Phil Town's Rule #1 is a hot selling item. Its promise of 15 minutes a week of work, guaranteed profits, and no risk is a lofty goal. Like virtually all popular investing books, Rule #1 has inspired groups of followers on one side—people actually making money with the system—and clusters of haters on the other side.

Before I get into strategy, let me preface by saying: I like Phil Town. I don't know him personally; still, I like how active and passionate he is about helping people. He truly believes (as do I, as does Buffett) that a focused portfolio of wonderful companies, purchased at a discount, is the key to low-risk, high-return happiness. He also sees and exposes many of the problems and risks inherent in mutual funds.

An Easy Read

Rule #1 is an easy read. Conversational. Fun. Inspiring. The first time I read it, I breezed through it in an evening and was quite pleased. If you are completely new to the stock market, the concepts and terminology in this book are a great primer.

The Valuation

Town uses a method of valuing stocks by trying to predict the future price based on past growth rates and future price-to-earnings (P/E) projections. Not to dumb down his system too much (he has some great info about finding companies worth analyzing), but his method basically comes down to this: use the past earnings growth rate to project future earnings, put a P/E ratio on the earnings, and you'll know the future stock price.

Great way to analyze stocks? Probably. Great way to value a business? That's a different story. Before I go on, let me throw a Buffett quote in here:

When Berkshire buys common stock, we approach the transaction as if we were buying into a private business.

There's No P/E In Private Businesses

Let's say that Google is a private company and that you wanted to buy it. As a public company, Google's P/E is about 44. No private business sells for 44 times earnings—it's insane. In fact, many private transactions take place at two to five times earnings.

Sanjay asked the question to Phil Town over at Phil's blog. The result: A link to a blog post that doesn't answer the question at all. Why? I have to speculate that Mr. Town knows that he has a good method for picking stocks, but is not presenting Buffett's method of valuing and owning businesses.

The Three Tools: Not In Private Businesses

Town also introduces readers to the three tools—technical indicators that should tell you when to buy and sell your businesses. It is Town's contention that charting stocks will allow you to see when the big institutions are buying and selling so you don't get blindsided when a stock tanks.

If you own truly wonderful businesses, you shouldn't be jumping into and out of your positions. Let's take a look at some Buffett quotes:

Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.

Nobody likes to see their account value drop; still, if you constantly try to get out when its dropping, and then try to buy after your stock has begun rising again, you'll miss out on a lot of gains and will ultimately pay more in commissions (eating up your return a bit). Price follows value in the long run—who cares what it does on a daily basis?

As far as you are concerned, the stock market does not exist. Ignore it.

On a daily basis, there is no stock market. Let it serve you by offering to you a handful of wonderful companies at a discount. Then, walk away.

Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.

Lethargy, bordering on sloth should remain the cornerstone of an investment style.

Forget the tools. Make the right decision, regardless of tomorrow's outcome. In the long-run, wonderful companies bought at a discount will grow, and their stock price will follow.

An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.

If you owned a private company, you wouldn't (and couldn't) constantly buy and sell every time someone called you and offered super-high and super-low prices. When a stock price jumps up and down, that is exactly what is happening—someone is calling and offering you a bunch of crazy prices. In the end, so long as your business is growing at a satisfactory rate, you'd be wise not to panic and jump in and out.

The Result

I think Town presents a rational and nice approach to trading stocks, and he uses some Buffett concepts and teachings to sell that method, but Rule #1 falls short on valuing companies in a Buffett-esque manner.

Can you profit from Rule #1? Probably moreso than from other trading books. Still no matter how he sells it, let's call Rule #1 what it is: an active traders guide to educated gambling in the markets.

Does it need to be on your shelf? Only if you like the excitement of the stock market and want to trade. If you are looking for a long-term, buy-and-hold Buffett strategy, Rule #1 probably isn't for you.

Previous: Just Because You Know The Value... (Sep 18, 2007)
Next: When Should I Sell My Stock? (Sep 20, 2007)

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Comment on this [ 5 ]	By: Joe Ponzio

comments

What is the difference between your find-average-past-growth-project-it-and-do-a-dcf-calc, and a P/E approach? They are, in fact, two versions of the same basic assumptions.

by Israel on September 19, 2007 at 10:35 AM

Not exactly. P/E is used for trading stocks; Net Income and earnings are for the IRS; DCF is used for valuing businesses. Town has a good method for picking and trading stocks; still, if you tried to apply that method to buying private businesses, you'd quickly find that you couldn't.

It is important to remember that stocks are pieces of businesses. Though you can learn to profit by actively trading stocks (or anything for that matter), there is another way: value and own a business.

If you focus on what truly matters to business owners (and buyers), you'll quickly learn that net income, earnings, and P/E ratios mean nothing—they don't help your company grow and your success is not determined by them. In fact, as a business owner, you'd want to keep net income/earnings (and hence P/E) as low as possible so you don't pay high taxes—all while generating as much cash as possible.

In the end, we would be wise to take our advice directly from Buffett rather than from someone who translates Buffett into a system (myself included—we'd all be wise to read the Berkshire reports for ourselves). Consider Buffett's lessons in the context of Town's methodology:

For some reason, people take their cues from price action rather than from values. What doesn't work is when you start doing things that you don't understand or because they worked last week for somebody else. The dumbest reason in the world to buy a stock is because it's going up.

We believe that according the name "investors" to [those] that trade actively is like calling someone who repeatedly engages in one-night stands a "romantic".

Again—I'm not knocking Town or his methods, I'm simply reviewing his strategies in the context of valuing and owning businesses.

by Joe Ponzio on September 19, 2007 at 11:27 AM

For me this book is a Buffett / Graham style stock selection guide but Town also teaches the reader how to jump in and out of the market when the institutions are selling out, which cannot be a bad thing because this can sometimes occur randomly with little warning or obvious reason.

However on the basis Town only advises on buying into to fantastic business's with 10 years of + 10% growth rates if an individual was to ignore the tools, markets and charts but followed Towns stock selection guidance he would still hold a set of great predictable business's and considering price follows value wouldnt be too far from traditional value investing principles.

Town knows we cannot all be as good as Buffett when choosing business's so he has designed a safeguard for investors to jump out if things start to go wrong and if the entry level was 50% of the sticker price which he says is a must, we can escape without losing money.

by Oz on October 12, 2007 at 8:20 AM

Oz,

I think Town has a wonderful stock trading method for active investors. There are a zillion ways to make money in the stock market, and Town shows you one side of that.

I do disagree with his "sticker price" as a valuation method. His sticker price attempts to put a price on the stock and then discount it back to today - using nothing more than market mutliples. Basically, this business will be worth "X" because today everyone is paying "Y" and that is likely to continue. Constantly increasing the P/E ratio is a dangerous game - especially when it is a large part of your valuation method.

If you believe you can't be "as good as Buffett", so be it. I see no reason why people can't be "almost as good" - a strategy that will likely result in great long-term results. Hey, I'm not "as good as Buffett", but I'm still doing it.

And I believe you can too.

by Joe Ponzio on October 12, 2007 at 1:33 PM

I have not read this book, but I have heard of this method. I use it too, but only as a quick way of seeing if a company might be underpriced.

I just use this formula:

EPS (ttm) x 1,(expected growth rate after margin of safety)^5 x average P/E

Then I discount that price with 1,09^5 to get the intrinsic value estimate.

If the price is far below that estimate, then I will look into the company some more and do some 'real' analysing and valuation.

by Nick K. on February 19, 2008 at 3:23 AM

Strategy Review: Phil Town's Rule #1