Book Reviews

Book Review: Rule #1 by Phil Town

Rating: Very Good

Background: Another “value investing” book, but this one’s pretty good. The content is very similar to Buffettology but it lays everything down in a clear, simple to understand manner, with not much homework, that should appeal to the “Defensive Investor” as defined by Graham. The book highlighted many important points about value investing, which I may omit in my summary below if I have already internalised them.

Key summary:

  1. Rule #1: Don’t lose money – Rule #2: Don’t forget Rule #1.
  2. Certainty comes from buying a wonderful business at an attractive price.
  3. The Four Ms
    1. Meaning – Does the business have Meaning to you?
    2. Moat – Does the business have a wide Moat?
    3. Management – Does the business have great Management?
    4. Margin of Safety – Does the business have a big Margin of Safety?
  4. Meaning
    1. Do you want to own the whole business?
    2. Do you understand it well enough to own all of it?
    3. 10-10 rule: I won’t own this business for 10 minutes unless I’m willing to own it for 10 years.
    4. Are you willing to buy it as if your family will have to depend on the earnings of the business for the next 100 years?
  5. Moat
    1. Five types of Moat (aka sustainable competitive advantage)
      1. Brand – a product you’re willing to pay more for because you trust it
      2. Secret – a business that has a patent or trade secret that makes direct competition illegal or very difficult
      3. Toll – a business with exclusive control of a market – giving it the ability to collect a “toll” from anyone needing that service or product.
      4. Switching – a business that is so much a part of your life that switching isn’t worth the trouble.
      5. Price – a business that can price products so low no one can compete.
    2. The Big Five
      1. Big Five
        1. Return on Investment Capital (ROIC)
        2. Equity, or Book value per share (BVPS), growth rate
        3. Earnings per share (EPS) growth rate
        4. Sales growth rate
        5. Free Cash Flow (FCF or cash) growth rate
      2. The Big Five numbers are proof of the existence of a Moat. All of the Big Five should be equal to or greater than 10% per year for the last 10 years.
      3. Look at 10-year averages, 5-year averages, 3-year averages and 1-year (i.e. the most recent year). Look for consistency.
    3. Rule on Debt: To determine whether a business’ debt is reasonable, find out if it can pay off its debt within 3 years by dividing long-term debt by current free cash flow.
  6. Management
    1. A great CEO should be
      1. Owner-oriented.
      2. Driven.
    2. Read articles written on the CEOs, his annual letters to shareholders, etc.
    3. Look into insider trading to make sure executives are not unloading lots of their stock.
    4. Look at the CEO’s compensation to see if its reasonable.
  7. Margin of Safety
    1. Calculating the Sticker Price (aka fair value)
      1. Get the current (i.e. TTM) EPS.
      2. Estimate the future EPS growth rate (i.e. the Rule #1 growth rate). Take the minimum of the past equity (yes, equity, not EPS) growth rate, and the average analysts’ estimate for earnings growth. [I do not quite agree with using the equity growth rate here. The reasons given in the book were that if EPS increases while equity stays the same, the intrinsic value will not grow. My counter would be that the impact of that should be reflected in the P/E ratio, to show how much an investor is willing to pay for earnings-that-don’t-add-back-to-equity. Qualitatively, that bad scenario can also be screened-out in the Big Five. Finally, since the point is to estimate EPS 10 years later, the historical EPS growth should be the best proxy.]
      3. Calculate the EPS that will occur ten years later.
      4. Estimate the future P/E ratio. Take the minimum of the average historical P/E ratio, and the default P/E (= 2*Rule #1 growth rate).
      5. Calculate the stock price 10 years later.
      6. Calculate the sticker price by discounting the stock price to today’s value (e.g. divide by (1.15)^10 if required return is 15%).
      7. Find the Margin of Safety (MOS) price by dividing the sticker price by 1/2.
  8. When to Sell
    1. There are two times to sell
      1. The business has ceased to be wonderful. E.g. the business economics has changed and the moat has disappeared, or the CEO has ceased to be owner-oriented.
      2. The market price is above the sticker price. Institutional investors tend to take profits at that time. Rule #1 investors should look for better opportunities that have a lot bigger MOS.
    2. Guideline for re-buying a business
      1. Yes you can buy in a wonderful business at a MOS that is less than 50%. BUT ONLY IF you had bought in originally with the full 50% MOS.
