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[Suresh]

Book Take on Rule #1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week! by Phil Town

Amazon.com: Rule #1 by Phil Town

I. OVERVIEW

I.A. The actual practice of value investing, such as discussed in our Value Investing Primer is cumbersome for many retail investors. Mr. Town provides an eminently readable volume that methodically takes the retail investor through the mechanics of value investing for beginners. He starts off by citing Warren Buffett’s classic line: Rule No. 1: Never lose money; Rule No. 2: Never forget rule No. 1.

I.B. Rule No. 1 is implemented by buying a “wonderful” company at an “attractive” price.
I.B.1. A “wonderful” company has”
I.B.1.a. “meaning” to the Rule 1 investor to the extent that he/she understands the company’s business model and would buy the whole company if he/she could;
I.B.1.b. a “moat” that provides the company with financial strength and predictability; and
I.B.1.c. good “management.”
I.B.2. An “attractive” price entails buying the company with a big margin of safety, e.g., buying a dollar’s worth of value for fifty cents.

II. HOW TO IDENTIFY A “MOAT”

II.A. There are five types of moats:
II.A.1. a brand-based moat, wherein a premium price can be charged because of the trust associated with the brand, e.g., Nike;
II.A.2. an intellectual property-based moat, wherein a company’s intellectual property makes direct competition difficult and raises barriers to market entry, e.g., Coca-Cola;
II.A.3. a toll-based moat, wherein the company has exclusive control of a market and charges a toll for users of the market service or product, e.g., Washington Post, and Google;
II.A.4. a switching-based moat, wherein switching costs are so high as to discourage switching to a market competitor, e.g., Microsoft; and
II.A.5. a price-based moat, wherein the company’s prices are so low as discourage new market entrants, e.g., Wal-Mart.

II.B. The moat must be sustainable over the long haul.
II.B.1. There are five indicators of a sustainable moat: a) return on investment capital, b) sales growth rate, c) earnings per share growth rate, d) equity growth rate, and e) free cash flow growth rate.
II.B.1.a. Return on investment capital (“ROIC”) is the rate of return a company makes on cash from credit and equity that it invests in itself every year. ROIC = profit / (cash – expenses). Over ten years, the ROIC should be increasing or staying the roughly the same. To appreciate the trend, look at the 10-year ROIC, the 5-year ROIC, and the last year’s ROIC.
II.B.1.b. Sales growth rate is the growth rate of total revenues. Over ten years, the sales growth rate should be increasing or staying the roughly the same. To appreciate the trend, it is necessary to look at the 10-year average, the 5-year average, and the last year’s average.
II.B.1.c. Earnings per share (“EPS”) growth rate is the rate of growth of the company's profit allocated to each outstanding share of common stock. Over ten years, the EPS growth rate should be increasing or staying the roughly the same. To appreciate the trend, it is necessary to look at the 10-year average, the 5-year average, and the last year’s average.
II.B.1.d. Equity growth rate is the rate of growth of the company's book value. If equity is not growing, the company does not have funds to spend on increasing market share and/or developing new products or services. Over ten years, the equity growth rate should be increasing or staying the roughly the same. To appreciate the trend, it is necessary to look at the 10-year average, the 5-year average, and the last year’s average.
II.B.1.e. Cash growth rate is the rate of growth of free cash flow. Free cash flow is cash that a company is able to generate after laying out money required to maintain or expand its asset base. Over ten years, the free cash flow growth rate should be increasing or staying the roughly the same. To appreciate the trend, it is necessary to look at the 10-year average, the 5-year average, and the last year’s average.

II.C. The rule of thumb for Rule 1 investors for reasonable debt is whether long term debt can be paid off in three years. Long term debt / current free cash flow = number of years required to pay off the long term debt.

