Rule #1 Investor

I just finished reading Phil Town’s Rule #1 book. It provides a relatively straightforward approach to a value-esque style of investing. Something along the lines of CANSLIM, Rule #1 investors focus on what Phil Town calls the 4Ms – Meaning, Moat, Management and Margin of Safety. I’ll outline the strategy below and over the next few months evaluate its capabilities.

The goal with Rule #1 Investing is to seek a 15% annual rate of return on your investments. By combining simple fundamental analysis and basic technical analysis investors can find quality businesses whose stocks are selling at a big discount – 50% off the sticker price – intrinsic value.

To get started, you need to identify businesses that have meaning to you. Phil Town uses a method to identify those activities that 1) You are passionate about, 2) You are good at and 3) You spend money on or earn money from. Those that fall on all three lists should be your target industries. Delve into those industries and identify some companies that you are familiar with and whose stock you would be proud of owning. Town says to own only businesses who you would be willing to own completely for 100 years. If you wouldn’t own it for 100 years, don’t own it for 10 minutes.

This really seems to be the bulk of the effort. Identifying businesses that you want to invest in. Because once you have a list of companies, its just a matter of collecting some data an analysing it. Once this step is done, you will have a watch list that can be, but doesn’t necessarily need to be updated over time.

So, now you have a set of businesses, the next is to separate the good from the bad and the ugly. This is the Moat.

This is the protection that business has from its competitors and the market. Types of moats include the brand, barriers to entry in the industry, “switching” – its just not worth the effort to change products (think Windows), etc. However the real way to identify a Moat is through 5 key growth rates

1. ROIC – Return on Investment Capital
2. Sales Growth Rate
3. EPS Growth Rate
4. Equity Growth Rate
5. Cash Growth Rate

Town wants investors to analyse 10 years of growth and ROIC. Why? Because any less you are taking on additional risk in new businesses. To figure these out is rather simple, but I won’t go into it here. You can read the book or visit his site for calculators that will help. Also, a lot of the figures are available or easily derived from free online sources. The key is that they all grow at 10% or more (use 10 year, 5 year and 1 year growth rates) and they’dvbetter not be declining. The most important numbers are the ROIC and then of the growth rates – equity.

Once you’ve narrowed your list to stocks that have wide moats, you can proceed to the next step… evaluating management. Sure you could do it before, but that’s just a waste of time. Why research management (which requires a lot of reading) before knowing what companies are even worthwhile and if they don’t have a wide moat, they’re not worthwhile.

Management, like yourself, must be in the business for the long haul. You don’t want a CEO who is solely out for his own personal wealth (do they exist?). You wan’t someone at the helm who is owner oriented (that’s you as a shareholder) and driven. Read about the CEO, read his annual letters, see what he’s all about. If he’s honest about the business’ situation – he identifies the problems the company faces, he explains how he plans to overcome those problems, he is honest about the future and the past, he’s probably in it for the long-run. If he just says everything is rosy, then he’s probably focused on making more money for himself. Also, make sure insiders aren’t selling off. If the execs are selling a lot of their shares (30% or more, Town recommends), then don’t get in… they know there’s a problem brewing.

Margin of Safety (MOS). This is how Town helps reduce risk – increase the margin of safety. He calls this getting a dollar for fifty cents. Here you calculate the sticker price of the stock (again, read the book or visit the site). Once you know the intrinsic value of the stock, you only want to pay half that. What you’re trying to do is buy a stock for the long run – 10 years. How much will that stock be in 10 years, how much is it worth now, and buy it at a discount. If the business is going to grow at 20% year, you can calculate what the stock price should be in 10 years. And figure out if its worth buying. But make sure your getting it for half-off, because if something going to go wrong, you have padding. Makes sense, right? Even if the business doesn’t do as well as you expect, you should be able to capture some gain simply by the fact that it is currently misprices (the Efficient Market Theory has no place with Town).

We’ve looked at the fundamentals of the company, but you have to time your purchase and sale. Getting out is easy – if the company loses its moat or meaning, or once the stock is above the sticker price… Getting in needs a little timing. Just because the stock is selling at a big discount doesn’t mean it won’t continue to go down a little more. So what you need to do is look at the technicals. There are three that Town focuses on:

1. MACD
2. Stochastics
3. Moving Average

MACD – Town recommends a 8-17-9 MACD which is a faster model than the more traditional 12-26-9. What this does is basically compare the 8-day, 17-day and 9-day (the trigger) exponential moving averages. By calculating the difference between the slow and fast moving averages you can determine when to buy/sell a stock. When the MACD crosses the trigger (9-day EMA) is the signal to get in and out – of course when it crosses above – buy, when it crosses below sell.

But don’t pull the trigger just yet! We want to confirm the signal. That’s why we look at the Stochastics.

Stochastics look at the high and low prices over a period of time. It compares the current day’s price within the high and low over that period (14 days is considered among the best time periods). Plotting against a 5 day EMA will set triggers. When the stochastic crosses above the 20th percentile its a positive signal, when it crosses down through the 80th percentile its time to get out. What stochastics do is basically chart momentum – this is the institutions getting in and out. Remember, institutions set the price of the stock, not the individual investor – so you want to buy in when insitutions start to buy in and get out when institutions get out. (Think CANSLIM – follow the big guys).

Finally, moving averages. Using the 10-day moving average is Town’s recommendation. When the stock price busts up through the 10 day moving average that’s your buy signal. When the stock price breaks down below the 10-day moving average you should sell. Simple enough.

We need all 3 indicators to give us our signals. When all three say get in – do it. When they all say get out – listen. In general, the Stochastic if set up as a 14-5 stochastics will be your first to notify you. The Moving average will be your second indicator and the MACD is generally the final confirmation (ifconfigured as suggested).

What’s important about the Rule #1 investor is that they don’t buy and hold. You find a good company with a stock price at a deep discount (50% off) then you trade that stock as the technicals tell you to, until the company goes bad or the stock sells above the sticker price. After your first purchse into the stock, you don’t need to keep waiting for it to go back to 1/2 price in order to buy. You buy and sell the technicals. When the Stochastics, MA and MACD say buy, buy and when they say sell, sell. Again repeat until the business loses its meaning or the stock price is above the sticker price.

One last note – when within 20% of the sticker price – you better be ready to take your profits. Put in a trailing stop (5% below the market price). Because at this point institutions may start to get out. Remember, we want to be with or ahead of the big guys.

Well, without going into too much detail, that about sums up over 300-pages of advice. It seems simple enough. I will start to implement this strategy and see how it works. You can follow my progress to see if it works or not.

To get more info visit Phil town’s site at http://www.ruleoneinvestor.com or pick up his book Rule #1.

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