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Beginners: Effective Adoption of Warren Buffett’s Principles Could Make You Very Rich

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Beginner do-it-yourself value investors have it tough.

Finding an undervalued stock is a challenge, even for the most seasoned of analysts. Beginners who seek a wide margin of safety tend to be led down the path of a “cigar butt” investor, who scoops up the cheapest of stocks with the hope that they’re mispriced to the downside. Not only is cigar butt investing an ineffective strategy, but it’s also a potentially dangerous one that could cause investors to realize massive losses that may never be recoverable.

Finding value isn’t as simple as screening out the cheapest stocks based on traditional valuation metrics like P/E, P/S, P/B, and the like. A lot of the “bargain-bin” names that show up in such screeners are value traps that could wreak havoc on a new investor’s portfolio.

Unfortunately, like many things that seem too good to be true, they usually are, so investors need to be highly skeptical with their analysis to ensure that the risk/reward trade-off is, in fact, favourable.

Just because a stock is cheap doesn’t mean it’s undervalued.

Unfortunately, a lot of new investors figure this out the hard way after they’ve already lost a considerable amount of wealth in stocks with “cheap” single-digit P/E multiple that insidiously corrects to the upside as a company’s earnings plummet in conjunction with the stock’s value.

How to be a Buffettarian investor

For newcomers, there isn’t a distinct line that separates cigar butt investing from Buffett-style value investing. Heck, Warren Buffett himself used to be a cigar butt investor before he adopted a strategy that made him one of the wealthiest men on the planet. Instead of emphasizing the cheapness of a stock above all else, he values intrinsic qualities of a business and the long-term advantages that a company has over its competitors.

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” says Buffett. “Just looking at the price is not investing.”

So, with that in mind, investors should be setting their sights on the best-of-breed names, waiting for an opportune time to pounce, rather than chasing every single stock that’s just made a new 52-week low.

Magna International (TSX:MG)(NYSE:MGA) is an example of a cigar butt and a value trap that’s hurt investors who’ve bought the stock based solely on the stock’s remarkably low valuation metrics. The stock is down 25% since June, and the trailing P/E (currently at 7.8) keeps getting more depressed — and even more attractive through the eyes of cigar butt investors.

Now, Magna may be a quality player in its industry (auto part manufacturing), but that doesn’t mean much when you consider the unfavourable industry environment and the company’s vulnerability to exogenous factors.

We’re in the late stages of a bull market, and as an extremely cyclical name, Magna could realistically plunge 70% from peak to trough once the next recession finally hits. Earnings will plummet, and the single-digit P/E ratio will go up in a poof of smoke, leaving many cigar butt investors with amplified losses.

Canadian National Railway (TSX:CNR)(NYSE:CNI) has a 15.6 trailing P/E that’s double that of Magna. In spite of the much larger P/E, CN Rail is actually the cheaper (and better) stock to own, especially when you consider we’re in the latter stages of the bull market’s life. The rails are the backbone of the economy, and when the markets reset, they’re usually the first ones out of the gate.

Auto part makers, however, will lag along with auto sales come the next recovery. Moreover, given the long-term secular decline of auto ownership, I believe the auto part makers could face larger headwinds that would warrant even cheaper multiples.

Foolish takeaway

Don’t be a cigar butt investor; be like Buffett and only buy the very best. The price you’ll pay is always an important consideration, but if you’re compromising on quality, you’ll find out very quickly that your returns will lag the market averages.

Stay hungry. Stay Foolish.

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Fool contributor Joey Frenette owns shares of Canadian National Railway. David Gardner owns shares of Canadian National Railway. The Motley Fool owns shares of Canadian National Railway. Canadian National Railway and Magna are recommendations of Stock Advisor Canada.

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