      2. The first time you buy into a particular business, you would not know the business as well as if you have owned the business for some time. Hence you would need time to prove that your investment hypothesis is correct.
      3. So the first time you buy, only buy in at 50% MOS. After you have been proven right and the price went up to the sticker price, you can sell the stock, and the next time you can buy in at a lower MOS (e.g. 20%).
  9. The Three Tools
    1. MACD (Moving Average Convergence/Divergence) shows the movement of institutional money in and out of stocks. Recommended settings 8-17-9.
      • The MACD subtracts the longer EMA from the shorter EMA (in this case subtracting 17-day EMA from 8-day EMA) and uses that ‘difference’ as a momentum oscillator. The difference (i.e. the MACD) is then compared with a trigger EMA (in this case the 9-day EMA).
      • Moving average crossover — If the difference moves above the trigger EMA, it is a bullish crossover; if the difference moves below the trigger EMA, it is a bearish crossover. It is better to look at the histogram here because you can see more clearly the trend of the difference between MACD and the trigger EMA using the histogram, so as to anticipate crossovers, rather than looking at  the two lines.
      • Centerline crossover — Some people use the MACD and compares it with 0 (rather than with the trigger/signal EMA), so crossing above 0 is bullish, crossing below 0 is bearish.
      • Essentially the MACD measures the rate of change of the shorter EMA vs. the longer EMA. If the shorter EMA increases faster (when the stock is going up) or decreases slower (when the stock is going down) than the longer EMA, the MACD increases. If the shorter EMA increases slower (when the stock is going up) or decreases faster (when the stock is going down) than the longer EMA, the MACD decreases.
      • Positive divergence — If a stock price drops to a new low, but the MACD does not make a new low (i.e. it is higher than the MACD value that was reached earlier at the stock’s previous low), then the MACD is saying that this new low is not as bad as the previous low. This is a bullish divergence. This can be seen graphically with the stock price trend line going down, while the MACD trend line having a slight positive slope.
      • Negative divergence — If a stock price rises to a new high, but the MACD does not make a new high, then the MACD is saying that this new high is not as good as the previous high. This is a bearish divergence. This can be seen graphically with the stock price trend line going up while the MACD trend line having a slight negative slope.
      • Trading with the major trend — John Murphy advocates using a two-tiered approach to avoid making trades against the major trend. First, use the weekly MACD-Histogram to determine the long-term major trend. Then only short-term signals that agree with the major trend would be considered. If the long-term trend were bullish, only bearish crossovers would be considered valid for the daily MACD-Histogram. If the long-term trend were bearish, only bullish crossovers would be considered valid.
    2. Slow stochastics tracks the overbuying and overselling of a stock. Recommended settings 14-5.
      • The %K figure indicates at which percentile is that day’s closing price, compared to the closing price of the last 14 days.
      • The %D is a 5-day simple moving average of the %K figure and serves as a signal line.
      • It is a buy signal if the %K line crosses up above the %D line, or the %K figure crosses up above the 20th percentile.
      • It is a sell signal if the %K line crosses  below the %D line, or the %K figure crosses below the 80th percentile.
      • The %K in the slow stochastic is the 3-day moving average of the %K of the fast stochastic, which is the raw calculation above. The reason is because the fast stochastic generates too many signals so the slow stochastic is needed to smooth it out.
    3. Moving average tracks an average of the stock price during a specific time period, and are a kind of psychological barrier to the stock price moving up or down. Recommended 10-day simple moving average (SMA). Phil Town later recommended on his website to go with a 30-day SMA to prevent being hammered by false signals.
  10. To make use of the Tools, make sure that your position is less than 1% of the daily trading volume.
  11. Buying / Selling Discipline (after performing the fundamental analysis above)
    1. The Three Tools (technical indicators) help to take emotions out of investing by setting fixed rules for buying and selling.
    2. Buy when all three tools are “green” (i.e. MACD and stochastics cross above signal lines and stock price crosses above 10-day SMA).
    3. Sell when all three tools are “red”.



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