Rule #1 Finance Blog

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Is Rule #1 Investing Value Investing?

Is Rule #1 investing considered value investing?

On occasion I will be interviewed by someone who has skimmed the book, or someone who will come to the conclusion that I am a value investor.

Here’s the logic: Rule #1 urges people to look for undervalued businesses and buy them when they are cheap — therefore, I am a value investor.

This makes sense to an extent, but it’s wrong…

What is Value Investing?

Value investing was pioneered by Ben Graham, Warren Buffett’s teacher.  Graham thought the best way to make money was to buy businesses when they are undervalued, wait for the market to realize its mistake, and then sell them when they were bid up to retail… and in all fairness to my people, that does sound a lot like my way of doing things.

However, Graham went on to define what “undervalued” meant to him.

He didn’t think anything was undervalued unless it could be bought for less than its liquidation value.   In other words, he didn’t put any value on the business as an enterprise that produced surplus cash.  It was undervalued if he could liquidate it and come out okay.

Not that he was in the business of liquidating businesses – he just assumed that the business was so undervalued that eventually someone besides him would realize it and the price would go up.

Warren Buffett loves his mentor and gives Graham full credit for teaching him how to invest: Simply buy a wonderful business at a great price and you are certain to make money.

Learn how to buy wonderful businesses at a great price by getting the best parts of my books, Rule #1 and Payback Time here.

But, Graham was investing during a depression and a world war and businesses were available at liquidation prices.

Warren Buffett and Value Investing

As I’ve pointed out on stage a thousand times, the Dow Jones Industrial Average was at 100 in 1905. In 1942, 37 years later, it was back at 100. If we see a stock market not go up for 37 years, I guarantee you we’ll see a bunch of businesses for sale for liquidation value, too.  But after 1942 the market began a long climb to a Dow Jones Industrial Average of 1000 by the mid-60’s and during that time, Graham retired and Buffett began his career.

During that time, Warren Buffett was having trouble finding businesses below liquidation value.

Enter Charlie Munger

Buffett’s partner, Charlie Munger, another brilliant investor, convinced Warren that in a non-depression / non-war market, real businesses are almost never on sale below their book value — and the ones that are, aren’t worth buying.

Warren took to calling those kinds of businesses “cigar butt” businesses. They only have a couple of puffs in them… but they are just laying there to be picked up by anyone who wants them.

Charlie successfully argued that there is a good reason that the cigar butt businesses were so cheap – they were mostly crappy businesses.  He figured life was too short to be messing around with bad businesses run by bad management.

It was a lot better, he thought, to buy a wonderful business at a fair price than to buy a fair business at a wonderful price.

Especially when you are trying to move billions of dollars into or out of it. He won Warren over and Warren stopped buying Berkshire Hathaway-type problem companies and started buying Coke and The Washington Post

…And the rest is history.

Why is Rule #1 Investing Different From Value Investing?

Which brings us back to what kind of investing Rule #1 is.

Generally speaking, value investing means buying stock that has very low PE ratios that reflect low growth rate prospects for the future.

We look for businesses that are undervalued, yet growth businesses.  And, of course, we’re not paying cigar butt prices.  We have to buy at what Charlie Munger calls a “fair price”. But then, for Charlie and Warren, a “fair price” requires a big discount to retail, and that discount is fundamental to buying anything.

Value Investing as it Applies to Rule #1

When applying value investing to Rule #1, we do indeed try to find cheap stuff, although we prefer it to be wonderful cheap stuff, I’ll buy less than wonderful cheap stuff if:

A) It’s cheap enough

B) It’s consistent and durable enough to be able to determine (A).

In other words, although I wrote in Rule #1 and Payback Time that I am looking for 10% growth rates in the Big Four and ROE’s above 10% and no debt, I’m not dogmatic about it.

Yes, the Toolbox will paint scores that are less than optimal with red or yellow, but it’s a computer program, not a human brain, and until I can figure out a better way to categorize what’s out there, those Rule #1 Scores will have to do for a starter.

The point here is to not let those Scores be an ender.  And the way to do that is, of course, to be sure you know your industry and business.  One thing I keep in mind is that Buffett bought See’s Candies when it had a Big Four growth rate of about 4%.

Know the Value, Then Buy at a Discount or Margin of Safety

Because Charlie and Warren use the words “fair price,” some people call this sort of investing “GARP Investing.”   GARP stands for “Growth At a Reasonable Price.”  But, they miss one of the most critical aspects of Rule #1 Investing.

That critical aspect is margin of safety.

