During this final week in 2006, The Simple Dollar is reviewing one of the top investment book of the year (based on Amazon.com sales). What does Phil Town’s Rule #1 really all about, and does it bring anything useful to the plate that we didn’t already know? This week, we aim to find out.
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.
Tomorrow, we’ll discuss the five key numbers for determining the moat of a company. Thursday, we’ll look at getting started using Rule #1, and Friday I’ll issue my buy or don’t buy recommendation.
Rule #1 is the eighth of fifty-two books in The Simple Dollar’s series 52 Personal Finance Books in 52 Weeks.