Rule #1 Finance Blog

With Investor Phil Town

REFRESHER COURSE: HOW TO BEGIN IDENTIFYING 4M BUSINESSES

The following question came to me from Alex, age 16, who may be the youngest Rule #1 investor to write to me so far. He saw me speak in Boston a few months back and has been emailing me since, practicing by doing a 4M analysis on Delta. For those who, like Alex, don’t know where to start when picking a company to research, read on. This is a good refresher for regular readers and a good intro for new ones.

I also suggest everyone reads my recent blog post about how to invest money wisely.

Mr. Town,

I listened with rapt attention to your speech at the Boston seminar, but I must admit that I can’t afford success magazine.com and have to use something called smart money instead (same basic idea… imaginary money, buy imaginary stock), and I have very little idea of what I am doing. And I am ashamed to concede this (I hope this doesn’t reveal me as ignorant) despite your useful tips and everything, I still have no idea what companies I should be picking…

Alex

My response:

Dear Alex,

My students that don’t have Success tools use MSN Money and Yahoo Finance and still get the job done, so I’ll be referring to those tools as we go along.

Most of the time, in general, the stock market prices businesses according to their value. But sometimes it doesn’t. In addition, some businesses are highly predictable but most are, as you pointed out, very unpredictable. For example, it is very difficult to say with any degree of certainty that Delta will be around in ten years. On the other hand, we can say that Coke will be.

I call this style of investing ‘Rule #1 investing’ because I focus on not losing money and don’t worry at all about making money. (Rule #1 is from Buffett who said there are only two rules of investing. “Rule #1: Don’t lose money” and “Rule #2: see rule #1.”)

I was taught this by a rich guy who learned it from Buffett who learned it from Graham. Bill Ruane at Sequoia and Bill Nygren at Oakmark Select use The Rule. Eddie Lampert (hedge fund making 29% for two decades and who bought Kmart and Sears) is a guy who follows The Rule. All the investors I know who have 20-year track records exceeding 20% a year follow the Rule.

If you follow The Rule, you will want certainty before you invest a nickel. Certainty only comes from buying a wonderful business at an attractive price. Notice I say ‘business’, not ‘stock’. I look at stocks as businesses, figure out what they are worth and then buy them when they are mis-priced.

Frankly, this would be very difficult if it weren’t for the fact that over 80% of the money in the market is managed money that is moved around in huge chunks of billions of dollars. When fund managers move the money from one stock to another it takes them 8 to 12 weeks simply because doing it faster causes their tactic to be visible and obvious – meaning their competition will aggressively move to get out (or in) first, and that causes the market price to change rapidly… bad news for the fund manager.

Therefore they sneak in and out, placing thousands of computerized trades of about 400 shares per trade. (A guy moving out of a 2 billion dollar position has to make around 500,000 trades to do so, and that doesn’t happen overnight without a huge change in stock price).

Since the big guys take so long to get clear of a problem, they tend to become very emotional when the problem is obvious and everyone wants out. They also tend to be very short-sighted simply because they are judged quarter to quarter. In other words, the combination of the market demand for short term success and the length of time it takes to move out of a position combine to create a very emotional market, which can misprice great businesses in the short run.

That is why Harley Davidson, Urban Outfitters, Whole Foods, Apollo Group, Bed Bath and Beyond, Cheesecake Factory were all priced too cheap in 2000, while GM, JDSU, Dell, Yahoo and many other businesses were priced too expensive.

We buy the former and sell the latter. It isn’t hard. You just have to know what the value is.

I’ll teach you how to do that as we go along. First, you’re absolutely right about Delta. It has no real value because no one wants them. So even thought the stock might be a speculative gold mine, Delta isn’t a predictable business and, therefore, isn’t something I can put a value on. If I can’t value it, I can’t know it’s an undervalued business, can I?

So here’s your next homework:

  1. Find at least one industry that you know a lot about already. The way to do that is to draw three circles that intersect.
  2. Title the first one Passion, the second Talent and the third Money.
  3. List in the first circle what you love to do, in the second what you are really good at, and in the third, where you make and spend money.
  4. Anything that lands in all three circles is something you know a lot about.
  5. Go to Yahoo Finance, Industries and look up the industries that correspond to anything that is in all three or two circles.
  6. Send me the list of industries and we’ll go from there.

Be sure to check out my new investing courses, too!

Phil

That’s the first step in how I mentor people to help them become Rule #1 investors. So get cracking on those lists!