This is a sequel to Phil Town’s first book: Rule #1. Both books are quite good in presenting a simple system for novice investors to pick stocks. The first book deals with the basic concepts of value investing, coupled with some technical analysis (MACD, Moving Averages, Stochastics) to determine entries and exits. It lacked some key components which this new book tries to supplement.
New material for this book includes guidelines on portfolio management (position sizing, how to buy into a position), technical analysis (support and resistance levels, trend lines), and the concept of Payback Time (more commonly known as payback period in corporate finance). Basically it recommends buying in at a price that either has a margin of safety, or gives a low payback period (10 years or less). Technical analysis is used to determine when to buy in (provided the price level remains below the buy-in price you determined), and when to sell (e.g. break support levels with high volume).
The book doesn’t answer some tough questions such as how much to sell (i.e. what % of the position), exactly when to sell (e.g. break any support level? break trend line? trend line of what time horizon? does the distance to the sticker price matter?), etc.
In Phil Town’s website, he wrote that Rule #1 is a trading strategy which follows big mutual fund money in and out of the market using Stochastics, MACD, and Moving Average. Rule #1 trading is designed to work best as a short-term strategy in an overpriced market. On the other hand, the stockpiling method is designed for longer-term, and is best in an underpriced market. Stochastics, MACD, and Moving Average need not be used.
Overall, this book is not bad, and Phil Town has a huge following. There is another book Value.able by Roger Montgomery which also gives a simple system for novice investors, which also has generated a large following. Still haven’t managed to get a copy to read yet, would be interesting.
Key to Being Wealthy
- The key to being wealthy is to stockpile stock in a business you’d be excited to own all of, at as low a price as possible.
- Qualities of a perfect business to stockpile
- Simple, easy-to-understand business.
- Has some form of durable monopoly.
- Products are cheap to make.
- Products are cheap to sell.
- Has huge profit margins.
- Can raise its prices with inflation.
- Sells a universal product.
- Sells a habit-forming product.
- Products and processes make the world a better place.
- Management is owner-oriented, passionate, dedicated, and honest.
- A wonderful business has 3Ms
- Great Meaning to you (i.e. simple)
- Big Moat
- Management that is owner-oriented, dedicated, passionate, and honest
Best to find companies that are in all 3 circles
- Passion – What you are really passionate about in your life.
- Talent – What are you talented in.
- Money – Where you make or spend money.
- Five moats (qualitative identification)
- Brand – Willing to pay more for a product because you trust it
- Secret – Patent or trade secret which makes direct competition illegal or very difficult
- Toll – Exclusive control over a given market
- Switching – Switching to another product isn’t worth the trouble because it is already so integrated
- Low cost – Products priced so low no one can compete
- Big 5 Numbers + Debt (quantitative identification)
- ROIC should be >= 10%. ROIC = NOPAT / (Debt + Equity) = Operating Income * (1-tax rate) / (Debt + Equity).
- Earnings, Sales, Equity, and Cash Flow from Operating Activities should grow at >= 10%. For the cash flow, Phil Town’s online calculator uses Free Cash Flow = Cash Flow from Operating Activities – Capital Expenditure, rather than looking at just the Cash Flow from Operating Activities.
- Debt can be paid off in 3 years or less of earnings.
- Note: ROC can be temporarily low because a company is spending to expand its business.
- Management red flags
- High compensation
- Golden parachute
- Using business assets for non-business matters
- Buying other business to make a bigger empire but lowering ROIC
Margin of Safety (MOS)
- EPS for the last 12 months
- EPS growth rate for the next 10 years. Take the lower of
- Your estimate from looking at the past growth rates of earnings, sales, equity, and operating cash flow. Equity Growth Rate is usually but not always the best choice.
- Analysts’ consensus growth estimate
- P/E ratio in 10 years. Take the lower of
- Average of the historical low and high P/E ratios, can also reference the average annual P/E
- Double the earnings growth rate
- Minimum Acceptable Rate of Return (MARR). 15%.
- Calculate the sticker price by discounting the future stock price at the MARR.
- Margin of safety price = 50-80% of the sticker price
- Same as Payback Period in corporate finance. Growth in earnings is included.
