Tuesday, May 16, 2006

Book Review of Rule #1

Rule # 1





This is one of the most recent books on “value” investing. (As used here, my term value investing merely refers to the idea of buying a company or its stock for less than its value; as opposed to other reasons).

Remember I view everything I read through the prism of having only been a student of investing for 4 months now and therefore comment on its utility to me as a new investor. Such comments may have more or less value depending on your own experience. While I at times may offer criticism of the book it is not negative by any means; but rather constructive as the utility of the book from my point as a new investor.

With that said….

Overview
The Book
My Comments


I. Overview

Overall I think this is a very good book for a new investor. This book’s value is not found in the originality of the subject matter, the concept of paying less for what you buy has been covered by Ben Graham, Philip Fisher, and Warren Buffett for many years; but this book is original in that it provides a more accessible way for people to understand those concepts without having to read the original text.

But if for one reason or another they prove too daunting to you then “Rule #1” is a good primer substitute for the original work.

Essentially this book is very similar to Joel GreenBlatt’s Little Blue Book Book in that it provides a simple “formula” in which to find good companies and figure out if they are inexpensive.

The difference between the two is the Rule # 1 provides a more hands on way to apply the theory. Greenblatt’s book does include a theory and a system but the application of that system is dependant on the business which he provides; whereas the Rule #1 book provides a similar theory and system but allows and encourages the independent application of that system. I think both books do a good job in simplifying the theory; Rule #1 just allows a person to be less dependant on a particular information source than Joel Greenblatt’s book does* (which may or may not be a good thing for all people). Essentially Mr. Greenblatt tells you how to find good companies selling at a discount, the only problem is order to do this you have to go through his website, which may not be a negative but it fosters a dependence on him].

Therefore, I think Rule #1 should be read by ever new investor who desires a basic understanding of how to identify good companies and determine if they are selling for a “sale” price.

The Book

The Book can be divided into three separate parts. Essentially the book shows you:

How to evaluate a company as to whether it has a distinct advantage over other companies to determine if it is a “great” company that we should want to own

How to determine what a fair price for the company is on a per share basis and to figure out whether the current price allows for a margin of safety just in case we were over optimistic in our evaluation of just how good this company is

How to apply certain technical indicators to buy and sell stocks.


To identify good companies the author takes you through a multi-step system. The best way to understand it would be to use the link I have on the right to the Phil Town blog and read the last year or so of blogs which uses examples and case studies to show how the concepts are applied. Essentially, you must understand the business and it must be reasonably stable and growing.

I think the book simplifies the process of identifying a great business a bit too much in that of the three steps this one is the hardest to do in my opinion. My opinion is based on the fact that the ability to forecast how the economy may or may not change and that effect on a particular business is the ultimate question. Using the past to demonstrate the soundness of a company today may demonstrate that it is great today and yesterday; but the application of the past to the future is a process that requires caution and more than a bit of humility to understand the limitations of one’s own ability to predict the future.

But as far as explaining the concept Mr. Town does a good job of communicating it to someone with no prior exposure.

To determine a fair price for a company Mr. Town also provides a simple way to perform a discounted cash flow analysis (which is a way to determine the future value of a business today looking into the future). Mr. Town does a good job of is trying to show the new investor that you do not need an advanced understand of math to figure out the present value for a company. The book also does a good job explaining the concept of margin of safety.

The final part of the book is perhaps the most original for a new investor. Mr. Town articulates the idea that several decades past Mr. Market was the collective conscious of millions of investors acting at once. In the last two decades Mr. Town points out that the actions of individual investors has been replaced by mutual funds.

In essence the book argues that mutual funds/institutional investors ARE the market (Mr. Town calls them the Big Boys) now because in many issues they collectively own 30-70% of a companies common stock. Mr. Town believes that the advantage little investors have over the big boys is that we can enter or exit a position much more easily then they can.

In essence in order to maintain an orderly market a mutual fund will have to take 3 weeks or so to accomplish its move. Therefore, when a Big Boy decides to act us little people need to get out of the way in Mr. Town’s opinion.

How do we do that? Well Mr. Town uses three technical indicators which he believes can signal when a stock is going to move up or down.

Prior to the book being published I posted on Mr. Town’s blog on how and why the indicators might work. This is not to say that they do work, just to show that they might be worthy of further study.

