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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About Phil Town – 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.

  • Eddie Pena

    I always think about well known stocks that devalue and then go to zero.
    how would this strategy have not been caught in the Enron debacle? Would the rule #1 method stayed out of it, or seen it as a value stock at a low price?
    Thanks

  • Jason Musick

    Loved the Email today I was thinking about the part of the book where you mentioned the irrational behavior of the Stock market. I know you mentioned a book to read about this in rule number 1. Do you recall the name? I would love to read it. Or better yet do you have a list of books to read that you suggest. I just started reading The little book that beats the market by Joel Greenbratt very funny guy to read. Easy to understand.

  • john c

    Zinc is not a RuleOne company and therefore belongs in your”Risky biz”portfolio.You should only have 10 percent of your overall portfolio in “Risky biz”.

  • Thomas D. Oakley

    I know Mohnish Pabrai really likes Horsehead Holding (ZINC). They appear to be a really good company but they have had problems getting their new plant up-to-speed. In April, the stock was going for over $15 and today it is at $1.59. Would you say this is one of those stocks to jump on? Or could the problems with their plant lead them to $0?

  • Tom

    All, I feel the market is overpriced. I’ve been out before the recent dip with some nice profits. Now prices are just climbing and the disconnect between the earnings and stock prices are higher then it is rational since people are just too optimistic.

    Am I the only one who feels that way?

  • Garrett

    Rulers,
    Dad emailed this morning. He said he’s watching Exxon – “and looking for a bottom…What do you think?”

    MEANING:
    The family has owned XOM for many years now. Grandma bought some and then Mom and Dad inherited those shares. Today XOM’s dividend helps pay for Mom and Dad’s retirement. We understand the biz enough to simply know that XOM isn’t going to go out of business in their lifetime. Dad doesn’t need 10% annual returns or anything. He’s 74.. Mom just turned 71 this month. They’ve got enough in retirement that dad feels like they are “over the hump” where they won’t out-live what they have.

    Dad’s not going to read the quarterly earnings statements on XOM. He’ll leave XOM’s seeking alpha articles to me and expect me to tell him if something really bad is happenning. And he’s not going to freak out if the shares drop a bit. He’s just looking at getting a small dividend check every quarter and doesn’t want to sit too much in cash.

    MOAT:
    XOM competes with the big guys – Chevron, BP, Royal Dutch Shell. If you’re a foreign company and want to oil, you’re going to call Exxon or BP. And if you want the best in off-shore driling, then you’ll probably call BP.
    Exxon, like BP, is taking a hit financially right now due to the US/Russian sanctions. Exxon had some huge success recently, but those Russian sanctions are preventing them from extrapolating and exploring further. They’ve made some partnerships to help Russia, but are on hold for now.

    But one thing that XOM does that I didn’t realize till Phil mentioned it is that XOM’s replacement costs are not quite like BP’s. BP is replacing oil with oil. Whearas XOM is replacing oil with Natural Gas. Now this might have changed with some recent discoveries in Alaska but that was an interesting tid bit of info.

    BP’s been better at finding new oil than XOM. But then again of course, XOM doesn’t have the U.S. judicial system kiling the golden goose that employs all those people and funds those British pension accounts.

    The bottom line is that XOM’s MOAT is their ability to do incredibly complex drilling in remote locations and work with foreign governtments all over the world.

    MANAGEMENT:
    XOM is a consistent performer. No drama here. Just buy and hold and buy more on the dips. Looking at Phil’s Toolbox, we’ve got solid performance on our ROIC and ROE. I especially love XOM’s BVPS Growth Rates – very, very consistent. Management knows what they’re doing and will just keep on doing it. If the world stops runing on oil, then Exxon, BP, Royal Dutch Shell, etc, will lead the world in replacing it.

    How about Mr. Buffett? What’s he think about XOM? Everybody knows Buffett bought XOM. That could create a pretty solid floor – just like it has on IBM. XOM is Buffett’s 7th largest holding and according to Gurufocus it represents 3.8% of his portfolio. Looks like Buffett is in with a basis right around $90.00.

    MOS:
    Commodity prices are taking a big hit right now. Oil is hitting some multi-year lows. Don’t try to buy XOM based on a Discounted Cash Flow valuation as in Rule #1. It just isn’t going to get that cheap – ever!

    If you really want to try to buy XOM at some price, I believe you’re going to have to look at the dividend yield, book value and Payback Time.

    Baby Boomers and Retirees aren’t going to let the price drop so much that they don’t start buying it to get that dividend. That’s what attracted dad to it. He believes XOM will keep paying at least an inflation adjusted dividend. That’s going to mean something close to a 3% dividend yield is probably the best he’s going to get putting our price right about $90 per share. XOM has the ability to payout the div and nobody is going to let the price drop so low that the dividend yield is returning 4% or 5% with today’s 10 year treasury at 2.25%.

