Morningstar.com
Keeping It Simple Isn't Stupid
Friday August 30, 7:00 am ET
By Mark A. Sellers
Seventeenth-century French philosopher Blaise Pascal once said, "All man's miseries derive from not being able to sit quietly in a room alone." I can't think of better words to describe investing.
As I write this, the S&P 500 index stands at around 900, the same level as in July 1997. That means most investors' portfolios have gone nowhere, on average, over the past five years. Sure, there have been moments of euphoria and, lately, despair. But on average, an investor who stuffed his or her money under a mattress and "sat quietly in a room" for the past five years would have been no worse off than those of us who scrutinize every nook and cranny of the stock market.
Times like this remind me just how simple stock investing is. When the talking heads start to blather on about sector rotation, unemployment numbers, technical indicators, the falling U.S. dollar, or the direction of interest rates, do yourself a favor and hit the "mute" button. These things are just noise.
When thinking about whether to buy a stock, there are only three main considerations.
Economic Moats
First, you need to determine if a company has what Warren Buffett calls an "economic moat." An economic moat is a long-term competitive advantage, and the wider the moat, the better the quality of the company. How do you determine the size of a company's moat? You must think about two important things: the attractiveness of the industry in which the company competes and its competitive position within that industry. This means sickly industries, such as steel manufacturing or the airlines, will have few companies with wide economic moats. By contrast, the pharmaceutical and data-processing industries, which have very attractive long-term economics, include numerous companies with wide economic moats, such as Merck (NYSE:MRK - News), Pfizer (NYSE:PFE - News), Automatic Data Processing (NYSE:ADP - News), and First Data (NYSE:FDC - News), among others. Just being in a good industry isn't enough though--a company also has to have a strong position within that industry. Thus, not every pharmaceutical or data processor gets a wide moat rating. Still, a mediocre data processor probably has a wider moat than Nucor (NYSE:NUE - News), the best steel company.
Margin of Safety
The second critical factor in making the "buy" decision is valuation. Specifically, you need to determine whether a stock's price is far enough below its intrinsic value to give you an acceptable margin of safety.
Why is a margin of safety so important? Because, as humans, we make mistakes from time to time. You may calculate Johnson & Johnson's (NYSE:JNJ - News) valuation to be $70 per share, when in reality it may be worth only $49 a share. If you buy the stock at $70, there's a decent probability the stock could fall and take several years to get back to your purchase price. But if you require, say, a 30% margin of safety before buying, you'd wait until Johnson & Johnson fell below $49 before jumping in. In other words, a margin of safety mitigates your valuation risk.
This method isn't perfect, and it virtually guarantees you'll miss out on some great opportunities. Microsoft (NasdaqNM:MSFT - News), for example, always looked overvalued during its meteoric runup in the 1980s and 1990s, and being conservative would have meant missing this opportunity. But those investors who refuse to buy unless they have an acceptable margin of safety were selling stocks, not purchasing them, during the latter part of the 1990s and in early 2000. Those people, including Warren Buffett, look pretty smart right now.
Your Time Horizon
Finally, to do well in the stock market, you need another kind of patience: the ability to wait out bear markets without panicking. If your time horizon is anything less than three to five years, you probably shouldn't be buying stocks in the first place. Over any short time period, such as one to three years, stock markets are inherently unpredictable. If you're buying stocks with money you'll need next year, the year after, or anytime before the next five years, you're playing with fire. Sure, things may work out well, but as we're seeing now, markets can go nowhere for stretches of five years or longer.
So there you have it--three simple questions to ask yourself before buying a stock: Does the company have an economic moat? Is there an acceptable margin of safety? Am I willing to wait three to five years for the stock to perform as expected? If the answer to all of these questions is yes, it's time to buy the stock. If the answer to any of these is no, sitting on the sidelines is appropriate.
Stocks to Buy
Right now, there are several stocks with wide economic moats selling at acceptable margins of safety. A few of the most compelling opportunities, in my opinion, include Paychex (NasdaqNM:PAYX - News) ($24), Applied Materials (NasdaqNM:AMAT - News) ($13), First Data (NYSE:FDC - News) ($34), Citigroup (NYSE:C - News) ($33), American Express (NYSE:AXP - News) ($36), Eaton Vance (NYSE:EV - News) ($29), and Intel (NasdaqNM:INTC - News) ($17). |
