Wouldn't you love to have some magic words you could say, like "abracadabra", to make yourself wealthy?
Nothing's that easy. Yet Warren Buffett, the world's third richest person and investing legend, did have three words for investing that worked their magic on his fortune. Like a spell to protect his portfolio from severe losses, the three words "Margin of Safety" have guided his 60 years of investing.
They have kept him from overpaying for stocks and even avoiding bad investments completely.
If you buy a stock that you think is going to head upwards (why else would you buy it?), what is one of the worst things that could happen? The stock could suddenly nose dive 20%, 30% or even 50% within the next year.
When you consider buying a stock, you want to build in a margin of safety – for the unknown. Buying stocks at bargain prices is one way to create a margin of safety. Buffett said it's like buying a one dollar bill for 70 cents.
Some hot stocks are priced at very high earnings multiples. The company may be great, but if it has one bad quarter or half year, investors could drop it like a hot potato, leaving you with a potential loss.
One solution is to buy quality stocks when they're out of favour or experiencing some trouble. The froth of a high share price is wiped away, but at some price investors will step back in to buy up the quality stock on the cheap.
Some quality stocks currently at comparatively low prices are:
TPG Telecom Ltd (ASX: TPM): The telecommunications company has extensive internet network infrastructure and was planning to compete directly with the new national broadband network (NBN) until the government tried to inhibit that. The telecom's share price slid, but now you can pick it up about 12% off its November high while the company revises its next business steps.
Also, there's Super Retail Group Ltd (ASX: SUL). The specialty retailer saw its stock head down for almost all of 2014 while the mining pullback and generally weak retail trade kept earnings growth under pressure. Since mid-December, other investors looking for a big margin of safety started buying up the stock. If retail shopping improves, Super Retail Group should benefit because its products are auto accessories, camping gear and sports apparel that people tend to spend money on.
