By Dan Dzombak, Motley Fool,
Warren Buffett has made billions for himself and shareholders of Berkshire Hathaway (NYSE: BRK-B ) following the one rule of investing: Don’t lose money. While it may seem simple, it’s actually the hardest part of investing. Most investors make a key mistake that loses them money year after year. If you read along, I’ll fill you in on the mistake that costs investors billions, reveal the three most important words in investing, and show a tool you can use to profitably put these words to work for you.
If you listen to investors, they’ll often talk about the risk-reward ratio of an investment. Seriously, who thinks about the risks of an investment before they envision the REWARD$? For example, the market is entranced with the lure of Molycorp and rare earth metals. The opportunity is seemingly huge, which has investors hooked, yet there are scores of things that could go wrong. Another example is YRC Worldwide, which has been crushed by the market as it flirts with bankruptcy, but become a favorite among penny-stock investors for its potential to hit the jackpot should things work out.
If you focus on the risk first and not losing money, the upside will take care of itself. By loss, I mean a permanent loss of money — not just a few-months decline in share price. In the short term, stock prices will fluctuate. In the long term, a stock’s price will follow the performance of the business. You should thus focus your efforts on making money over the long run by investing in strong businesses, with excellent managements, when the businesses are undervalued.
The key is to find companies that meet all three of these criteria. If you get the first two right and the last part wrong, it will cost you. There is no denying Baidu (Nasdaq: BIDU ) is an unbeatable business. It’s one of those rare tech companies, like Google, that have a competitive edge that will last for years. The company has shown amazing growth the past few years and is expected to continue as more Chinese consumers and businesses get on the Internet. Unfortunately for investors, this unbeatable business comes at an astoundingly high price. This situation is reminiscent of Google in 2007-2008. Investors believed the sky was the limit with Google’s share price. As a result, investors began to think that buying Google at any price was a good investment. They were mistaken.
From December 2007 to November 2008, Google dropped 63% from its high of $714. We’re not here to guess how high investors will bid up a stock. To win in the long run, you need to figure out how you might lose money and buy at a price that protects you from things not going as planned. To do this, we look to the single most valuable concept in all of investing.
The 3 most important words in investing
Margin of safety.
It’s simple. Imagine you calculate a stock’s intrinsic value at $20 a share, and the current market price is $17 a share. While the stock might appear to be trading for less than it’s worth, that’s a narrow margin of safety. As a rule of thumb, many value investors look for a 50% margin of safety to protect them from their assumptions being wrong. However, in some cases they may require a smaller margin of safety.
The quality of the business, strength of the balance sheet, and future growth opportunities all affect the margin of safety. For example, Philip Morris (NYSE: PM ) has one of strongest brands in the world, is diversified around the world, and is growing at a reasonable rate. The margin of safety you need to invest comfortably in Philip Morris is much less than say for Sirius XM Radio, which also has a strong business, but whose level of debt could cause significant problems should the company trip up. You need a larger margin of safety for Sirius since the chance of permanent loss of capital is significantly higher.
Most investors don’t keep tabs on their companies’ fundamental values. That’s a mistake. You need to follow companies over time, read past the headlines, and wait to invest till a stock is undervalued. If you do so, you’re in a much better position to spot potential trouble early. Better yet, you’ll improve your odds of investing in home run stocks at great prices that provide the market’s best returns.Berkshire Hathaway, Don't lose money, many value investors look for a 50% margin of safety, Margin of Safety, permanent loss of money, rule of investing, rule of thumb, strong businesses, Warren Buffett, when the businesses are undervalued, with excellent managements