For me, a “reasonable price” would be the price at which I would expect to make 15% a year if the business does what it should do, what I expect it to do.  But, as you already know, Rule #1 insists on a Margin of Safety price that is about 50% BELOW a “reasonable price.”

So we’re not GARP investors either, and here’s why:  I’m not Warren Buffett and neither are you.

Face it, Buffett is a genius, and geniuses see things you and I don’t see. Since we’re not geniuses and are capable of missing something important, it’s necessary for us to be a bit more patient and wait until we not only get something wonderful, but also get it at an extraordinary price…

A price that, ten years later, will cause people to say, “Wow, you stole that thing!” — and they’d be right.

That’s what I mean by a Margin of Safety.

The key thing is to know the value and then buy at a big discount.  The whole thing about ‘wonderfulness’ is that, particularly for a novice investor, we need it to be wonderful (in terms of meaning, moat, and management) in order to know what the thing is worth.  In other words, if the business isn’t highly predictable its quite hard to know what it is worth.

See’s Candies is highly predictable and therefore quite easy to value.  It is wonderful in that sense.  It doesn’t grow much, but if you could buy it for the right price, you’d have a little goldmine.

Good Stock Prices or High-Quality Businesses?

To that point, what is more important, a really high-quality business or a really good price?

The problem with really wonderful companies, really high-quality companies, is that they don’t go on sale.

As long as everyone knows the business is wonderful, the institutional investors running pension funds and mutual funds will buy it and because they buy it the price goes up until the potential return on the investment has been bid up to the 100-year market average of about a 7% CAGR.  See Coke for an example.

On the other hand, if a business has no Moat and is, therefore, by definition, not wonderful, it’s future cash flow is in doubt and therefore, the current value of the future cash is going to necessarily be quite small.

The Quality of the Business Precedes Price

Thus, the right answer is that quality precedes price.  In other words, it has to be a wonderful business to have a decent valuation.

Wondering how to find a great business at a decent price? Join my weekly webinar to find out how.

With that said, it is also true that if I can buy a company that I know the value of, it doesn’t have to be the most wonderful business in the industry.  All it has to be is predictable and durable enough to have a predictable long-term cash flow by which I can value it and then priced to buy at a big discount to that value.

Of course, Mr. Market, being anything but stupid, will bid up everything in sight if he’s feeling greedy so the only way we’re going to get a shot at a good price is if: (a) Mr. Market is having a market-wide emotional melt-down or an Event happened that created a short-term problem for this company/industry.

A) Mr. Market is having a market-wide emotional melt-down or,

B) An Event happened that created a short-term problem for this company/industry.

Either way, the risk of putting up money appears to be significant, at least for the next year or so, to the institutional guys and they withdraw.  The result is a valuable business on sale.  That means we have to consider what risk actually is if we are to make investments when smart people are running for the hills.

The Risk Lies in Following Mr. Market

To Rule #1 Investors, real risk lies in following Mr. Market.  If we do just follow the market, the best we’ll do long term is about 7% average and even that is emotionally tough to get.  You’d have to keep your money working in the market through huge price drops, drops that regularly will, marked to market, wipe out 50% of your portfolio.

Yes, it does come back in the long run but the question is always ‘how long is the long run?’  At some point in an investor’s life, the long run is too long.  The real risk of being in the market in this way is felt as an investor gets close to retirement; the closer the time to live off the money, the more the fear is felt that a market meltdown will destroy the retirement.

This is why retired people go to bonds while Buffett is all-in on stocks.

Stay Rational

Moving rationally against Mr. Market, against the crowd, against the prevalent emotion, is the key to risk reduction; the emotion of the mob puts businesses on sale and buying $10 bills for $5 is not risky.  A market meltdown is unlikely to affect well-purchased positions for long.

Keep this in mind: If you find yourself excited about a company because everyone is excited about it, or you’re thinking of investing because everyone is thinking of investing, it’s probably time to take a big step back.

Conclusion

The fact of the matter is that the best risk reduction comes from not buying a big loser more than by buying huge winners.  The winners will come.  It’s the losers we have to watch out for and the key thing that makes a loser a loser is that you bought a bad business at a terrible price.  Stick to buying businesses that are durable when Mr. Market puts them on sale and you’ll retire wealthy and stress-free.

Now go play.

I teach a weekly webinar with my wife, Melissa where I’ll show you how to invest rationally with less risk if you want to learn more, click the button below.

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P.S. Want to learn more about value investing?

Check out these related investing resources to learn how to use the strategy:

A Complete Guide to Value Investing

Famous Quotes by Warren Buffett

The Best Way to Invest Money

Investment Calculators to Help You With Rule #1 Analysis

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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.