Saturday, June 23, 2007

Rule #1 Investing

At some future point I hope to be able to start putting aside money for retirement. I am currently finishing a medical residency and together with a mortgage, school loans, and a car loan I am over 300,000 in debt. When I finish residency and get a real job, I am hoping to get into a very modest home and my goal is to be completely out of debt in 5 years. Now some would say that is unwise considering the low interest rates on my school loans. However, I feel the right thing is to pay debts immediately. That said, I am looking forward to starting on saving for retirement. Accordingly, I have been working on my financial literacy. Finance is a rich world with a complex language and culture. All these new terms: capital, assets, equity, price earnings ratio, book value per share, and earnings per share. When I look at all these terms a quote from Johann von Neumann comes to mind, "when it comes to math you don't understand things, You just get used to them." I think the same thing can be said of finance.

My wife learned of my interest in finance and checked out a great new book to help me "get used to" the concepts in investing. The book is entitled "Rule #1" by Phil Town. Phil made a fortune on investing in the stock market and is now making a fortune selling his book and teaching others his stock market investing formula. Actually, Phil's formula is not Phil's. His strategy came from none other than Warren Buffett. Warren Buffett, after learning this strategy from Benjamin Graham and David Dodd while attending Columbia University, went on to become the single most successful investor of our day and went on to became one of the richest men in the world; second only to Bill Gates.

Mr. Town begins his book by telling his own American rags-to-riches, Horatio Alger story. Mr. Town started out as a river guide working for Outward Bound, an adventure wilderness rehab program for troubled teens and adults. On one occasion he was guiding a group of VIP donors down the Colorado River and just narrowly escaped dying in the most dangerous rapid on the river. Afterwards, one of the VIP's expressed his appreciation to Mr. Town for saving his life (or not ending it) and offered to teach him how to invest in the stock market. Phil Town started out with only $1000 and 5 years of "Rule #1 investing" later, he was a millionaire.

So, what is Rule #1? Simply put, Rule #1 is: Don't lose money. And as Warren Buffett says, "Rule #2 is: Don't forget rule number one." So, how do you assure that you never lose money in the stock market? First, Mr. Town dispelled some very pervasive investment myths.

First, many money managers teach that to avoid risk, you should diversify in bonds, mutual funds, and spread your money across a huge swath of random companies. According to Town, Buffet, Graham and other so-called "value investors," they believe the best way to avoid risk is to invest in a few meaningful, healthy, well-managed, under-valued companies. Town argues that bonds, which earn 5%, take 20 years to double. 5% hardly covers for inflation. Mutual funds and index funds make 10% but are subject to the ups and downs of the stock market. The Dow Jones, for instance, has long periods with no change punctuated by a few brief ups and downs. "Rule #1" investing, on the other hand, promises at least a 15% return regardless of whether the stock market goes up down or stays the same. As you will see below, the difference between 10% and 15% is huge.

The second myth is that you need someone else to manage your stock portfolio. Town says, no way. Thanks to the Internet, the information and tools that were once only available to the experts is now available to everyone. Town likens the influence of the Internet to finance with that of the printing press and religion. For the first time, everyone has access to the financial statements of all the best companies in the world, enabling us to see which companies are profitable, sustainable, well-managed, and undervalued. If we then invest in only these low-risk companies then we are guaranteed to earn healthy 15% returns.

So, what makes a company a "Rule #1" company. Town says that a company worth investing in has to satisfy the 4 M's. First, the company must be meaningful to you. That is, you should be familiar and understand what the company does. Also, you should only invest in those companies you feel are a benefit to society. This makes sense long term as harmful companies are usually only out to make a quick buck and then end up crumbling (i.e. Enron). You should be proud to be a part-owner of the company itself and not just consider yourself an owner of stock.

Second, the company needs to have a moat. A moat is a company's protection from competition. Effective moats can be a brand, patent, low-price, or monopoly. Other protective moats are companies whose services are offered elsewhere but switching to another company is too much of a hassle (H&R Block).

