The One Investment Rule That Will Never Lead You Astray

When Bejamin Graham talked about stock market valuations, he often relied on trailing metrics like the P/E ratios over the past ten, fifteen, twenty year timeframe to determine whether a company was appropriately valued or not. You may wonder why this would be advisable, given that it is the growth of the business and the dividends paid out after you make your initial purchase that matters—not what the trailing metrics indicate.

What Graham understood was this: Using trailing P/E ratios rather than forward forecasts forces the investor to incorporate a margin of safety whether he likes it or not. It is a great way to guard yourself against undue optimism that sets the stage for disappointment. In his supplement to the shareholder letter this weekend, Charlie Munger explained one of Berkshire’s methodological advantages in this way: “It never had the equivalent of a ‘department of acquisitions’ under pressure to buy. And it never relied on advice from ‘helpers’ sure to be prejudiced in favor of transactions. And Buffett held self-delusion at bay as he underclaimed expertise while he knew better than most corporate executives what worked and what didn’t in business, aided by his long experience as a passive investor. And, finally, even when Berkshire was getting much better opportunities than most others, Buffett often displayed almost inhuman patience and seldom bought.”

Most people do not have this kind of patience. That is okay—dollar-cost averaging will give you results that mirror the growth of the business you select over the long run in most cases, and as Benjamin Graham points out, you get to collect dividend, rents, and interest during that period of overvaluation so that you could end up with better returns than would otherwise be the case if you had to wait for a couple years before receiving the opportunity to buy. Buying a great company at an overvalued price won’t set you back in life—the real concern is for the people that have been sitting on the sidelines, recently re-entered the market, and then sell whenever stocks tumble to fair valuation and then down to undervaluation. That is what you want to avoid.

But still, Munger’s advice in this weekend’s letter reminded me of Graham’s advice that you can never screw up if you take the company’s profits over the past ten years and refuse to pay above the average P/E ratio of the stock at that time. It is a nearly foolproof strategy that will protect you against buying high. The only thing I’ve been able to concoct that has similar overwhelming probabilities of success is this: Only buy companies that have been raising dividends for 20 years, been growing profits on average north of 5% for the past ten, and exist outside the technology and banking sectors. Those controls make it hard to screw up, especially if you apply that rigor to every investment selection you make.

Is it foolproof? No. You need to recognize what a rule like that does. It doesn’t lead you to all the great investments necessarily, it prevents you from making bad ones. For instance, Lockheed Martin is currently in the midst of one of its golden eras that will likely make many of its long-term holders respectably rich if they set aside a decent amount of capital, reinvest the dividends, and then look under the rock to see what shows up in fifteen years.

If you applied the Graham test, you would arrive at an artificially low price because Lockheed Martin got cheap during the financial crisis and then stayed cheap in the years immediately following because the U.S. government sequester had a threat of budget cuts to the military that put a lid on the company’s valuation. Applying these kinds of disciplined rules would prevent you from making a sound investment in something like Lockheed Martin.

The point of me writing this post is to get you thinking: What are you doing that makes you disciplined with your investing today? There are a lot of little fictions you can set up to help you out—Buffett has spoken before about the twenty punchcards, and yesterday I was talking about the John Wooden paraphrase where you prentended that there were only a few companies that you would be allowed to commit to for the rest of your life. There’s a lot of overpriced trash out there right now. While the stock prices are high, you should take the opportunity to make sure your portfolio contains the quality you desire and perform a check to see if anything is selling at 30% above what you think would be a reasonable buy-in price for the stock. You want to do these kinds of checks now—not after a 35% decline.