The Business of Value Investing.pdf

18 The Business of Value Investing

of buying a share of stock based on the business ’ s future earnings

potential, asset values, or balance sheet strength was virtually unheard

of. Instead, speculators were buying shares of businesses hoping

for the next great oil fi eld or gold mine discovery. Investors did not

understand or even consider the concept of looking for cheap busi-

nesses that had high margins of safety. Graham provided an almost

scientifi c formula characterized by intense analytical effort toward

approaching stocks. The underlying premise was that a stock repre-

sents a piece of a business, and the investment approach should be

rooted on that concept.

Notice the three underlying characteristics of an investment

operation: thorough analysis, safety of principal, and a satisfactory

return. An investment must encompass all three. Interestingly,

the order of the three conditions is very important. Obviously,

you fi rst must analyze the business and fi gure out what it is you

are buying. You can achieve this goal only through deep, rigorous

analysis. Then, before you should consider how much money you

stand to make, you fi rst should rule out any possibility of a sub-

stantial loss in capital. One of the cornerstones of value investing

is understanding that capital preservation comes fi rst; only after-

ward should you think about capital appreciation. You see this

devotion toward capital preservation in various sayings by many

of today ’ s most successful value investors: “ Preserve the downside

and let the upside take care of itself ” or “ Heads I win, tails I lose

little. ” No matter how you word it, the idea is the same: Preserving

your capital ensures a very high degree of long - term investment

success.

Some very simple math will bring this point home. Consider

two investors. During the fi rst year, a tough time for stocks, both

investors suffer a down year. Investor A is down 10 percent while B

is down 25 percent. The next three years are more favorable mar-

ket environments, and both investors do well. Their performance

results are:

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