Investment Strategy: Rule #1 Investing
In a nutshell:
Rule #1 Investing is an investment strategy used to pick stocks. We analyse the ‘4 M’s’ – meaning, moat, management, margin of safety, in order to choose stocks to invest in for the long-term. This post will cover the basic approach, read Phil Town’s book Rule #1 Investing for more information.
- This strategy implements approaches that famous value investors have used over many decades – including Warren Buffett and Charlie Munger.
- We do this by using the ‘4 M’s’ approach:
- Meaning: Do you understand the business?
- Moat: Is there a sustainable competitive advantage?
- Management: Are management invested? Do they act with integrity?
- Margin of safety: Is the stock at a considerable discount? Never buy without a margin of safety!
- We personally follow this strategy and will publish more in-depth posts into each section in the future.
- Margin of Safety
- Final Word
Rule #1 Investing is an investment strategy to pick individual stocks. We personally use it to choose and select companies to invest in!
Now, before we begin, if you haven’t invested in the stock market before, or don’t know where to begin, we would suggest having a look at previous posts we have published – why you should invest, factors to consider before investing, and passive investing. This will help set you up for stock market success (hopefully!).
So, Rule #1 Investing is a book written by Phil Town, and is where we go through four steps – and these steps are called the ‘4 M’s’. We will talk about these in detail below, but the 4 M’s are:
The Four M’s
- Margin of safety
By looking at each ‘M’ we are able to build up an analysis of a company, and find out ultimately whether we should invest it in or not!
So, the idea is that we want to evaluate each M before investing in a company. Whilst Phil goes very in-depth in his book, this is the first time we have written about this strategy – so in this post we will be breaking them down simply, showing you the essential parts of each M to give you an understanding of how this strategy works.
Get the book!
We would highly suggest getting Phil’s book. We have it and have read through it multiple times! If you do decide you would like to read the book, you can get it here:
(Note: this is an affiliate link, if you do purchase using our link we will get a small commission, thank you in advance if you choose to use our link – its really appreciated!).
Now, onto the 4 M’s!
Simply put – you need to understand the company that you want to invest in.
Now, you don’t need to know the company like the back of your hand, but you do need to know the basics. Some questions you should know the answer to are:
- What product(s) do they sell?
- What industry do they operate in?
- How do they make their money?
For example – Facebook. They sell an online service in the form of online ads, operating in the technology industry, making their money by allowing me, you, and others, to advertise on their site. You want to understand the basic of the business!
Use your passions/interest to find stocks
Often, you will find that businesses you understand, and have a meaning to you, will come from things that you are passionate in.
Do you like eating out with your friends and family? Then you probably have been to many restaurants, some good and some bad. Why not do a bit of research into the good restaurants and see if it might make a good investment?
Do you like going to the gym and staying fit? Chances are you’re wearing gym kit, or going to a gym, from companies that are listed on the stock market. If you have been wearing the same brand of kit for years, find it comfortable and it never shrinks, why not have a look into the company and see if it would be a good investment?
Do you like cars? Or planes? Or anything? Do some research into where your passion lies. As a consumer you have first hand knowledge of what products are good and bad – and these may make a good investment!
In our opinion, Moat is probably the one of the most important things to look at before investing in any company.
Simply put – you want to find a business with a competitive advantage. This means that the business that has a certain future, and is better than its competitors.
Types of Moat
Phil Town talks about five types of Moat:
- Brand Moat (eg – Coca-cola, McDonald’s)
- Secret Moat (eg – businesses with patents)
- Toll Moat (eg – utility companies)
- Switching Moat (eg – Apple, Microsoft)
- Price Moat (eg – Walmart)
You want to ensure that the Moat is sustainable. We want to invest for the long-term, so want to make sure, as much as possible, a competitor can’t just come in the market and take customers or market share.
If a business if number one in its industry – such as Apple, Coca-Cola, Gillette, then it is likely they will have a Moat. You can probably think of loads of companies of the top of your head that have these types of Moats!
The Big Five
Now, we want to confirm that the company actually has a Moat. Another way to do this is to make sure that the company has a Moat in its numbers. In particularly, we want to look at:
- Return on Investment Capital
- Sales growth
- Earnings per share growth
- Equity growth
- Free cash flow growth
You need to look at these numbers over 1, 5 and 10 year periods, and ensure that each number is 10% or more! You can find these numbers on various sites, including: Morningstar, Yahoo! Finance, MSN Money, Wall Street Journal, and so on!
Write It Down
The simplest thing to do, and what we did when we first started using this method, is to simply write the numbers down on a bit of paper and work it out that way! Alternatively, you could set up a excel spreadsheet and use that to record all the numbers you need.
This might seem daunting, but trust us; once you’ve done this for a couple of companies it becomes second nature!
The most important thing is – never buy a business without looking at the Big Five!
A company may seem good on the surface, but these numbers provide stone-cold truth that they have been performing well over the last 1, 5 and 10 years.
The most important number is Return on Invested Capital, or ROIC. This gives you us an idea of how much we can expect to get back from the business as a return each year. It shows that the management is being effective in using our money to grow the business.
This is probably the trickiest of the 4 M’s, and probably the one most overlooked, but is still an important part of the process.
We want to see if management are trustworthy and act in our best interests if we were to be a shareholder. One way to find this out is to see if the management team are directly invested in the company.
For example – Facebook (again). Mark Zuckerberg’s wealth depends hugely on how Facebook’s share price is performing. Therefore he is likely to do what is best for the company, rather than acting in his best interest, or inflating numbers to hit a bonus – as so many directors have done over the years. Look at whether directors have any shares in the company, if they do this is a very good sign!
Another point when looking for great management is to see if the founder(s) are still at the company. In Facebook’s case, Zuck founded it and is still there. Another example is Apple – although still doing very well, when Steve Jobs died and Tim Cook took over a lot of people doubted him because they thought he didn’t have the vision that Steve Jobs did.
For management we can go into a lot more detail, such as looking at insider trading, reading letters to the shareholders, and so on. But, this is the basic idea. We want to ensure that the management team is acting in our best interests.
Margin of safety
Now, we never want to buy a stock without a margin of safety. Essentially, this means that any mistakes that we may have made in our estimation of the company’s value are accounted for.
Rule #1 Investing looks for a 50% margin of safety.
If a stock if currently trading at £100, and we calculate the fair value of the stock to be £120 – then surely we buy it because its undervalued?
No! We need a 50% margin of safety, so will only buy the stock when it falls to £60.
This is why it’s great to always be researching companies and building a watch list of companies you would like to invest in. Then, when the stock price falls on bad news or because of a recession, we can invest!
Now, in the book Phil Town goes into detail of how to calculate the value of a company. This idea is we try to predict the future EPS and future Price/Earnings ratio, and look for a minimum return of 50%.
This is a whole blog post it itself, so we won’t go into the maths here – but if you want to find out more information we will have a full post on this soon!
Rule #1 Investing – Final Word
This is the Rule #1 Investing strategy in a nutshell. We analyse four aspects of the company, all in-depth, calculate an intrinsic value and then decide whether we want to invest or not.
We personally use this strategy when analysing stocks, so will definitely have more posts on this soon.
But, in the meantime, if you want to find out more about this strategy then consider buying the book. You can find it here!