Rule #1 is a book written by Phil Town that aims to teach you how to invest in stocks that will earn you a minimum of 15% per year with low risk. Phil Town is an American motivational speaker, Investor and author of 2 New York Times bestsellers “Rule #1” and “Payback Time”. Rule #1 is a book for anyone regardless of age, money or social status who wants to learn how to be a value investor similar to that of Warren Buffett.
The book will take you step by step through the process of finding companies that mean something to you, analysing if they have future potential, how to value them and when to buy and sell.
Here are the things I learned from Rule #1.
Rule 1 of Investing
Warren Buffett and Benjamin Graham said that Rule 1 of investing is don’t lose money.
Rule 2 is don’t forget about rule 1.
To make sure you don’t lose money you need to make sure you are investing in wonderful companies at attractive prices.
In order to invest in such companies they need to meet 4 rules or the ‘4 Ms’.
- Margin of Safety
What makes a company wonderful?
A wonderful company will meet the first 3 Ms.
It will have meaning to you, it will have a sustainable competitive moat and it will have competent management.
When is a company at an attractive price?
A company is at an attractive price when it is trading at a discount to its Intrinsic Value or ‘Sticker Price‘ as Town calls it. If something is worth $1 it is at an attractive price if you can buy it for 50 cents.
The first ‘M’ that needs to be met is that the company must have meaning to you. What does it mean for a company to have meaning to you?
Not a lot really. You just need to like what the company does and believe that they can keep doing it for the next 20 years or longer.
A great way to find companies to invest in is to think of anything you are passionate about, you have a talent for and anything you spend money on or earn money from.
When choosing companies you have to ask yourself the question “if i was rich enough to buy the entire company, would I want to?”.
If the answer is yes then move on to the next ‘M’.
A moat is something that helps a company fight off competitors. If the company is the castle, you would want a deep, wide moat to protect it.
Town says there are 5 types of moats.
- Brand – customers are willing to pay more for a product with a strong brand because they trust it. Think of companies such as Coca Cola, Nike, and Harley Davidson.
- Secret – some companies have trade secrets that make it illegal or very difficult for their competitors to compete. Companies such as Pfizer have patents and Coca Cola has a secret recipe.
- Toll – when a company has exclusive control of a market. You either buy through that company or you go without. Media companies, utilities and ad agencies have a toll moat.
- Switching – a company that has become so much a part of your life that it isn’t worth switching. Software companies have strong switching moats because you don’t want to learn how to use new pieces of software all the time. If you have always owned Windows-based computers you are unlikely to switch to Mac OS or Linux.
- Price – when a company is able to price their products so low that no one can compete. Walmart, Amazon and Costco all have price moats.
In order to accurately value a company, you need to be able to predict their future earnings. Sustainable competitive moats make the future earnings of a company more predictable.
If a company does not have a sustainable competitive moat then their future earnings are unpredictable. If a company’s earnings are unpredictable we can not accurately value it.
The Big 5 Numbers
Town says if a company has a competitive moat then it will be reflected in “the big 5 numbers”.
The Big 5 numbers are:
- Return on Invested Capital (ROIC)
- Equity (Book Value) Growth
- Earnings per Share (EPS) Growth
- Sales (Revenue) Growth
- Cash Growth
All the big 5 numbers will be 10% or greater if the company has a competitive moat.
The numbers should be stable or growing over the past 10 years if the moat is sustainable.
When analysing the management of a company we are most concerned with the CEO. The CEO is the person who determines the path of the company and ultimately our return on investment (ROI).
The CEO should be someone who lives and breathes the company.
The CEO should show 2 key traits
- They should be owner oriented
- They should be driven
If a CEO is owner oriented their personal interests should align with the shareholders (owners). Warren Buffett said – The CEO should “run your business as if it were the only asset you will own over the next 100 years”.
Town says a CEO is driven if they have a BAG, a Big Audacious Goal. This will become the company’s visions. It is what will get the CEO up in the morning. Here are some examples of BAGs.
NASA – Land a man on the moon.
Walmart – Become a $125 billion company by year 2000.
Boeing – Become the dominant player in commercial aircraft and bring the world into the jet age.
Margin of Safety
In order for a company to be available at an attractive price, you must be able to buy it at a considerable margin of safety. The margin of safety is the difference between the price of a stock and the intrinsic value or “sticker price” of a stock.
Town recommends applying a 50% margin of safety the first time you buy a stock. This would mean that if you believe a company is worth $1 that you would only be willing to pay 50 cents for it.
Obviously in order to buy a company at a margin of safety we first need to calculate the sticker price.
Calculating the Sticker Price
The value of a business is equal to the money it will make its owners in the future.
No one knows exactly what that will be so it’s impossible to determine an exact sticker price for a company, we can only make our best estimate.
In order to calculate the sticker price we need 4 things.
- Current EPS
- The estimated future EPS growth rate
- Estimated future PE (Price to Earnings ratio)
- The minimum rate of return.
We want to know what the company will be worth in 10 years time.
In order to figure out what the company will be worth in 10 years, we need to estimate how much the company will be earning in 10 years.
To figure out how much the company will be earning in 10 years we need to grow the current EPS by the estimated future EPS growth rate for 10 years.
We then need to work out what the market will be willing to pay. If we multiply the future EPS by the estimated PE ratio we will get our future price.
We then discount the future price by our minimum rate of return to find our sticker price.
If we apply our margin of safety to the sticker price this is the amount we are willing to pay for the stock. For example, if we find the sticker price of $100 and we apply a 50% margin of safety we would only be willing to pay $50 for that stock.
One of the most surprising things I learned from the book was how to use technical analysis to complement your fundamental analysis, mainly how to time your entry and exit.
Town uses 3 technical indicators or ‘tools’ to time his entries and exits.
- Moving average.
I won’t go into detail here how he uses them but to put it simply. If the stock is trading at a 50% discount or greater to its sticker price and all 3 indicators say “buy” he buys. When the stock price is nearing the sticker price and the indicators say “sell” he sells.
When to Sell
Technical indicators aren’t the only reason Town will sell a stock. He has two fundamental reasons.
- The company is overvalued
- The company is no longer wonderful.
When the company is getting close to its sticker price it may be a sign that the company is starting to become overvalued. Using the technical indicators we can time our exit before the price comes back down.
A company may no longer be wonderful when it loses its competitive moat. A company will lose its competitive moat for two reasons.
- An outside attack
- An inside traitor
An outside attack occurs when a competitor breaches the company’s moat.
This can happen for 2 reasons.
- The management failed to defend the moat, such as failure to innovate.
- The competitor created a product that made ours obsolete such as what the CD did to the cassette tape.
An Inside traitor is when the CEO is no longer working in favour of the shareholders. Usually, this occurs when the CEO is more concerned with building an empire rather than looking out for the shareholders. What they will essentially do is waste money trying to grow the company reducing our returns. If we aren’t able to get a decent return from the company then it is no longer wonderful.
Rule #1 by Phil Town is an excellent book if you want to learn an investing process for buying wonderful companies at attractive prices. This is essentially the style of investing used by Warren Buffett.
I haven’t gone into extreme detail on how to calculate the value of a stock or how to use the technical indicators because I don’t want to share all the book’s secrets. If you want to learn how I recommend that you read the book.
Rule #1 also covers concepts such as common investing myths, debt, how to calculate growth rates, dividends, share buybacks, insider trading and how to overcome the barriers to get started investing.
Get your own copy of Rule #1 by Phil Town (affiliate link)