Keeping It Simple Isn't Stupid

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 980, about the same level as December 1997. That means stock prices have gone nowhere, on average, over the past five and a half years. Sure, there have been moments of euphoria and, more recently, despair. But on average, an investor who kept his money in a low-interest savings account and "sat quietly in a room" for the past five years would have been no worse off than those who scrutinize every nook and cranny of the stock market. 

This reminds 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.

There are two components of an economic moat: the attractiveness of the industry in which a 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 (MRK),  Pfizer (PFE),  Automatic Data Processing (ADP), and  First Data , among others.

Just being in a good industry isn’t enough, though—a company also needs 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 (NUE), the best-run 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 (JNJ) valuation to be $70 per share, when in reality it may be worth only $50 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 $50 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 (MSFT), 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 a stock without an acceptable margin of safety weren't buying stocks during the latter part of the 1990s and in early 2000. Those people 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 five years, you probably shouldn’t be buying stocks in the first place. Over any shorter time period, stock markets are inherently unpredictable. If you’re buying stocks with money you’ll need next year, the year after, or anytime during the next five years, you’re playing with fire. Sure, things may work out well, but as we’ve seen, 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 at least five years for a 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
Because of the recent 30% runup in the market, there are only a few stocks Morningstar covers that are selling at acceptable margin of safety. To find out which ones, Premium Members can click  here to see the stocks that currently carry the highest Morningstar Ratings.

This article originally appeared in Morningstar StockInvestor, Morningstar's monthly print newsletter on stock investing. Each month, StockInvestor brings you two exclusive Morningstar Stock Portfolios--The Tortoise and The Hare--as well as bulls vs. bears debates on high-profile stocks, "red flag" stocks to sell, and in-depth commentary on issues affecting the market. Also included is a monthly review of Morningstar's Bellwether 50, a watch list of 50 large companies with wide economic moats. For a free sample issue of StockInvestor call 800-735-0700.