philtown.com

April 17, 2005

How do I use this FAQ?

Here is the FAQ  overview and explanation.

What is Rule #1 investing?

Rule #1 investing is simple. It’s worked for 80 years. (Not that I'm 100 years old. I've been investing with these ideas for 20 years and they worked well for me). These ideas will still be the foundation of successful investing 100 years from now.

You make a list of wonderful businesses ('wonderful' is very specific - a business with a durable competitive advantage).

You then determine value, value being different from price (by conservatively estimating future earnings).

You then wait to buy that business at 50% off its value, like buying a $100,000 sticker price Mercedes for $50,000.

To be able to get that discount you must be patient and wait for market fluctuations. As Buffett says, Mr. Market can be highly volatile in the short run. Sometimes we sit in cash for months or even years waiting patiently for the right price. If we buy wonderful companies at attractive prices we know we are going to make money, because we just bought a dollar for fifty cents.

Buffett has been talking about this for years and a lot of investors out there do it. As he says, it isn't hard to do; it just takes patience and knowledge of value. Anyone can learn.

How is Rule #1 investing different from other methods of investing?

Rule #1 investors act as business buyers - not stock speculators. We look at an entire company, from its Management to its Balance Sheet, to see if it's something we'd be proud to own.

Rule #1 investors "bet on the jockey" - excellent management - because we understand that the best and easiest way to become wealthy is to buy into a wonderful, durable business that will be around to support us for the next 100 years.

Wonderful companies have wonderful leadership and build equity over time.

Not-so-wonderful companies build empires, overpay their executives and cut and run without paying back their investors.

As Rule #1 investors we see ourselves as business owners and look to buy companies headed by CEOs who think the way we think. We look for CEOs who maintain honest business tactics and aim to grow and sustain the business over the long term.

How, specifically, does Rule #1 work? What is the process?

It's simple. My RULE #1 book is there to show you how.

First off, we Rule #1 investors make a list of wonderful companies that have Meaning to us-that is, we find companies that we understand and that have proven, durable competitive advantages (Moats). These Moats ensure their long-term survival and profitability.

We then conservatively estimate each company's future earnings and work backwards to arrive at a fair value.

Because the stock market can be highly volatile in the short run, sometimes it prices companies below their intrinsic value.

To get a 50 percent discount, Rule #1 investors wait patiently for these market fluctuations to bring us wonderful companies at attractive prices.

To use a metaphor, we get a $100,000 Mercedes for $50,000. The key to making money is to sell this Mercedes later at its value-$100,000.

If we wait to buy wonderful companies at attractive prices, we know we're going to make money, because eventually the same market that priced them too low will correct itself and price them at (or above) their actual value. (Nobody's crazy enough to leave a Mercedes worth $100,000 at $50,000 forever!)

This is when we sell and make money.

Buffett has been talking about this for years and a lot of investors out there do it. It isn't hard to do; it just takes patience and the knowledge of calculating value. Anyone can learn.

Why change the way I'm investing now? Why not just diversify and hold for the long term like everyone says?

It’s a bit of a wake up call to understand that in the last 100 years the stock market has given a zero rate of return excluding dividends to diversified 'low risk' investors 37 years in a row (1905-1942), then 18 years in a row (1965-1983) and now 5 years in a row (2000-2005). That's 60 out of 100.

Don't you think that should make us consider that it’s the market run-ups that are unusual, not the other way around?

And doesn't it follow from that that long term index or mutual fund investing right after a big run-up might be a recipe for a long term hole in your retirement?

Can you handle a zero rate of return for the next 20 years?

If not, shouldn’t you take control of your financial future instead of leaving it to the market? Especially if you can learn to invest so you know you won’t lose money?

How can you be certain you won’t lose money?

Answering that question takes me about an hour on stage so I won’t try to answer it completely here except to say that if you can buy a dollar of value for fifty cents then you are certain to make money. The key is to nail the value of the thing you want to buy. And if you can’t nail down the value, then don’t buy it. You wouldn’t buy a used car you didn’t know the value of, would you? Wouldn’t you at least look at the blue book?

There isn’t any "blue book" for stocks, so how do you know the value of a business?

Here’s the key: you have to know that it is a wonderful company before you can figure the value. You simply can’t figure the value of a company that isn’t wonderful, no matter how much you want to.

A wonderful company has some sort of durable competitive advantage (Moat) and its future is predictable.

Once you find a wonderful company (and there are lots of them) that you understand (there are less of those), there are tools that will do the math for us, but if you don’t own them, you get out an Excel spreadsheet and do the following formulas:

1. =FV(): put in 10 yrs, the growth rate and the current EPS. You get EPS in ten years.

2. Multiply the future EPS by 2 times the growth rate. You get the future stock price.

3. =PV(): put in 10 years, 15% and the future stock price. You get what I call the sticker price – the value.

Understand that this is all useless if you don’t understand the Moat or if the business future isn’t predictable. In that case, move on. There are 14,000 businesses to look at. You’ll find a few that you want to own, that you understand and that you can put a value on.

If you don’t find any, don’t buy any. Staying in cash does not violate Rule #1. Buying something you aren’t certain about does.

How much is enough to get started investing with? Is $1000 okay?

As a RULE #1 investor the right amount to start with is $0. You wouldn’t ride a bike down a steep hill your first day, would you? That could hurt. So can investing your own hard-earned money when you don’t know what you are doing. First you have to get started with training wheels. You do it as if you are using real money for awhile and see what happens when you are making all your own decisions. Then, once you’ve gotten it right 10 times, you can start with $1000 for real. With $1000 you buy one stock and remember Rule #1. With $10,000 you still buy one stock. Keep it focused. If you have $100,000 you own maybe 5 stocks. Meanwhile, read Automatic Millionaire by David Bach and The Millionaire Next Door by Bill Danko and anything by Suze Orman and find places in your life to save a little money. About a year from now you’ll be one of the best investors on the planet AND you’ll have money to invest.

How does investing money in the market actually work? Do I need a broker?

You need a broker but you don’t need to pay a lot per trade. Somewhere between $5 and $11 is the most you should pay.

Google “online brokerage”. You’ll get a list of websites. Scottrade was the first on the list when I did just now. Good company. $7 per trade. Ameritrade is good, too. $11.

Pick one, call the toll free number and a nice person will guide you through opening an account. It's just like opening a checking account. You put a $1000 in an account and you’re ready to go. You click on the trading button, put in the symbol of the company you want to own, the number of shares, click market order and review and then, if it looks right, click buy.

The broker will immediately buy the stock at the best price and take the money from your account. When you sell the stock, they reverse it and put the money back in your account. Simple just like RULE #1.

How much time does it take to invest your own money?

It takes Phil Town about 15 minutes a week or so. Some weeks several hours while I’m playing around doing searches. Some weeks when I don’t have any money in the market, I spend less than a minute a day.

What makes it so quick is having a fairly short list of businesses that I am interested in owning and having good tools that do most of the work. If one of the businesses on my list starts getting a lot of institutional money into it, it's time for me to take action. Otherwise there isn’t anything to do.

Jim Cramer differs with me on this. He thinks it takes about an hour per company per week and you need 5 companies minimum. That’s five hours a week. But then Jim is doing this to make money. I’m doing it so I don’t lose any and that takes a lot less time, I guess.

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