Rule #1 – Book Review

I’d come across a few references to Phil Town’s “Rule #1” and finally decided to pull it out of the library and give it a read. The rule #1 referred to in the title is Warren Buffett’s idea that the most important rule of investing is “never lose money”. Mr. Town promises a “simple strategy for successful investing in only 15 minutes a week!”

“Successful investing”, according to the author, is a return of 15 percent or more “with almost no risk”. He claims by the end of the book he’ll have proved it. Its presented starting with the idea that the author is a simple river guide who saved the life of a rich guy, who rewarded him by teaching him how to invest (and now, lucky for us, he’s decided to make money by selling us information how to invest via books and $90 get motivated seminars rather than just make cash in the market himself). Unfortunately, I remain unconvinced.

The first 32 pages basically explains repeatedly that a 15% return is really good. I get annoyed at books that start by saying “I’m going to tell you something great here, but first let me start by saying HOW great its going to be!!!” I *KNOW* that a reliable, 15% returns is good. When I was a kid, interest rates were sky-high and I got some bonds and GICs yielding over 10%. I don’t need 32 pages telling me its good. I knew as a kid this was a good thing (some people reminisce about snowball fights or fishing trips of their youth – for me its interest rates).

Warren Buffett quotes can be a bit like proverbs or fortune cookies messages, very open to interpretation. Perhaps Warren Buffet meant one shouldn’t invest in anything that might go down in value (and we should only purchase investments with FDIC insurance)? I know he doesn’t mean that, but it’d be pretty easy to take that position if “don’t lose money” is the sum of our instructions.

While the author definitely tries his best to tie his strategy in with Warren Buffett, from the title to his Ben Graham-esque approach, he undermines it later in his book when he suggests incorporating elements of technical analysis (MACD, Stochastic and Moving average) when deciding when to buy and sell.

Warren Buffett has this to say about technical analysis: “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer” and “If past history was all there was to the game, the richest people would be librarians.” A pretty damning judgement from the guy Phil Town respect enough to use as the basis of his system. Another Buffett quote which could be used to denounce this book is “The best way to own common stocks is through an index fund”.

I understand that its the nature of anyone with a stock buying system to discount the Efficient Market Hypothesis, but Mr. Town gets snarky towards Professor Malkiel, taking some of Malkiel’s comments out of context and unfairly condemning the man and his ideas.

The system itself SOUNDS good, but I think any trading system probably has a good story behind it. The basic idea is that you find a business you like, with a moat (a reason why it should be able to keep beatings its competitors, such as Disney’s brand, or Microsoft’s massive install base). He identifies 5 big numbers (ROIC, Sales, EPS, Equity, & Cash) and demands they be consistently above 10% over the last 10 years (and trending upwards). He suggests looking into the CEO, and finding someone who is honest with the shareholders and looking out for the company’s best interest. Using some magic he determines a “sticker pricer” for the stock (what it *SHOULD* be worth), then insists on a “margin of safety” where you buy it for half this price or less.

He presents equally convincing rationale for his recommended technical analysis tools.

Its an entertaining read for what it is (I suspect Phil would be a fun guy to have a beer with), but I couldn’t help but feeling at a few points that “this could be dangerous stuff if he’s wrong and people buy it”. Ultimately I don’t believe its possible to earn 15% in a low risk manner (we’d all be doing it if it was). He makes the argument that its possible for us small guys but not for the institutions, because they’ve got too much money, which I accept for what it is. But somehow Buffett does it with lots of money. And lots of small guys lose their shirts.

I was wondering if there are any bloggers who have been following his system and posting returns. He uses what I think is a bit of a cop-out by demanding that people invest in companies they personally care about (the meaning part of his system), and therefore he doesn’t release many details about his own trades (since what is meaningful for him is different than what’s meaningful for you). I did find one trade where he bought Whole Foods in 2005 (he mentions it in his book), and while they did great in the year after he bought it (doubling), its since kept sinking (he bought at $45, adjusted for the stock-split at the end of 2005, and its currently worth $20). One of Buffett’s quotes he uses is “If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.”

I realize its not fair to pick a single trade and judge a whole system by it (although honestly this was the first trade with concrete details where information was provided at the time of purchase, instead of cherry picked later, I came across that was made using his system). Mr. Town would probably defend his pick either saying “10 years isn’t up yet” or “I used my technical analysis tricks to sell it at the peak”. Fair enough, but I’d love to see someone who provided an ongoing, real-time history of their trades using this system and see how close they get to 15% a year.

I also realize that, as much as I like his approach, Derek Foster is also selling a stock picking system (and many of the criticisms in this post could be leveled against his books).

If there’s any uncertainty, I don’t recommend this book. If you’re dead-set on implementing a stock picking strategy, you could probably do a lot worse than this, so maybe this would be the least of many evils. I’d recommend following Mr. Buffett’s advice and just buy an index fund.