If – like me – you pick and buy your own stocks, your goal should be to beat the market.
That means if the S&P/ASX 200 (INDEX: ^AXJO) (ASX: XJO) falls 5% in a year, you'll want to be better off.
If it rises 10%, you'll want to be up more than that.
However if you discover, after a few years of active investing, your strategy isn't working, you've got to ask yourself why and consider buying an index fund or seeking an investment service which is beating the market. After fees, of course.
But remember to focus on the long term. Try with a small amount of money at first and go easy on yourself. Too many investors believe one or two years is the right amount of time to be invested.
Ben Graham, the father of value investing, famously quipped: "In the short run, the market is a voting machine but in the long run, it is a weighing machine." Indeed I'm a firm believer that value investing is best done over the long term.
And I'd rather be generally right than specifically wrong. I focus on more than one year's profit result when passing judgement on a company.
This is especially true when they have complicated financial structures, multiple operations, exposure to numerous currencies and are heavily regulated.
Understanding the key risks faced by a business and using very conservative forecasts, is the only true way to estimate fair value.
Is Australia and New Zeeland Banking Group (ASX: ANZ) a buy? I hear you ask.
At a touch under $32 per share, ANZ trades on a price-to-tangible book value of 2.25 and price-book ratio of 1.9. Usually, this is much higher than I'd be willing to pay for any bank but given its aggressive growth strategy in Asia and so-so profitability, it's worthy of a closer look.
Since the dividend yield is what attracts most Australian investors to big bank stocks and banks aren't like ordinary businesses, we'll use dividends as a proxy for free cash flow.
Applying ANZ's 10-year historical average growth rate of 6% per annum for the next five years. Then using a terminal growth rate of 3% thereafter, at a discount rate of 9% (which is generous in my opinion), fair value is around $35 per share.
However if we up the discount rate to 10% – which is what I usually require – fair value is smack bang on $30 per share.
As I write, ANZ shares are trading at $31.92. So I wouldn't buy them today.
Would I buy them at $30.00 per share? No.
In fact I wouldn't even buy them at $28.00 per share because I know what I don't know. And that's a lot, believe me.
Indeed I know I'll never know every single detail about ANZ's operations and I know I won't get my forecasts right. As a result, chances are, my intrinsic value estimate is wrong.
Therefore to mitigate these risks, the price I'd pay for ANZ shares would be at a steep discount to my fair value estimate, using the 10% discount rate.
This gap between market price and my intrinsic value estimate is what value investors call "margin of safety".
Having a wide margin of safety (say, 30% or 40% to the current market price) maximises upside potential and mitigates risk. In bull markets, such as now, these types of bargain issuances are scarce. But they're by no means unusual in a bear market.
In fact between 2008 and the very beginning of 2013 (just shy of five years), ANZ traded below its fair value, albeit slightly for much of the time.
However during the GFC – remember Australia and our big banks emerged in a much better position than most – ANZ shares fell over 60%.
And do I think Australia will be subject to another market crash in the years ahead? Yes.
Therefore I know I can afford to be patient and wait for a better buying opportunity.
Foolish takeaway
I encourage everyone to try their hand on the sharemarket. But if you're not willing to put in the hard work, research companies and stick by your guns, your returns will be mediocre, at best. Every investor should have a goal of beating the market, convincingly. Unfortunately many don't. However by having an adequate margin of safety, investors can minimise risk and maximise upside potential.
And at today's prices I believe ANZ shares are not worthy of a 'buy' rating.
