Value Investing - 5 Basic Principles

Return on Investment - Equalized Across All Options

Return on investment is almost the same everywhere AFTER accounting for risk.  This idea goes by many different names such as the "invisible hand", the "efficient  market principle" or "competition drives out profits".

For example, while US treasury bonds currently pay about 3% and Greek debt pays 13%, they're really the same!  The market is currently guessing that the Greeks have about a 10%chance of defaulting within one year. When you calculate your expected value from both of these investments it works out the same. If one investment pays a whole lot more than others, after adjusting for risk, then many investors would flock to that investment, driving up its price and driving down its risk-adjusted yield  (i.e. competition driving out profits).

Capital Preservation

Many gambling schemes (e.g. Martingale betting) ignore the very real possibility of the gambler being wiped out and not being able to bet any more.  To avoid this people generally diversify and only invest a small amount of their not worth in highly risky things.  You'll sleep better if you can't be wiped out by one unlucky event.

Price Earnings Ratio - The value of growth

The P/E or price earnings ratio is a simple way to measure what the return is this year for a given company.  A P/E of 20 means that it earns 1/20th of what it costs to buy a share.  Note that 1/20th is a return of 5% which is a decent return in this market.  Of course you need to consider also the risk that this company will go bankrupt as well as the possibility that they will grow a lot.  So start-up companies can justify a P/E or 100 if you think that their earnings will double every year for the next 3 years because they have an awesome market-displacing product or process.

Avoid Debt

Debt is risk.  If a company has a lot of debt on a per-share basis then they have to take a big chunk of their revenue to service that debt.  Currently interest rates are near record lows, so there is some risk that rates could rise significantly.  Just ask those people who bought houses with ARM's (adjustable-rate-mortgages) about that risk.

If a debt-ridden company currently has a P/E of 20 and interest rates double then the P/E could quickly go to 50 or 100, which would in turn drive down the stock price (the P part) until the P/E becomes something more reasonable.  Another problem with debt is that it reduces a company's agility.  If a company has high debt and unexpectedly needs to raise capital for some reason, then it will pay a high interest rate to compensate investors for the risk.  Similarly if there's a great opportunity to buy a competitor who's going out of business, the company with high debt will be at a big disadvantage in a bidding war with a low-debt rival.

Contrarian Investing - Avoid the popular, consider pariahs.  

OK, generally I believe in the efficient market principle, at least as a very good first approximation.  This means that investments are usually fairly-well priced to balance the risk and reward, considering all of the available information.  However bubbles do form, such as housing prices in 2005 or the internet stocks in 1999.  If everyone thinks that this investment "can't lose!" maybe you should consider other less-trendy alternatives.