money (provided their share prices have already fallen down to 50% of the IV)?

That’s our topic for the next episode…

To be Continued…

 

The Wealth Maker

 

[1] Warren Buffett was one of Ben Graham’s devoted students. He had followed Ben’s methodology for a long time, then introduced some of his own modifications. However, the theme and style of Buffett’s investment approach still resembles that of Graham’s to a great extent. Together, they have had changed the business of value investing for good, and for the better…

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