Strategy Review: Phil Town’s Rule #1

September 19, 2007 by Joe Ponzio

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.

A Note From Joe Ponzio

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