Rule #1 Finance Blog

With Investor Phil Town


First, everything I say from now on is predicated on owning a YUMMMMY stock.

A business that I own as a business that will, over time, provide me with an earnings yield that will exceed 100% per year.

A business that is highly predictable based on its past consistently high 5 numbers: ROIC and the 4 growth numbers: Gross Profit, Earnings Per Share, Equity and Free Cash Flow. The GEEC numbers. Oh, and it has a big moat – best of its class- and great management. Our YUMMMMY stock has gone up and up. How do we know when it has gone too far and it’s time to sell it?

We end at the beginning. (Isn’t that some kind of clever Zen thing?)

At the beginning, we had to know the value. What I call the Sticker Price. Otherwise there is no way to know that I am buying $1 for $0.50. And in the end, I still have to know the Sticker because as long as Mr. Market is pricing my company below the Sticker Price, there is still what I call Head Room – the space between today’s price and the actual value of the company. And as long as there is Head Room, there is low risk upside to the price.

Once Mr. Market’s price goes above the Sticker, I’m looking for the door. What I expect will happen is that whatever euphoria drove the price to crazy high levels will disappear; and then Mr. Market will screw up and price the business far below Sticker Price again. That’s when I’ll buy it back and start the process over.

What I just described is completely valid as long as you have nailed a really conservative Sticker Price. If you don’t — if you set the Sticker Price based on good numbers that could get hammered in a recession — that Margin of Safety that you thought you had could disappear in a couple of bad months. We don’t want to be sitting there if that happens.

Rule #1 is Don’t Lose Money. We have to protect ourselves from a drop in the whole market. Mr. Market is pretty confident these days and is pricing most great companies accordingly … which means at or above the Sticker. Which means a drop in the whole market is entirely possible, and that drop could take our wonderful company and give it a not so attractive price. We need to protect against that.

Here’s a recent example: I posted back in Feb 2005 when I started the blog that I’d just bought WFMI for $90. Later I sold it at $102, bought it back at $99, and sold it again yesterday at $117.

Althought the market price of $117 is still far below the Sticker price of $180, I still got out. Here’s why: I noticed the insititutional money moving out.

Institutional fund managers control the price of every significant stock in the market. Out of $17 trillion invested today in the US markets, over $14 trillion is managed by pension, mutual, insurance and banking fund managers. They have over 80% of the bucks, so they control the price. They get out… it goes down. They get in… it goes up.

They also work a lot harder at managing their billions than I do managing my millions because it’s a lot harder job. They are like Michael Jordan playing with 100 pounds of lead on each leg. Even I could beat him.

In this case, the 100 pounds of lead is the sheer size of the money they have to move around, and the fact that they must invest it every day. That’s what they get paid to do. Me and you, we can just leave it in cash as long as we want. Oh, and it takes them about 8 weeks to move the money without unduly upsetting the market. It takes me and you about 8 seconds, and we have zero impact on the stock price when we sell or buy. Yeah, us.

What that all means is that if we had a way to watch the big guys, we could protect ourselves from a crashing stock price by getting out quickly. And we can, in fact, do exactly that.

More in the next post…

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.