Rule #1 Finance Blog

With Investor Phil Town

Phil Town Explains Payback Time and Stockpiling

The other day I received a comment from Doug, about a discussion he had with his wife.  (Click here to read his question.)  The topic: the differences between Rule #1 investing, Payback Time, and value investing.  Here's what I told him.

Hi Doug (and Ms. Doug),

I love your post.  Thank you.  First, we're not 'value' investors if by that we mean guys who buy cigar butts.  But we could be in the future if cigar butts are the way to go.  It's just that right now we still have a pretty solid economy and there aren't many cigar butts lying around, so it's too tough to make any money doing that sort of Ben Graham thing. 

We still want wonderful businesses.  So I still don't know what to call us.  Maybe "Valuation" investors.  Basically, we try to do the same thing Graham did – find the value of the thing you want to buy.  In our case (and Warren Buffett's as well) we're not just considering the net equity of the business if it dies when we look at value.  We are also looking at a business as a living thing that produces cash and will do so for a long time into the future.  That kind of business is, by definition, "wonderful" and has a much higher value alive than dead because of all that cash it may earn in the future. 

In Rule #1 I showed you how to make money using Tools and trading in and out with the big guys to avoid getting hammered if you screw up.  In Payback Time I show you another way to make money that is particularly effective in a market like the one we are in.  In fact, if you do find a wonderful business, I think you can make a lot more money stockpiling it than trading it in this market.  But before I get into that let me explain the difference.

Trading means you are buying and selling depending on signals generated by the big guys – the institutional investors.  But in a big down market, it's possible to die, as I said in Rule #1, the "death of a thousand cuts" by getting in on the Tool signals just as the stock is about to drop in price.  You get out but with a small loss.  If you repeat this a number of times in a big downward market trend you bleed to death.  Even though you bought a great long term business, you still lost a lot of money as it went down.

A different way to look at the same stock situation is to take a long term investor point of view.  I call this "Stockpiling".  Mr. Buffett calls it "consuming" a stock.  It's been used by people to get mega rich. 

Here's how it works in a nutshell: You find a business you really (and I mean really really) understand.  You set a "Stockpiling" price at the lower of the Margin of Safety Price or the 8 year Payback Time price (and you can read my new book, Payback Time, to see how that's done).  If the price falls below the Stockpiling Price, you stockpile.  You buy.  And here's the big non-intuitive change: once you buy, you hope the price goes down, not up.

Here's why: When you do stockpiling, you are essentially doing Dollar Cost Averaging, but you're doing it with a brain.  You don't just buy regularly at any old price and hope it all works out in the long run.  You buy only when you have a big Margin of Safety price, and you buy as often as you can when it goes lower.  As you do that, when the stock price goes to its retail value your rate of return goes up quite a lot above where it would be if you only bought that one time.

Now, how do you keep your wife from calling you crazy?  Well, you tell her Warren Buffett does this exact thing.  But she'll tell you that you aren't Warren Buffett.  Then you tell her that you've done your homework, you'd love to own this entire business, and you are stockpiling as much of it as you can while the price is unreasonably low. 

If she asks you why you think you know more than the professionals who do this every day, tell her you don't, but you do know about this one business and that it is a very good business, and if the stock market shuts down tomorrow, in ten years it will be worth about 8 times more than you are paying for it.  And if you are wrong, you are buying it so cheap that even if it's only worth 2 times what you paid for it, that's a better return on your money than putting it in a bond.

Oh, and you can point out (when it exists) that this business is also paying a dividend of 2% a year — more than a money market account.  And not only that, but if you bought the whole business right now and kept the earnings, your rate of return on your investment would be running about 7% a year from the net earnings and rising every year at about 15% (in this hypothetical case). Which means in ten years your yield (or return on investment) from earnings will be almost 30% per year.  Ask her where you can get that sort of return other than by buying a great business.

In fact, you want to point out that this strategy is about finding a few great businesses and buying them whenever you can get them at great prices in order to accelerate your overall rate of return.  Which is what you need to do to retire well.  Remind her that if you want to live on $50,000 a year in today's dollars and you plan on retiring in 20 years, you'll need to have about $3.6 million in the bank to do so without having to worry about making it to 95 with money. 

Now about the free workshop.  I've been teaching a workshop that I charge $2995 for because learning this from a book is not enough for some people.  It helps some people to get it live, to practice with real examples and with a teacher in the room.  It's useful enough that I've made it available to you guys who have the book.  Free.  I intend to continue to do so as long as I can.

Regarding tools.  I've been out there as a spokesperson for Investools, a good toolset, for over ten years.  I finally decided I had to create tools for Rule #1 and Payback Time readers that automated what I show you how to do on free sites, because Investools just wasn't interested in doing that. 

Why would you need tools if you can do this for free on MSN?  Same reason people built tractors and sold them to people who had mules.  It's a lot better deal to be farming with a tractor because its a lot less work and you make more money.  You don't have to have the tractor, though.  Farming is farming.  You dig a hole, you stick in a seed.  And great investing has been done the same way for the last 100 years.  You find a wonderful business and you buy it when it's cheap.  Tools just help you speed up the process.

Hopefully we'll have some great tools ready to go in a few months for those who want to invest in them.  Oh.  Did I mention we're going to charge for them?  We are.  But I'm going to keep teaching you guys how to do this stuff using free sites. You don't need tools to invest and you don't need a tractor to farm.  It's a time saver is all, and it's only going to be worth it to some of you, not all of you.  So don't feel bad if I offer tools and you don't want them.  I still love you.

Now go play.

Phil Town

Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and 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.