What is the number one rule in investing

How to Find Wonderful Companies (Part 2): Rule # 1, Rule Number 1

In the second part, How to Find Wonderful Companies, I want to go into "Rule # 1" of Phil Town. The rule is simple: "Never lose money" - never lose money.

The book is based on Warren Buffets two rules for investing:

  1. Never lose money
  2. Don't forget Rule No. 1

Phil Town’s strategy is therefore this Value investing. He searches using the Fundamental analysis for companies he believes are undervalued. To do this, he uses a relatively simple method and buys the shares of the companies with a "Safety cushion". Even in an unfavorable scenario, a loss of money is very unlikely.

The first part was about 4 points to consider when looking for wonderful companies. Here I've already briefly touched upon what Phil Town looks for when choosing stocks. This time I would like to go into more detail about the methods that he describes in his book “Rule Number 1”. Caution: The article has become a little longer 😉

Rule number 1: The four Ms

To find wonderful stocks, Phil Town looks for companies that meet the "four Ms":

  1. Meaning (meaning for you)
  2. Moat (moat)
  3. management
  4. Margin of Safety (MOS) (safety cushion)

Meaning

The first question that should be asked: “What does the company mean for me?”. This is followed by the questions "Do I want to own the whole company?" And “Do I understand the company enough that I could own it in its entirety?”. And if you want to own the whole company, so to speak, then you should proud of his possessions be.

However, it is not necessary to analyze the company down to the smallest detail.

For example, do you like to exercise and do you prefer to wear Adidas clothing? How do you feel when you think about that you could own the whole company? Do you think that's great? Great, you mastered the first step. And consider: If you don't want to have the company for 10 years, then you shouldn't even own it for 10 minutes.

Moat (moat)

The Moat is emblematic Moatthat surrounds a company and protects it from attackers / competitors. Phil Town is different five moats. The more a company owns, the better.

1. A strong brand

A company whose products you trust - and are therefore willing to pay more. Phil Town names Coca-Cola, Disney and Nike, for example.

2. Business secret

Patents or trade secrets that make it difficult for competition. These are, for example, Intel, 3M or Pfizer.

3rd fairy

The company has a certain monopoly and can therefore collect a "fee". For example utilities or media companies.

4. Switching

The company is so firmly integrated in people's everyday lives or in other companies that switching would be very time-consuming or not worthwhile. Examples of this are Microsoft and Paychex.

5th prize

The company can offer its products cheaply without competition. Phil Town calls this Wal-Mart or Costco.

management

I have already described most of the points that make a good manager in the first section of the previous article.

Phil Town elaborates this a little further in his book and advises shareholders or potential investors that Management statements to compare with the bare numbers. Problems are often kept secret. Faults should be named much sooner and the manager should explain how he would like to fix them.

It should also be ensured that Wrong decisions also meet the CEO (monetary). In the book you will find some exciting examples of how the manager goes home with a big check, even with big mistakes.

For example at the Albertsons supermarket chain. Although sales and earnings per share are stagnating, the CEO only mentions the “solid business performance” and “increased customer friendliness” in his letter to shareholders. While the shareholders sit on a 40 percent price loss, the manager received $ 76 million in salary.

Or Bristol-Myers Squibb. From 2001 to 2004 the value fell by more than 50 percent. Among other things, because a contract was signed for a drug worth 2 billion dollars - but the FDA banned the approval a little later. Including bonus payments for this "successful" deal, the CEO received around $ 41 million. Here, too, the "solid financial performance" was praised in the letters to the shareholders.

Margin of Safety (MOS)

A. wonderful company one would also like to one wonderful price to buy. There is no financial benefit, for example, if you buy a Ferrari for 200,000 euros, but the recommended retail price is only 100,000 euros. It would be really worth it if the car were suddenly offered for only 50,000 euros, even though it is still actually worth 100,000 euros.

What is quite unrealistic for the car example is not for stocks. Investors sometimes panic and throw their stocks at the market - whatever the price. Then you can sort of share these stocks Bargain price get hold of. Phil Town only buys stocks when they're 30-50 percent below their suggested retail price. To do this, however, you have to know how to calculate the recommended price for a stock.

