How to Invest: A Basic Overview of Rule #1

Welcome to the Introduction to Rule #1 Investing. I’m Phil Town and this is Tutorial 1: Rule #1 Strategy- The Overview of the Basics.

This is part 1 of a 9-part series on How to Invest using Rule #1 strategies
Part 1 [You are Here]: Rule #1 Strategy- Overview of the Basics
Part 2: Meaning- The Three Circles
Part 3: Moat- A Durable Advantage
Part 4: Moat- The Big Four
Part 5: Management- Owner Oriented
Part 6: Margin of Safety- The Growth Rate
Part 7: Margin of Safety- Sticker Price and MOS
Part 8: Margin of Safety- Payback Time
Part 9: Zombie Value- Tangible Book Value

 

What is Rule #1 Investing All About?

Rule #1 Investing started with Warren Buffet who said that there are really just two rules of investing.

  • Rule 1: Don’t lose money.
  • Rule 2: Don’t forget rule number one.

So rule number one is about investing, not about speculating. Investing is about certainty.

Who Uses Rule #1 Investing Principles?

Who uses Rule #1 style investing anyway? Well, just about the best investors in the world are unanimously using this strategy.

It’s all about focusing on a couple of key things that we’re going to talk about. Ben Graham started it all. Warren Buffett is the most famous proponent to Rule #1 investing. Tom Knapp, Bill Ruane ran Sequoia fund, Charlie Munger of course, is still helping run Berkshire Hathaway. Eddie Lampert one of the best investors right now. Bill Ackman runs Pershing Square. Bill Nygren runs Oakmark Select and Whitney Tilson runs T3.

These guys are hedge fund managers, some of the best investors in the world. Rule #1 Investing is about focusing on not losing money, that’s the basic idea. Not losing money means first be certain of what you’re doing, and then go ahead and make the investment because guessing and hoping and wishing and praying and waiting is what most people are doing.

They just buy something and hope and wait. These are not Rule #1 strategies.

Investment Strategy: Always Be Certain

Warren Buffett said, “Be certain,” and here’s how you’re going to be certain. If you buy a wonderful business at an attractive price, you’re certain to make money. It’s essentially like buying a $10 dollar bill for five bucks. You focus on a couple of key things to make sure you know what you’re getting.

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What’s a Wonderful Business?

What’s a wonderful business? First off, it’s an understandable business. Second, it has a durable competitive advantage, and third is that the CEO is someone who we believe is honest, very passionate about what they’re doing and they’re owner oriented. That means they have our best interests in mind.

What is an Attractive Price?

What’s an attractive price? Well, first you need to know the value of the business as a business. You can’t figure out the price until you know what its worth and then you buy it at a discount to its value.

So doesn’t everybody use these principles? Well, it’s amazing, Warren Buffett said, “It’s extraordinary to me that idea of buying dollar bills for $.50 cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records and it doesn’t make any difference. They just don’t seem able to grasp the concept, as simple as it is.”

We’re going to go back and make sure we understand it now.

The Four M’s: Meaning, Moat, Management, Margin of Safety

What’s a wonderful business? It’s understandable, we call that the meaning of the business. It’s durable, we call that the moat. Like the water around a castle protects it from attack. The CEO is honest, passionate, and owner-oriented, we call that management. Those are the first three M’s. We make sure that we understand all three M’s before we go forward, then we look at the price.

Ben Graham, who taught Warren Buffett how to do this said, “The three most important words in investing are Margin of Safety”.

Margin of Safety is a price we arrive at by looking at the sticker price, which is the value and then we look 50% below that to buy it or we look for a payback time of 8 years or less, we’ll discuss that in another tutorial, or we’re looking at 70% of tangible book value or less. We’ll take a look at that in another tutorial as well.

4 Straight Forward Steps to Becoming Wealthy

  1. Find a wonderful business, and were going to do that by looking at meaning, moat, and management (M, M, M).
  2. Know what it’s worth as a business.
  3. Buy it at a discount to its value and that’s Margin of Safety (M).
  4. So there’s the four M’s, meaning, moat, management, and margin of safety and you’re going to repeat that until we get rich.

Conclusion

So, this tutorial has been an overview of the basics, next the first M, meaning. Your homework is to memorize the 4 M’s. Meaning, moat, management, and margin of safety. Then think about this, what are you passionate about in your life? What do you love doing? What do you feel like you’re talented at? What do you love spending money on?

Think about that, that’s going to be something we talk about in the Tutorial 2: Meaning- The Three Circles.