You can read it at

http://philtown.typepad.com/phil_towns_blog/2006/02/
getting_out_of_.html


Essentially the indicators are used to avoid losses and to book profits.


My Thoughts

As stated I thing that the book does a real good job of simplifying the Graham/Buffett style of value investing in identifying good or better companies that are selling at a discount. I also think Mr. Town does a good job of not boxing the new investor into having to use one data source or subscribe to one service. Mr. Town does a great job of explaining what he recommends but shows how to get the necessary information for free.

On the other hand I think that new investors should be very cautious when projecting what will be a good business in 10 years. This is the most tricky part to me and one that requires a lot of thought.

Also the use of the technical indicators is bound to be a controversial topic among value investors. In a bull stock it may be a great way to book profits on the highs and reenter on the dips, but in a bear market for that particular stock getting in and out may be tricky for the average person. It also goes against much of what Buffett has said, not that his is the final opinion, but it should not be ignored.

Also trading increases the friction costs of broker fees and if applicable taxes.

The use of indicators though is somewhat interesting because he is not advocating using the indicators as a means to determine whether you should buy a stock; but as a means to determine when the “insiders” are making a move up or down and to get in or out before they finish the move.

I see a lot of talk and posting about what Buffett or Fund Manager X is buying…(see gurufocus.com as an example)…essentially people want to know what the successful investors are doing or thinking… there is really nothing wrong with that because it is simply studying success. So when ever Buffett, et. al. discloses a new or exited position (usually in a quarterly report) everyone looks at it to see what’s going on…

And a lot of times they all follow each other because they don’t want to get left out in the cold (the I am safe in a crowd thought process, as long as I do as good as the other guy I am okay) or the company ios one that has been on value investors rader for a while (Dell Tyco for recent example)

What Mr. Town has done is offer a theory on how to anticipate what the money mangers are going to do in real time based on their limitations on size….

For instance lets you have determined that company X is a good company that you understand and feel can predict what its current value is with a margin of safety. Assuming that it is selling with a suitable MOS (fair price is 50 selling for 25) should you buy it now?

Well if the big boys come to the same conclusion and want to buy a million shares they will take 3 weeks to do it…and other big boys will see the move and do it to…and what MR. Town believes is that when this happens we can see it using certain technical indicators and get in front of it…

The same thing goes for negative movements …Company X might be announcing earnings in a month…we can read about the estimates. but that’s it…

Well the big boys eat, drink, and party (so to speak) with the people who do know (CEO, CFO, COO, etc) and they will get a “whisper” at the club or the golf course…and if a big boy is bailing on a stock (or buying) pre announcement we may see it, using Mr. Town’s selected indicators, because the big boy will have to start the move a few weeks out…

So the little guy like me might not get the whisper directly but if I pay attention I might see it anyway…

If you go back to my post on Mr. Town’s blog you will see what I mean

As you can read from Mr. Town’s blog doing this sounds simple but takes a lot of practice. So as a new investor the idea intrigues me but no system is perfect and I do not have the resource or skill to determine or backrest Mr. Town’s use of the indicators over a wide number of stocks. I would say to anybody to tread very lightly in the use of technical indicators.

So as a new investor I would recommend this book for the following reasons:

If you are not sure how to figure out what is a great business then this book provides a good simple way to think about it

If you are not sure of how to do a discounted cash flow analysis then this book provides a good introduction

And if you have ever wondered if you could use technical indicators to make money than this book talks about that and gives you some ideas

but this book like all books is a starting point for further research.

If you are having a hard time reading Benjamin Graham’s work or understanding what Buffett means than this book could serve to help you get into other works. But this book should not be the last book you read on investing (if there ever is such a book). And you should also read a lot of material form Graham and Buffett as well as others regarding the merits of technical trading even if it has a value basis.

Also just reading Mr. Town’s blog will be great as well or will serve to fill in some gaps he could not address in the book.

Overall this is a good book to get if you are just starting out or find Graham et. al. a little to in-depth at this point.



Take Care

Steven

8 comments:

Phil said...

Thanks for the review, Steven!

Hendrik Oude Nijhuis said...

An interesting idea is to connect Town's ideas with those of Joel Greenblatt! (auteur of: The little book that beats the market)

Success in investing,
Hendrik Oude Nijhuis
www.magicformulastocks.com

Steven said...

I will give it a look.

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