The third M is management. A great company is lead by a great CEO and board. Signs of great management include a CEO who receives a modest salary, does not issue stock options, and has little debt. Other signs of good management are CEO's who talk candidly in their quarterly summaries about real problems, takes responsibility for them, and then talks about how the company is going to solve them. Another sign of good management is a company who buys shares of its stock back from time to time.

Town also gauges a companies health though several calculation he calls the "Big 5 numbers." Basically, he looks up on the companies financial summary available on MSN, and looks for consistent, double-digit growth in Sales, Equity(BVPS), Cash, Earnings Per Share(EPS), and Return on Capital(ROC). If the company is consistently experiencing 15-20% growth per year in all these areas then their stock will likely experience similar growth.

The 4th M is where the value in "value investing" really comes into play. The 4th M stands for "Margin of safety." This has to do with the principle of only buying stock at 50% off. Many finance experts teach that the price of a stock always reflects the value of a company. Town says, not so. The market usually reflects the value of a stock but, as the Internet bubble shows, the market can act irrationally and emotionally and over- or under-value stocks from time to time. So, buying stocks at a discount requires calculating the correct price of the stock and then patiently waiting for the price to fall at least 50% below its "sticker price."

E.1: Stock Price = P/E * EPS
E.2: EPS = Net Earnings / Outstanding Shares
E.3: P/E ~ 2 * Projected EPS Growth Rate (Historical Equity or BVPS Growth Rate)

So, how do you determine the sticker price of a stock? First, according to equation (E.1), you have to know the current EPS. Then you need to know the projected EPS growth rate over then next 5-10 years. You can calculate this from the historical equity growth rate (BVPS not EPS) or by using the analysts projections which are usually a tad more conservative. Using those values you than can calculate the future EPS in 10 years. The next step is to obtain a value for the future PE which is either the current PE, or 2 x the projected EPS growth rate (historical equity growth rate (BVPS)). Using the most conservative numbers and equation (E.1) you can calculate the projected price of the stock in 10 years. Then assuming a minimum acceptable return of 15% per year, you can back calculate what the stock should be priced today. 50% of this "sticker price" is the discounted MOS price.

[These calculations can be made automatically at the Rule#1 Investor website or you can use the rule of 72 which tells you how many years it will take for a number to double for a given % compounded annual growth rate: e.g. 72/35% = 2 years, 72/20% = 3 years, 72/15% = 5 years, 72/10% = 7 years; 10 years at 15% = 2 doublings.]

Here is a sample calculation. Lets say Microsoft has an EPS of 1.5 and a projected EPS growth rate of 15%. That means in 10 years the EPS will double twice according to the rule of 72 (see above). So, the future EPS will be 1.5 * 2 * 2 = 6. The future PE can be assumed to be the same as the current PE, or 2 times the projected EPS growth rate, which would be 15% * 2 = 30. Then, using Equation (E.1) we can calculate the future stock price as 6 * 30 = $180/share. Then we can approximate the appropriate present sticker price by using the rule of 72 and assuming a 15% minimum growth rate (always use 15% here). That means that in 10 years the stock price would have doubled twice, every 5 years. So presently, the stock should only be worth: $180 / 2 / 2 = $45/share. Then calculating the Margin of Safety, $45 / 2 = $22.5/share. So, even though Microsoft is doing well and is a consistent gainer, a Rule #1 investor would not buy stock until its price fell to around $22.5/share.

So, once you know the MOS price of a stock, Mr. Town recommends patiently holding your retirement savings (IRA) in short-term bonds while you monitor a handful of "Rule #1" companies until their stock inappropriately, emotionally, or otherwise irrationally falls near their MOS price. Then you go all in and ride the stock all the way back up.

I should point out that stocks rarely ever get much above $100/share except if your Google because big stock prices seem to scare people away or otherwise make it difficult for people to buy stock. Consequently companies will routinely split their stocks which halfs their price per share. Long term grafts of stock prices adjust for, rescale, and consequently hide these splits so it appears like stocks had small initial growth and then just shot up in the last 10 years.

Some people just buy cheap stocks on big companies that are hurting hoping they will turn things around. This strategy is risky and not "Rule #1" investing. If you have done your homework and the company has it's 4 M's and great Big 5 numbers and therefore is a great "Rule #1" company, you can be certain the stock price will rebound.