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Phil Town is an investment advisor, hedge fund manager, two-time NY Times best-selling author, ex-Grand Canyon river guide and a former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence. You can follow him on google+, facebook, and twitter.
  • Karen

    I have been looking at AOBC. It use to be SWHC, or Smith and Wesson. The name change bothers some people but I can see they are trying to smooth out their sales by copying Vista Outdoors. They still have Smith & Wesson but now it’s one of several brand name Outdoor Companies. The numbers look good. It’s got meaning to me, great management as far as I’ve found and is at or close to the MOS. I’d love to hear what someone else thinks about this company. I’m a beginning Ruler and am very cautious right now!!! Thanks!

  • Christopher Mulford

    Just dug into TSO. My Rule1 valuation is based on PBT vs. MOS and it’s approaching a good entry for the first traunch of shares. Overall the company has been able to transform from a pure play refiner into an integrated refiner/logistics/marketing company. Still room to grow the business from a logistics and marketing standpoint which I believe will be great 10 years from now.

  • Pankaj

    Just finished reading your Book on rule # 1 investing. A great book for an individual investor like me.

    I also just registered my email id for your website and its blogs.

    I have a query regarding selling a stock.

    In the book, you have a chapter on when to sell which says you should sell the stock in two situations i.e. when the stock price has crossed the sticker price and when the company is no longer wonderfull. But in the chapter on three tools, you say that when the tools signal “get out” it is the time to sell. Should I sell everytime the tools signal get out. I just checked these tools for some of the stocks, where I could see that these tools signals buy and sell quite often(frequently) in a three month period or may be in a months duration. Should I sell everytime there is a sell signal from all three tools?

  • Rick Westfall

    I’m not convinced I’m doing this right yet, so I figured I would post here and see if anyone can verify that I’ve identified a Rule #1 stock. I’m looking at SWKS. Based on my calculations, they are well under the MOS with over 10% numbers on the important Big 5 numbers. Anyone want to chime in on this stock?

    • William Patrick Law

      I don’t understand this business so I wouldn’t invest in it. And despite my degree in engineering, I’m not sure that I have the capacity to understand it well, not having working in the industry for any length of time – which is what I believe it would require. But that wouldn’t stop me from trying…

      Here is the company description:
      “Skyworks Solutions Inc, together with its subsidiaries is an innovator of high reliability analog and mixed signal semiconductors within the automotive, broadband, cellular, infrastructure, industrial, medical, tablet and wearable markets.”

      What are its subsidiaries? Will something come out different than LTE infrastructure or an innovation that will make much of their business obsolete? What is stopping Samsung or Foxconn from getting another supplier? How does that or will that be likely to affect the business? Do they even have a moat? (patents maybe, but how many of the 2600 patents that they have make money for them or is it just a couple?) I don’t see any reason why their competitors can’t replace their technology with something else as happens in most technology companies, so where is the moat? Why have sales dipped lately? Is this an “event”? Meaning to me? etc.

      Then, I would probably give it an MOS of 77$US (smoothed EPS of 5.18, growth 15%)…trading for 77.31$/share today! (I personally discount electronics by 10% growth rate from analysts and historical)

      Lastly, if I could answer all of those questions and educate myself on the rest of the company then I would try and explain it to my wife and father who would suggest that I could look into eating burritos or wings or something…CMG, BWLD, TXRH…

  • Grace J Power

    Netscout and Tucow

  • Logan Grant

    I’ve kind of had my eye on BWLD and FOSL. Thoughts?

    • Michael Kiriazis

      I like BWLD too especially with the recent drop from norovirus case (event). Only at about 20-25% MOS currently, but if the market can drop off this recent high some, I will probably start to get in the next time the indicators all signal up (could be soon as stock just moved above its MA, with MACD and stochastic down currently but starting to trend up)!

      • Christopher Mulford

        I want BWLD to go on sale too. From the looks of it the restaurant industry may be up next for some turblance. Hopefully it will put some of these companies on sale. For now it is time to enjoy a wait and see approach.

  • Levon

    What about apple? Price dropped.
    Bidu also dropped because of the drop in the China market. Seems to be good to buy now.

    • Michael Kiriazis

      AAPL was a great Rule One stock for me last year, but with their new lower forecasts this year, my Rule One analysis doesn’t indicate that they’re even on sale anymore. I’m going to stay away for awhile and continue to update my analysis each quarter.

  • Paul

    CMG seems like it is becoming an attractive buy (after hours Friday – below its MOS price based upon the defaults. Still not over it’s “event” right now though. Could get better in the weeks ahead!

  • Clyde Hall

    Thanks Phil