The key to making money in the stock market is invest for the
long-term, buying only undervalued stocks which, to quote Benjamin
Graham, have a “Margin Of Safety”. Ben Graham and Warren Buffett
both made enormous fortunes through long-term value investing. Indeed,
Buffett continues to do so and has averaged over 22% average compounded
annual gains over a 39 year period.
These results are phenomenal and not easy to emulate. However, with time
on your side and a little bit of work it is possible to do nearly as well as Buffett.
Even if you beat the S&P 500′s average long term return of around 11%, you are
doing very well indeed.
Suppose you invest $3,000 in a Roth IRA or other tax-efficient retirement account
every year for 20 years and achieve an average annual compounded gain of 11%
over that period. At the end of the 20 year period you could have around $238,000
disregarding dealing costs and dividends. You have only invested $60,000 – so
$178,000 is generated entirely through compound interest. If you were to emulate
Buffett’s 22%, that $60k would become $1,031,000. If you were to start earlier and
invest $3,000 a year for 40 years at 11%, you would end up with $2,132,483. Match
Buffett’s 22% on these investments over 40 years and you may wind up with a whopping
$55,000,000, for an investment of $120,000! That is the power of compound
interest.
Many people ask me “Which stocks do I buy?” and “How do I start?” They keep
making excuses NOT to start investing for the long-term. My advice is a bit like
a Nike commercial: JUST DO IT! Get started. Open a Roth IRA, start by putting
money in regularly, even if it’s only $25/month. It’s important to get into the HABIT
of regular savings. In the meantime you can worry about which stocks to buy.
Picking stocks to buy is not actually that hard. It should not take a great deal of
work. There are lots of places you can look for investment ideas: in fact there are
hundreds of investing websites, including The Graham Investor where we tend to profile
stocks that come up in value-based screens and give an opinion as to why
a particular may be worth following – not necessarily buying.
There are many different strategies to take; a typical one is to first screen for stocks
that meet a particular value criterion which might be any one of: a low PEG, high intrinsic
value when compared to current price, price below two-thirds of the Graham Number.
Once we have a list of suitable stocks meeting the basic criterion, we can filter
out stocks with poor cash flow, excessive debt, poor earnings, or insignificant anticipated
growth. We also avoid stocks with low liquidity by making sure average daily volume is
as high as possible, and stocks with low prices (typically steering clear of stocks trading
at less than $3).
Once the additional criteria are met, look at the charts for each stock. Look for
a recent clear downtrend or new 52-week low. Put the stocks with a most obvious
downtrend onto a watch list. In particular watch those where the downtrend also shows
declining volume. Look at the news for these stocks to see if there is an obvious
reason for their recent poor performance. Do not buy – they could go down more. We don’t want to try to catch the bottom; it’s a sure way to lose money. What we are
watching for is a clear sign of a reversal and buy as the stock moves up. Often a reversal
can take place slowly and imperceptibly, other times it can be an abrupt reversal. Most
often it is somewhere in between. Perhaps the stock has been beaten down by investor
sentiment in the form of an overreaction to bad news. At some point the bad news may
be dispelled or proven to be unfounded, and the stock will begin to return to fair value.
Or, some good news may come in and the stock reverses as investor sentiment
comes in. Typically when this happens, we want to see the downtrend broken
convincingly and the price rising on increasing volume.
How do we know if the downtrend has broken? Simply draw a line joining the high
points in the downtrend, and wait for that line to be broken to the upside with significant
volume. What is significant volume? It depends. The higher the volume the better. Look
for at least 150% of the average daily volume.
Once you have bought, set a stop loss order around 8-10% below where you bought. If
at all possible, set the stop loss order just below the lowest low point before the
reversal, so long as it’s not too far away from your entry. Spreading your risk can help
minimize losses. Divide your equity into at least 10 lots; if you have $5,000 to invest only
buy $500 worth of each stock and keep your stop loss 10% of that, or $50. If the logical
stop loss point is too far from your possible entry point, don’t invest. Stick to the rules
and cut your losses short. Let your profits run. In the long run you will make much more
on the winners than you lose on the losers — you can have 5 losers and still be down
only $250 or 5% of your equity.
Buying undervalued stocks with good fundamentals in this way at or near low points when nobody else has been interested for a while but there are signs of a reversal is possibly one of the least risky investment techniques because of the built-in “Margin Of Safety”.
(c) 2005 The Graham Investor – Value Investing You may use this article, as-is, provided
this copyright notice is kept intact.
Author Info: John B. Keown is an IT specialist, website builder and private investor who enjoys all things stock-related and in particular seeking out undervalued stocks. He can be contacted via http://www.grahaminvestor.com
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