Strong companies have strong balance sheets - "The Big Five"

As already indicated above, the statements of the management about a "solid business development" and the advantages of a moat should also be reflected in the figures. To this end, Phil Town considers five values:

  • Return on investment (ROIC, ROC - Return on Investment Capital)
  • Sales growth
  • Earnings growth per share
  • Growth in equity / book value per share
  • Free cash flow growth (FCF - Free Cash Flow)

All values ​​should have been at least over the past ten years ten percent per year have increased. In addition, the most important value for him is the ROIC. No matter how good the other values ​​are: If the ROIC is below 10 percent, the stock falls out of the grid. In an Excel spreadsheet it could look something like this.

The data does not go back ten years, but 7 years. Over the past 5 years that has been ROIC for example 11.35 percent and last year 12.34 percent. The average Equity growth averaged 24.5 percent over the past 7 years, compared to 17.6 percent last year. Below (21e) is the analysts' expectation of the average development up to 2021. I also have my table in that Cash / Debt Growth as well as the Increase in dividends extended (not included in the picture).

Calculate future share price

To calculate the future share price, Phil Town uses 4 or 5 values:

  • the current earnings per share (EPS)
  • estimated EPS growth (according to analysts) ...
  • ... or historical growth in equity
  • estimated future P / E ratio (price-earnings ratio)
  • minimum acceptable rate of return (15 percent per year)

If you know both the earnings per share and the P / E ratio in ten years, you can future course calculated become. If a company has an EPS of 10 dollars in ten years and has a future P / E of 20, a share is worth 200 dollars.

To determine the P / E ratio, Phil Town either takes that double estimated EPS growth (Analysts) or that Twice the historical growth in equity (Book value). Whichever is lower. Is that estimated EPS growth for example 24 percentwould result in a P / E of 48. The grows Book value per share around 20 percentthat would be P / E at 40. Since 40 is lower than 48, this P / E would be set. However, if the historical P / E is only 30, then this P / E would be used for the calculation.

Once we have found out the future P / E ratio and know the (probable) EPS growth and the current earnings per share, we can calculate the earnings per share in the future.

For example, if the current EPS is 0.89 cents and the EPS will probably grow by 24 percent, after one year we will be at an EPS of 1.10 euros. These 1.10 euros increase again by 24 percent, after which we are at 1.37 dollars after two years. After ten years, these results in earnings per share of EUR 7.65. If our set P / E ratio is 46, this results in (7.65 * 46) a calculated share price of around 352 euros.

Rule # 1: Calculate the recommendation price

To calculate the recommendation price, Phil Town brings the rule of 72 into play. According to this, the money doubles with a 15 percent return (the minimum acceptable return) every five years (72/15 = 5). In ten years the money doubles twice.

The next calculation step is therefore simple and always the same:

To the Recommendation price you simply divide the calculated share price in 10 years by 4. At a calculated price of 350 euros / 4 you get a recommended price of 87.5 euros. You can then check this result with a "CAGR calculator".

The 87.5 euros are now divided by two. Then you get that Security price or the "Margin of Safety". Only now do you have to look at the price at which the stock is currently trading. If the price is around 44 euros, the market seems to be irrational at the moment. Then the time has come to take advantage of the special offer.

Including the safety cushion, the annual return in the example would increase to 23 percent. According to Phil Town, it is also possible to buy a company with a MOS of 30 percent if you have already owned the company, fully understand the business model and are very comfortable with the investment.

Conclusion

With his "Rule Number 1" *, Phil Town teaches investors a relatively simple method for examining the business development of companies. And with the help of an Excel spreadsheet and the data that are even provided to us free of charge from Yahoo Finance, MSN or Marketscreener.com, the share price can be projected into the future.

A disadvantage, however, is that some high-growth stocks such as The Trade Desk (TTD), Zscaler (ZS) or, for a long time, Amazon have / had no profit at all and therefore do not have a meaningful P / E ratio. These would fall through the rule 1 grid and thus in some cases high opportunities would be lost. Phil Town personally collects such values ​​in his “Risky Biz” portfolio. However, these only play a subordinate, speculative role.

In my analyzes and investment ideas, I will also refer to Phil Town's methods from time to time. I may also attach one of my Excel spreadsheets so that you can understand my calculations. Or use it as a template for your own analyzes.

I am happy that you made it through to the end and I hope that I was able to provide you with another little added value.

annotation: The products marked with a "*" contain affiliate links. You will not incur any additional costs or loss of quality when using or purchasing these products or services. I only get a small commission through which you can support my project financially. Many thanks. 🙂