    Investors like XOM’s growing Book Value. How much are investors typically willing to pay for that growing book value? Well, a little digging shows us that most investors won’t let the price get so low that they aren’t paying at least 2 times whatever the book value is. So what’s today’s book value? The Trailing Twelve month book value is $42.18 per share. Multiply that by 2 and we get a pric eof $84.36 per share.

    How about looking at an 8 year Payback Time as Phil introduces in his second book, Payback Time? Just using the default data on Phil’s toolbox shows $81.61 as an 8 year Payback Time.

    Ok…so now we’ve got a few numbers and possibly some rational areas where we might see some floors or the stock to channel as investors buy and sell those XOM shares.
    $81.61 = 8 Year Payback Time
    $90 =’s Buffett’s basis
    $90 =’s 3% Dividend Yield
    $81.61 =’s 2 times the book value.

    So with that in mind, I’d expect XOM to stay somewhere in that range for a little while. If you know some cash flow strategies, there are probably some opportunites out there where you could execute some low risk cash flow trades.

    And as always, don’t be afraid to get a little help – I always suggest Newbie Rulers get into Jeff Town’s class and get a little hand holding.

    To Your Wealth!
    Garrett

    • Garrett

      typo in that summary :
      $84.36 =’s 2x’s Book Value

      To Your Wealth!
      Garrett

      • AngelaW

        Looks like the stock price has broken down the trend line and 200 day MA. Will be interesting to see how far gravity will pull it further down. Solid floor around $84 in FIB.

  • Garrett

    Rulers,
    I’m without a computer for awhile…till Oct 27th supposedly while it’s getting repaired or replaced… and typing with my thumbs on my iPad isn’t my preferred method of posting. So I’ll be brief and share this from our Southwest Airlines CEO, Gary Kelly, who was answering an employees question in this weeks company news called “Ask Gary”.

    I’m sharing it here as he gives a nice perspective in share buybacks that we as Rulers should understand.

    Here ya go:
    Gary: We have an e-mail question from David McClendon, Chicago Inflight. David asked “If we did not spend the $331 million in the first quarter repurchasing our own stock, could we have added that cash to our bottomline or considered it profit?”
    David, great question. I think the answer is no, fundamentally, if I think about your question. The cash that we have in the bank is at a point in time, so obviously we took $331 million in cash and we paid that to our Shareholders, and they gave us stock, and we retired that—is basically what is happening there. So, yes, we have less cash by doing that, but we’ve given it back to our Shareholders and what it does for you as an individual Shareholder is it increases your percentage ownership of Southwest Airlines, because we’ve taken and reduced the total number of shares. So your percentage ownership has gone up and the way you see that is your individual stock price goes up—and this is all in theory, and there’s plenty of evidence to support that but that’s fundamentally what we’re doing.
    The Shareholders own the Company, so if you think about the cash, it’s really theirs, and they will either support Southwest taking cash and buying more airplanes, and if they don’t want us to grow, then they would say then say, “Nope, I prefer that you give that cash back to Shareholders as Owners of the Company. So, a share repurchase has no bearing on the Company’s period profit, so the period in this case is the first quarter, so that is a flow concept. We sell tickets and get revenue for that; we fly airplanes; we have to pay for fuel and for salaries and other things. So, the net of those two is the profit—revenues we get from our Customers—as compared to the cost of flying and operating the airline. So, the profit is not affected at all by buying back shares, but the number of shares and then the profit per share is where you get the benefit from the share repurchase.
    So, share repurchases make sense when the Company is profitable. A more tangible illustration—a returning cash to Shareholders—is with the dividend. If you own Southwest stock, you’ve seen very nice increases in the dividend over the past several years—that’s cash in your pocket and all Shareholders’ pockets, so the dividends and share repurchases work in tandem and, once again, while dividends cost the Company cash, it is not reflected in the profit. So, transactions that we have with our Shareholders are not part of the profit each period. I know that’s a little bit technical, but would love to answer any more questions you have, if you want to give me or give our Finance Department a call on that.
    Thanks very much for your question. Congratulations on a very strong first quarter and just the fact that Southwest was in a position where it can return cash to its Shareholders. So, thanks so much, David.

    To Your Wealth!
    Garrett

  • Katie

    Did anyone notice that msn money recently changed their website layout? A lot of the information Phil describes in Rule #1 is not available or less years of data are shown. Does anyone know another place where this data can be found quickly?

    • Mike Mac

      See the comments to Phil’s previous post.