- Range of Payback Times for private businesses is from 3 to 10 years, with 8 years as the average for venture capital deals, and 6 years for smaller deals. Payback Time is less because it can be difficult to find another buyer, and the buyer cannot know what will happen to the business more than a few years out.
- Payback Times for public companies average 13 years because buyers are less worried that they cannot sell the business and get their money back (liquidity premium).
- A Payback Time of 10 years or less is an attractive price.
Steps to Wealth
- Find it
- Find a company with the 3Ms using screeners (e.g. MSN Deluxe Screener).
- Research competitors in the same industry
- Value it
- Decide on a Stockpile Price, i.e. what you are willing to pay. It can be the MOS price or Payback Time price such that you can get your money back in 10 years or less.
- Watch it
- Keep up with the businesses you would like to own but whose price is still above your stockpile price.
- Adjust the stockpile price if needed.
- Buy it
- Determine the number of businesses you should own by keeping the commissions small relative to your capital.
- Up to $20K, $40K, $70K, $100K, $1M – 1, 2, 3, 4, 5 businesses respectively.
- For initial buy-in, use 25% of the capital you allocate to the business.
- Own it
- Attend quarterly earnings conference calls, regularly visit the investor’s portion of the company’s website.
- Read SEC filings (10Q, 10K)
- Read annual report, and chairman’s letter
- Read news about your company (e.g. MarketWatch)
- Keep up on the top competition. What happens to a major player can similarly impact the entire sector.
- Read the industry trade publications and related websites. News often breaks first in the trades, before it reaches the business press or mainstream media outlets.
- Stockpile it
- Buy in at 25% of allocated capital each time. Last 25% can be split up if the stock keeps sliding.
- Stockpile Method #1
- Initial, 2nd, 3rd, 4th buy-in at 20%, 30%, 40%, 50% off Sticker Price respectively.
- Initial, 2nd, 3rd, 4th buy-in at 30%, 40%, 50%, 50% off Sticker Price respectively.
- Initial, 2nd, 3rd, 4th buy-in at 40%, 50%, 50%, 50% off Sticker Price respectively.
- Initial, 2nd, 3rd, 4th buy-in at 50%, 50%, 50%, 50% off Sticker Price respectively.
- Stockpile Method #2
- Monthly Allocation of Capital (MAC)
- Buy each allocation on the same day each month if the price is lower than the Stockpiling Price.
- Stockpile Method #3
- Floors and Ceilings (FACS)
- Floors = Support level, Ceilings = Resistance level
- When the price breaks through a Ceiling, the Ceiling becomes the Floor, and vice versa.
- Trend lines are diagonal, while FACS are horizontal.
- The more often the stock price bounces off the Floor or Ceiling, the stronger the Floor or Ceiling becomes.
- To determine how far the price will climb from the new Floor to reach the next Ceiling, look at the distance between the last Floor and the last Ceiling.
- A price move of over 3% above the Ceiling or below the Floor, accompanied by 150% of the average daily volume (over last 3 months), is a significant sign of a breakout that will last.
- Sell it
- Sell when the price exceeds the Sticker Price by 20%.
- Sell when you need the money.
- Sell when the fundamentals change for the worse.
- Repeat until rich
Use a Berky for your Investments
Qualities of a Berky (based on Berkshire Hathaway)
- Receives recurring cash flow. CEOs of Berkshire subsidiaries are rewarded for maximizing the cash sent up to Berkshire.
- Cash moves into Berky without being taxed twice. Berkshire subsidiaries can pass up the cash flow to HQ without dividend taxes.
- Allows you to reallocate the cash to investments of your choosing.
- Allows you to reallocate your investments.
- Allows you to get cash for personal emergencies.
- It’s a huge mistake to buy and forget. You want to see the problem coming and get out, and if you don’t keep track of the business and industry changes, you can get run over.
- There is a downloadable calculator from PaybackTimeBook.com that can calculate a growth rate that starts from a negative number.
- If you follow Phil Town’s sell rules to the letter, you can find yourself riding a stock up and back down again without selling. In the example with a hypothetical family in the book, the family actually “decided” to sell off near the top when the price broke a long-term trend support line, i.e. if they didn’t “trade” using technicals, the “results” can be quite different.
- 50-day simple moving average is useful to find support and resistance levels. Exponential moving averages puts more weight on recent data and is used more by short-term traders.