III. HOW TO IDENTIFY GOOD “MANAGEMENT”

III.A. Good management comprises Level 5 leadership, a term coined in Good to Great by Jim Collins. (See our Book Take on Good to Great by Jim Collins).
III.A.1. The two most important qualities of Level 5 leadership are:
III.A.1.a. owner-orientation, wherein management, in letters to shareholders, tells shareholders what it needs to know as owners, or white-washes mistakes and masks potential problems; and
III.A.1.b. driven management, wherein management has a “big, hairy, audacious goal” for the company over the next 10-30 years.

III.B. Two indicators of Level 5 leadership include:
III.B.1. large insider sales to total ownership percentages by management; and
III.B.2. whether management compensation is overpaid, and whether management makes money when owners do.

IV. HOW TO DETERMINE A MARGIN OF SAFETY

IV.A. The margin of safety is the percent below an intrinsic value of a company that gives the investor room for error in precisely calculating the intrinsic value. Rule 1 investors demand a 50% margin of safety. That is, the margin of safety price must be ½ of the calculated intrinsic value of the company.

IV.B. For Rule 1 calculations, the current intrinsic value of a company is the present value of intrinsic value of the company in 10 years, assuming a desired minimum rate of return per year. For a minimum rate of return of 15% (the preferred Rule 1 minimum rate of return), the current intrinsic value is approximately ¼ of the intrinsic value of the company in 10 years.
IV.B.1. The intrinsic value of the company in 10 years is determined as follows. Grow the current EPS at the estimated EPS growth rate fo r10 years to get the future EPS. Multiply the future EPS by the future PE to get the future market price. Get the present value of the future market price to get the intrinsic value of the company. So, to calculate the intrinsic value of the company in 10 years, the Rule 1 investor requires:
IV.B.1.a. the current earnings per share (“EPS”);
IV.B.1.b. the estimated future EPS growth rate;
IV.B.1.c. the estimated PE; and
IV.B.1.d. the minimum acceptable rate of return.

IV.C. How to determine the estimated future EPS growth rate and the future PE
IV.C.1. For estimated future EPS growth rate, compare the historical equity growth rate (which shows the company’s ability to generate surplus capital) with analysts’ estimate. Choose the more conservative estimate, unless it is possible to determine why the higher one is justified.
IV.C.2. For estimated PE, compare the default estimated PE (2 x estimated future EPS growth rate) with the historical PE, and choose the more conservative PE figure.

V. WHEN TO SELL

V.A. Sell when the company ceases to be “wonderful,” as described above.

V.B. Sell when the market price exceeds the intrinsic value of the company.

VI. WAIT FOR THREE TECHNICAL INDICATORS TO ALIGN BEFORE BUYING

VI.A. The Moving Average Convergence/Divergence (“MACD”) uses three exponential moving averages (“EMAs”): a slow EMA, a fast EMA, and a trigger EMA. The difference between the slow EMA and the fast EMA is plotted against the trigger EMA. When the slow EMA-fast EMA MACD crosses above the trigger EMA, there is a BUY signal because institutional money is likely moving into the stock, and the stock prices is likely to rise. Conversely, when the slow EMA-fast EMA MACD crosses below the trigger EMA, there is a SELL signal because institutional money is likely moving out of the stock, and the stock prices is likely to fall.
VI.A.1. The 12 day – 26 day – 9 day MACD was used in the original MACD analysis by George Appel.
VI.A.2. The 8 day – 17 day – 9 day MACD is a revision, which is more responsive.

VI.B. The Stochastic gives a closing price of a stock as a percentile rank relative to the closing prices of the last 14 days. If the closing price is under the 20th percentile, the stock is considered oversold. If the closing price is over the 80th percentile, the stock is considered overbought.
VI.B.1. When the Stochastic crosses up through the 5 day EMA, there is a BUY signal.
VI.B.1. When the Stochastic crosses down through the 5 day EMA, there is a SELL signal.

VI.C. Using a 10 day moving average, if the stock price crosses up through the moving average, there is a BUY signal.
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Suresh

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