Easy Steps to Becoming a (Better) Value Investor: Part 1

Worldwide Invest Better Day 9/25/2012
Worldwide Invest Better Day 9/25/2012

If you have ever been accused of being a contrarian, a naysayer, a negative Nancy, or a Debbie downer, you may be a great value investor. In contrast to our growth-hungry friends, we value people love to imagine the worst-case scenario. We say "no" a whole lot more than any other word. The next big thing is just the next big thing to avoid. When someone asks us whether we want to hear about this investment idea they have, we may politely indulge, but on the inside we're already grumbling.

Value investing isn't the easiest method of investing. But when broken down to the basics, it is a doable, logical process that you can start practicing today. Before you know it, you'll be on your way to investing like the world's greats.

Holla to my value homies
I like to use an old cliche to describe value hunters: The best offense is a good defense. The true beauty of this style of investing is the concept of capital preservation. Making money is great. We all want to do it. It's on the mind of every man and woman who walks through the doors of a casino. But what is far more important -- and what will immediately place you among the top echelon of investors worldwide -- is to avoid losing money. When you lose money, you are no longer investing to make money; you are now in a race to get to zero. Depending on the loss, that milestone could take months, years, or even longer to reach. When you lose 50% of your investment on a stock, you now have to make a 100% return to get back to square one. It's the worst thing you can do as an investor, and value investing aims to eradicate it from the realm of possibility.

So how do you accomplish this seemingly daunting task? Count on making mistakes.

Lesson 1: Margin of safety
I know we've all heard this term before, but let's review for the heck of it. When we establish a margin of safety in our investments, it means we compensate for our own errors and unforeseen events down the line. If you think you have identified the intrinsic value of a company, you may want to stretch your numbers by 20% to allow for mathematical errors, a potential loss due to a plant shutting down, or just a plain old, generic "oopsie." The rule here is: The larger your margin of safety, the more you can screw up.

The basic way to establish your margin of safety is to do the opposite of what most investors do. Instead of trying to determine how high the stock price may go, figure out how low it can dive. If everything from plant shutdowns to acts of God and technological disruptions slammed your prospective company one year, what would the stock price look like? Would it be a permanent correction, or something the company could adapt to? Downside-risk analysis should be your baseline for figuring out whether you have any interest in investing. If it looks like a stock can go to zero for any reason, think twice before buying some shares and make sure your risk is compensated by a low earnings multiple.

Many investors look at a company like Best Buy (NYS: BBY) and think it's very cheaply priced. If the company manages an effective restructuring, the stock could triple, quadruple, or better. But it would be of greater use to determine the liquidation value -- a viable alternative for a company like Best Buy. If management just can't figure out what to do and private-equity groups aren't interested or can't afford a buyout, what would the company look like when its assets were sold off? Is it a likely outcome? I don't think so, but it'll give you a floor for the price you are willing to pay for the stock. If you think it's worth $10 per share in a worst-case scenario, buying at today's price of near $18 may not be worth it.

The flip side is missing out on a great stock at a fair price. Warren Buffett claims one of his biggest investing mistakes -- besides buying the namesake of his holdings company, Berkshire Hathaway (NYS: BRK.B) -- was not buying Wal-Mart (NYS: WMT) in the 1980s. Buffett wanted the stock to come down a few more cents before he would start buying shares -- in order to meet his own margin of safety. Well, the stock never reached the low he wanted it to, instead going up -- way up. Buffett estimated that waiting for the stock to come down one-eighth of a percent in price cost his firm roughly $10 billion in the long run.

If you want to invest like Buffett but don't have time for the extensive legwork, check out this special free report. It covers a few companies that Buffett loves and we love, too.

The article Easy Steps to Becoming a (Better) Value Investor: Part 1 originally appeared on Fool.com.

Fool contributor Michael Lewis owns none of the stocks mentioned above. You can follow him on Twitter @MikeyLewy. The Motley Fool owns shares of Best Buy and Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. The Motley Fool has a disclosure policy.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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