  • Mike Mac

    Any opportunities out there due to the Ebola “event”? anything interesting due to the FEAR of oil prices continuing to fall forever ..BP, NE, ESV, DNR? Agricultural fears… AGCO gave terrible guidance. Will all ag stocks gets punished to stupid cheap prices….DE, POT, MON, etc? Infrastructure plays… I’m looking at getting back into Chicago Bridge & Iron (CBI) which is a buffett stock. There is some fear here from short seller reports re: financial engineering after an large acquisition a year or two ago. just some thoughts…

    • Hanno

      Not so far, yet.
      Would recommend to wait a few months. Red signals anywhere in the world now.

      • Mike Mac

        CBI at $48 (a 52-week low) is very interesting to me.

        • Hanno

          Stock is in free fall now. I don’t know CBI, did not look at it fundamentally. But from a technical point of view it is better to wait for a consolidation. It could fall below $40. It is possible, that it will happen. If it is worth owning the stock for you, I would say, it is a must buy below $36 and very at it’s all time low below $32! But CBI is likely to fall below $40 for my opinion.

          • AngelaW

            Hanno,
            Ha! I am learning how to read the charts right now. Besides Stan Weinstein’s book, what other books/sites do you find helpful to learn technical analysis?
            Thanks in advance.

          • Hanno

            Hi Angela!
            I collected some experience in the past years, since I am working with that market stuff.
            I was looking a lot of sources, not only one. I find it always good to get input from different sources and take what you think is helpful for yourself.
            The internet has so many possiblities. As I am a german speaking guy, I prefer german websites. But I am also international and so, if there is also a way to learn something in english, I do it. I bought one book about technical analysis. From a german investor. Not very famous I think. Saw him at a seminar workshop years ago. But the best way to learn technical analysis is just doing it. All you need is a good website with great visualisation opportunities.
            After changing the msn money website I fortunately found a replacement for it which is a lot better! What I am still looking for is a website where I can extract the fundamental data. MSN money was a good one, because it also had the data from europe and asian markets. Unfortunately Phils website only covers the US market. I like the US market, but there is more than that.
            So finally, what I can tell you is just exercise using the technical tools and play around with them. This is the only way you will learn how to use them. No book and nobody can do that for you.
            What also is very helpful is to papertrade. I do it for years and it also helps to get a feeling for your emotions, for yourself in general! You will see, that also if you are not using money, it is not easy to stay rational sometimes. That is good to learn something about your behaviour during investing and applying technical analysis mixed with (hopefully) fundamental analysis (like rule#1, which is the best). Phil has very great webinar videos which are teaching you everything you have to know. They are so great, I just can recommend them. What he knows and teaches is everything you have to know. Everything additional engagement is great for yourself and shows that you are going to your financial wealth in future.

    • Hanno

      I think that as long the oil price has not found its bottom, you should just stand on the sideline and watch the oil company stocks fall. There will be green signs to load up the truck, like Phil says. But at this time no green signs are visible. So be patient. It is better for you and your money pocket.
      As Phil teaches buy cheap companies. But be aware of not being impatient, greedy and emotional. That is the dark side of the force… 😉 There is no need to get in right now in this week, in this month. Wait for the green signs like Phil tought it.

      • BD

        Hanno,
        What is the new site you use for looking at charts? I’m sure you’ve heard a lot of people on here like Morningstar for looking up fundamental data… I’m still trying to find something better for this as well though

        Thanks,
        BD

        • Hanno

          Hi BD,

          I use Guidants.com
          It is a free charting tool with lots of widgets and technical tools. It has all charts I was looking for since I use it. Unfortunately, it has not all historical data now. But mostly a few years back. It is okay for me, but I liked to look at the companys history on chart basis.
          the great think is, that you really can do technical analysis “par excelance”! I like it. If you register, you can save Chart alerts, watchlists and Market/commodity lists. You can also save two customized desktops and link the single windows you use. Generally it is a german based website, but I think there is the possibility to have it in english as well. Since I use this chart tool and you have to know that it supports real time charting for some businesses, I try to day/week trade. It works really good with it!

  • Hanno

    Although a philosophical point of view is unusual und discusable in any way, it is also very hard to interpret the thinks said in a good manner. After years spending with investment and starting with you and your book long time ago, I understand what you mean. Maybe, because I also tend to drift into a philosophical point of view. There are many ways of discribing one only thing. But there are also a lot of ways how to interpret one said thing. Especially, if you are new to something. Listening to somebody with deeper understanding, it is about believing for first, and the willing to understand or also interpret the things which were said in different ways. It is about having an own point of view, that is, what you really want to teach, I think. And you always but a value on that beside explaining everything what’s going on in the world or in the market. If you are not able to have your own point of view and have an empty spirit (like it is said in the east or from bruce lee), you have to follow others, like for example Phil Town.
    Self dependence, self-reliance, self responsibility…. that is hard to teach but it is a basic requirement for having success as an investor and generally.