I largely elected to read Rule #1 because of the professed simplicity. I’ve read a lot of investment books over the last year or two, but they all fell into one of two categories: either they required a huge investment of time or they had flaws so large that even I could see them from a mile away.
This one stood out from the others that professed simplicity in one key respect: it professed to be heavily based on the investing philosophy of Benjamin Graham, David Dodd, and Warren Buffett. In fact, the titular Rule #1 comes straight from Buffett: don’t lose money.
The book does succeed in laying down a simple investment philosophy that makes a good deal of fundamental sense. It recommends heavy use of the internet for acquiring basic pieces of financial information, then using these to easily calculate basic metrics with which to judge whether a company is going to return a strong investment or not.
This system focuses on finding sure bets and, having played with the numbers a bit, it does a great job of finding very healthy companies. There’s only one problem: the book also seeks out stocks that are undervalued and investors have gotten sophisticated enough that finding undervalued sure bets is almost impossible.
In other words, like any other financial book, this book will not make you immediately rich, but it does succeed in other areas. Let’s take a walk through it and find out more.
The Four Ms
The central philosophy of Rule #1 revolves around identifying companies that are poised for growth using various metrics. At the center of these metrics is a set of four criteria for any company that you might invest in. Phil Town refers to these metrics as the four Ms. What are the four Ms?
The first M is Meaning. Does this business have meaning to you? Identifying businesses that have meaning to you boils down to making a list of your professional interests, your personal passions, and the areas where you spend excess money. Areas where these lists overlap are hot areas; areas where all three overlap are industries to look for companies.
The second M is a Moat. Is this business difficult to get into? For example, businesses such as gas stations are easy to get into because they’re simply selling commodities, but businesses such as the oil industry are hard to get into because of the resources and intellectual property required. The book provides a set of five numeric tools for identifying whether or not a company has a large moat; we’ll discuss these tomorrow.
The third M is Management. Is the company under strong management? Basically, if a company has a leader who is primarily in it for himself, you shouldn’t invest. How do you know? First, read a few puff pieces on the CEO to generally see if he or she is driven by big goals. Do they want to achieve something amazing or merely “increase shareholder leverage”? Second, see what their compensation is like. Is it tied to stock options that break open on short term gains? Is the compensation highly exorbitant? Those are red flags. Third, take a peek at what they’re doing with their own stocks. If they’re dumping excessive amounts (and the other company heads are, too), avoid this company.
The fourth M is Margin of Safety. Is the value of the company’s stock much lower than it should be? The book suggests a pretty cut-and-dried method for calculating what a stock’s price should be. Dig into a company’s data sheet on Yahoo! Finance and get the current EPS, the 10 year equity growth rate, and the average of the high and low P/E ratio. Take the current EPS and figure that it grows for ten years at an annual rate equal to the 10 year equity growth rate. Once you have that future price for ten years down the road, shrink it by the rate of return you want (say, 15%) ten times to return it to today’s values. If this calculated price is more than double the current price of the stock, you should buy in.
If all four of the Ms are telling you to get into a company, that’s a sure sign you should be getting into the company.
In Rule #1, the author, Phil Town, is pretty adamant about ensuring that any business that you invest in be surrounded by what he calls a Moat. In other words, you should only invest in businesses that have a track record of stability and show no signs of losing that stability over time.
In order to ensure that the business that you’re considering an investment in has a large moat, Phil recommends that you look at five key numbers, which he refers to as “The Big Five”:
1. ROIC (Return On Investment Capital)
2. Sales growth rate
3. Equity growth rate
4. EPS growth rate
5. Cash growth rate
Each of these numbers should be above the 10% margin over the past year. In addition, the average of each of these numbers over the past five and the past ten years should be over 10%.
Why are these numbers important? Together, they indicate the health of a company. Is the investment of capital returning anything? Are the sales growing? Is it earning more per share? Is the company building up equity and cash? All of these questions should be answered with a clear “yes” if your company is doing well.
It’s important to note that these numbers really only serve to ensure that the company is in fact stable, not answer whether or not the company is a good investment. Town’s philosophy is that you should always invest in stable companies that you like, not chase after the pot at the end of the rainbow just because the numbers look sweet.
Implementing the Rule
So, how do you get started implementing the investing program found in this book? Most of the latter half of the book focuses on just this issue.
First, take it slow. Don’t bet the farm on the first stock you find that seems like a good deal under this system. Keep your portfolio diverse and don’t bet everything on the first thing you see.
Second, use the three tools for identifying when to get into or out of a stock. Phil recommends using MSN’s Money Central for doing your research and finding out the values of these three tools; they’re all available on the site. If they all indicate “buy,” then buy; if they all indicate “sell,” then sell.
The first one is the MACD, or moving average convergence divergence. It identifies money coming into or out of a stock. If there’s money going in, then go in. If there’s money coming out, then go out.
The second tool is the Stochastic, which seeks to indicate major spikes in stock activity, which usually indicate great news or a major problem. You should follow the direction of these spikes.
The third tool is the moving average, which simply indicates whether the stock is currently moving in a healthy direction. If the current price is leading the moving average by quite a bit, it’s a good time to buy; if the current price is lagging the moving average by quite a bit, it might be time to get out.
The final step to implementing this plan is to overcome obstacles. Phil lists five major obstacles that hold back investors: bad debt (i.e., consumer loans), taxes on gains (he recommends shielding them in a Roth IRA or a 401(k)), overdiversification, fund managers (if you know how to invest, why let them have a cut?), and fear. If you can overcome all of these, you’re ready to go.
Buy or Don’t Buy?
To put it in a nutshell, Rule #1 is a simplification of the investment philosophies of Benjamin Graham and Warren Buffett. Phil Town basically takes their ideas, strips away almost all of the nuances, and leaves behind the bare skeleton of how Graham and Buffett invest. It’s simplified to the point that almost anyone could do it, for better or worse.
Of course, with such simplification comes some problems. The book’s philosophy is very good at finding companies that are going to be successful. However, it’s basically impossible to find companies this good. Companies that are so good that this method will find them are companies that large money managers have long ago discovered because they use nearly identical methods.
So here comes the recommendation: buy this book if you’re a beginning stock investor or a conservative investor. This book is loaded with great, simple metrics for finding great companies to invest in. If you follow Town’s philosophy as closely as possible, you will eventually find good companies for your money and you will make money.
However, I don’t recommend this book to experienced or risk-taking investors. Phil Town’s plan is focused on easy methods for finding good, stable companies that will make strong money over the long haul. If you’re looking for huge returns immediately and are willing to gamble to get them, go elsewhere; similarly, if you’re already familiar with Graham and Buffett, this book will be a simplification for you.
Personally, I enjoyed the book quite a lot, and I think you will too if individual stock investing is of interest to you.
Rule #1 is the eighth of fifty-two books in The Simple Dollar’s series 52 Personal Finance Books in 52 Weeks.