US T-Bills at 5% double every 2o years. So, $100,000 only becomes $200,000 at retirement age. 5% of $200,000 only generates $10,000 per year while in retirement. Mutual and Index funds average 10% per year if there isn't a recession or stock market crash. So, $100,000 doubles every 7 years. So in 20 or so years that's 3 doubles. $100,000 becomes $200,000, becomes $400,000, becomes $800,000. During retirement, that mutual fund investment would generate an annual salary of $80,000. If you sell and transfer to bonds at that point at 5% then your annual salary becomes $40,000. And that is before taxes for a 401K.

But lets assume instead, that you earn a 15% per year return with a "Rule #1" company. That same %100,000 would double in only 5 years to $200,000. And over the next 15 years it would double again to $400,000 , and again to $800,000, and yet again to %1,600,000. If you stopped there and left the money invested in your "Rule #1"company and lived off the 15% growth; your investment would generate an annual salary of $240,000. That kind of money would provide a rather comfortable retirement where you would be free to travel, spoil the grand kids, and contribute to numerous humanitarian and missionary projects. The difference between the average 10% return and the target 15% return makes all the difference.

Mr. Town hopes you never have to sell your stock. Your "Rule #1" company should continue to earn money far into the future. But, the Internet empowers the individual investor in selling stocks and not just in buying stocks. See, mutual fund managers cannot protect your money from a stock market downturn. They manage so much money, (14 of 17 trillion dollars) they just can't sell all their shares in a company overnight. That would trigger a panic, and cause a stock to tank even lower. So, if he wants to sell, your mutual fund manager has to sell slowly over weeks, months and even years. (Warren Buffett is cashing out of Coke, GEICO, Gillette etc by transferring his wealth to Bill Gates Foundation over the next 10-20 years). Consequently, If the stock market tanks overnight, you and your mutual fund manger tank with it.

However, the individual investor can operate swiftly and anonymously. When dealing with hi- or mid-cap stocks (Blue Chip), the buying and selling a couple hundred or thousand shares won't affect the price at all. Therefore, you can sell at any time. If you set up an account with an online broker like Etrade or TDAmeritrade you can set automatic sell signals. So, if anything happens suddenly your money is safe. Also, the tools at MSN and Yahoo allow you to see more gradual changes. You can actually watch the big fund managers buy and sell.

When viewing the chart for Microsoft on MSN or Yahoo, click on MACD (12-26-9) or (8-17-9). As you watch the MACD line diverge from the EMA line you know that a fund managers slowly buying stock or selling stock (solid green bars). I prefer to view the YTD chart with MACD and moving average displayed. At $10 per stock trade you are free to sell when the stock is high and appears to be turning downward (MACD intersecting EMA) and to buy again when the MACD is developing a positive slope and again crosses EMA (especially with a large positive or negative slope). Mr. Town says he may buy and sell a "Rule #1" stock 1o or so times a year which maximizes his gains throughout the year. And since you are only watching 1 or a couple stocks, managing them only takes a couple of minutes a day or 15 minutes a week. Or if that's too much, simply place an automatic sell and forget it.

So, it sounds simple. Maybe too good to be true. But so far I can't see any flaws in the logic. I am currently reviewing companies I know. I am in the medical field so I have some familiarity with the pharmaceutical companies and medical equipment companies. I use a computer and am familiar with the companies that sell the hardware and software. I also go to the store and am familiar with retail. Mr. Town suggests starting slow by creating a watch list of "Rule #1" companies and then creating a virtual portfolio at MSN or Yahoo. He recommends practicing these techniques and seeing if they work before I actually trying it for real.


Sngpsyc said...

I loved your line "I am over 300,000 in debt"... you made my debt appear much more managable :) I too have education loans, etc. I wish you and your wife a happy debt free life, and with what I have read in your blog I expect you to be very successful!
Make today a great one! ~C

Shad said...


This book was suggested to me by a member in my ward and I was researching it before I checked the book out.

Your post is old. Just wondering where you are in this process and what your thoughts are a year out.


Shad Stoddard

natebean said...

For those interested, I use to help screen for rule 1 type companies.

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