Editor's Choice

4 Low Risk Stocks For New Money

Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A good investment meets three criteria. It should have:

  1. Understandable business economics
  2. A durable competitive advantage
  3. A margin of safety

For a business to have understandable business economics it must fall within an investors circle of competence. Though some investors have specific circles of competence, some industries are naturally easier to understand than others: e.g. railroads (easier) vs biotechnology (more difficult).

Once investors understand the economics of the business, investors should be able to decipher, after some fundamental analysis, whether or not the business has a competitive advantage and if it is sustainable or not. A sustainable competitive advantage is what Warren Buffett often refers to as an economic moat.

If the business is both understandable and has a durable competitive advantage, future cash flows can be projected and a fair value estimate can be assigned to the business. Once a fair value is assigned, investors can require a specific margin of safety (or discount to fair value) based on the level of uncertainty associated with their predictions of future cash flows.

A margin of safety simply refers to leaving room for error in your valuation. For example, after some fundamental analysis, a company appears to be worth $100 billion; An investor who requires a margin of safety would not buy the company unless it is trading at a discount to this estimate, e.g. a 25% margin of safety, or $75 billion. This discount helps the investor minimize his or her losses or even still make a profit when his or her estimates turn out to be too optimistic.

Companies that score high on points one and two listed at the top of this article are typically not trading at significant discounts to fair value. If the durable competitive advantage is significant, it might make sense to buy these "core" stocks even when they are not trading at a discount to fair value (assuming they are not overvalued). The lower risk these industry leaders can provide investors compared to other investments is usually associated with a premium price.

4 Low Risk Stocks For New Money

The following four stocks (a) have understandable business economics, (b) possess durable competitive advantages, and (c) trade at a price equal to fair value or less, in my opinion.

Apple (NASDAQ: AAPL) is down 25% from from its high several months ago. Fundamentally, however, the business is firing on all cylinders. The company is printing cash like nobody's business, with a free cash flow injection of 27 cents per dollar of sales. The recent price correction was a result of unrealistic expectations; the stock was literally priced for perfection. At today's price, investors should be able to count on a reliable and significant cash flow stream for years to come as iPads, iPhones, iOS, Macs, and iTunes continue to create a virtuous cycle of increasing switching costs.

National Oilwell Varco (NYSE: NOV) has also taken a hit recently, down 20% from its high three months ago. The decline has created a great buying opportunity. The company's stock symbol is often said to stand for "No Other Vendor." It's position as the dominant leader in supplying many critical pieces of oil drilling equipment earns the company a clear and identifiable moat. This industry leader can be purchased at just ten times forward earnings.

Recommending Google (NASDAQ: GOOG) and Apple in the same article could appear naive, given the many spaces in which they compete, but there are also many ways in which they can co-exist. Yesterday, Google announced 10 million downloads of its new Google Maps app for iOS, another expression of Google's expertise in Internet applications and the extreme trust placed in the Google brand. Furthermore, its dominating presence in online advertising gives the firm a consistent and reliable source of revenue thanks to its 60% worldwide market share in search that keeps users returning on a daily (even hourly) basis. 

Don't forget about Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B), Buffett's castle of wide-moat franchises. With Buffett's new commitment to buy Berkshire Hathaway any time the stock falls below 120% of book value, downside protection has increased. Even more importantly, Buffett's all-star collection of great businesses continue to pump out new cash for Buffett to invest. This diversified collection of great businesses with durable competitive advantages means less risk for the investor.

The Bottom Line

All four of these companies have business economics that are fairly easy to understand and durable competitive advantages. In my opinion, they are all great long-term investments for new money.

DanielSparks owns shares of Apple. The Motley Fool owns shares of Apple, Berkshire Hathaway, and Google. Motley Fool newsletter services recommend Apple, Berkshire Hathaway, Google, and National Oilwell Varco. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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