Posted by Step 1: Find a wonderful business
Step 2: Calculate Intrinsic Value
Step 3: Buy at 50% Sale
Step 4: Repeat Until Very Rich
This is the method I learnt from one of the great Investors Phil Town. He has this wonderful free course on his website which I went through. You can check it out here at www.ruleoneinvesting.com
Step 1: Find a wonderful Business
3 M’s
- Meaning
- Moat
- Management
Meaning
The company should be understandable to you. You should understand how the company earns its revenue, how its assets help generate revenue, what are the expenses, what are the costs of earning the revenue. You should understand the factors affecting the revenues and expenses. You must be able to rattle off all the basic information about the company that you are investing in.
How to do it?
Scout for a business which you understand the meaning of (i.e. which is within your circle of competence) by looking at mutual fund portfolios, smallcase portfolios, smallcase screener etc.
Pick up any company you like and start reading its latest annual report to understand the business, the nitty-gritty of the business, the management, the history of the company, it’s market share, shareholding pattern, competition landscape etc. The aim here is to understand as much as possible about the company, its industry and how it does its business.
One more way to do it is what Warren Buffett calls Coat Tailing. Phil Town talks a lot about this strategy. He says all great investors in the world are coat Tailors. In this strategy, we copy the stocks the great investors like Warren Buffett is buying at around the same price and hold for as long as they hold. But we need to be cautious about it, understand the companies we are buying, apply all steps of rule 1 investing or else coat tail will soon become dog tail.
Moat
Big Four no.s (10Y, 5Y, 3Y, 1Y)
- EPS growth rate
- Sales growth rate
- Operating cash flow growth rate
- Equity growth rate
All should be more than 10%. Use screener.in to get the numbers. In case of equity growth rate, could also use the reserves growth rate and in case the earnings are erratic like in IndiGo could also use sales growth rate and then assume a decent net profit margin.
Look for Price to Book ratio, Price to Sales, Price to Earnings ratios.
Also, look for other perks like dividend each year and buybacks. Peter Lynch has said in his books to buy companies that regularly pay increasing dividends year by year or regularly buying back their shares, like TCS.
The company should be a leader in its industry and have a durable competitive advantage. It could have one or more of following five kinds of moat:
- Brand (Apple)
- Secret (Patent, trademark)
- Toll (Large market share)
- Price (lowest price advantage)
- Switching (Microsoft, Intel)
A company can also have more than one of the above moats.
In this step, we are trying to guess what growth rates to use in calculating the intrinsic value of the company in step 2. The more stable & predictable the company, the better.
Management
- Return on Equity
- Return on Invested Capital
- Debt (< 3 years earnings)
Both ROE and ROCE must be greater than 10% over long periods and debt should be manageable. Look for Debt to Equity Ratio, the Cash with the company at present, the current ratio, the quality of assets (the liability figure is real but the company can overvalue some of its assets or sometimes even undervalue its assets. This affects the stated book value of a company.)
Pay special attention to Debt in this step because Debt can kill a company whereas a company that doesn’t have debt can’t go bankrupt.
The management should be honest, able & competent. They should know how to manage the killer debt. They should know how to survive bad times. They should know how to survive and beat the competitors. Read the Chairman’s letter and Management Discussion and Analysis in the annual report. Look for the shareholding pattern and pledged shares in this step.
Step 2: Calculating the intrinsic value
Price is what you pay, value is what you get.
Warren Buffett
After researching the 3 M’s and understanding the business of the company, calculate the intrinsic value. You will need the following data for calculating the intrinsic value aka sticker price.
- Current EPS
- EPS growth rate
- 10 Yr FD interest rate
- A fair P/E ratio
This step is nothing but estimating how much cash can be taken out of business during its remaining life. And then discounting that amount to present value. For example, if we assume the EPS growth rate as 15% and FD interest rate at 7%, then we will increase EPS by 15% then discount it back by 7% over a period of 10 years.
Example: Maruti EPS = 253 (March 2019)
Assuming EPS growth rate 13% and FD interest rate 7%
253*(1.13^10)=859. Then, 859/(1.07^10)=437
Then, assuming a conservative P/E of 20, the intrinsic value should be 20*437=8730rs.
It was selling for around 6000rs. a week ago may be due to some short term problems that this sector is facing. I did the whole exercise above and found it is selling at a discount to its sticker price so I bought some. Let’s see if I can hold on till it reaches its intrinsic value again. There is a chance of making nearly 50% if I could do so.
You could also use Phil’s margin of safety calculator to calculate it easily.
Do Backtesting in this step to build confidence in this system of investing. Calculate the intrinsic value of any company in the past and see that if you bought it at a discount to sticker price you made money or not.
Add your wonderful companies to your watchlist and watch them every day.
Step 3: Buy at 50% Sale
Price is what you pay, value is what you get.
Warren Buffett
The meaning of the above quote is to buy 100Rs. note for 50Rs. When we do this we are getting value (100Rs.) and paying price (50Rs.). Let’s apply it on shares.
Suppose we calculate IndiGo’s Intrinsic Value as 2000Rs. and buy it 50% off at 1000Rs. it means we are getting 2000Rs. worth of something by paying only 1000Rs. When we do this we can’t lose money. And that is Rule no. 1: Don’t lose money.
Some investors also do the opposite. Suppose IndiGo is trading at 3000Rs. but its value is still 2000Rs. When anyone buys it at 3000Rs. they are paying price (3000Rs.) but getting value (2000Rs.). When anyone does this they lose money.
So we always have to buy it cheaper than its intrinsic value if we don’t want to lose money.
But in order to buy it cheaper than intrinsic value. We have to know the intrinsic value. We calculate it by the method in Step 2 above.
This step “Buying at 50% off” is probably the most important and hardest part of the whole investing game. This is the step that differentiates the Warren Buffetts from the average investors. This step accounts for about 90% of the whole rule one investing process.
That’s right. Step 1 and 2 account for only 10%. They are the intellectual processes. This step is a temperamental process. And Buffett says the most important quality for an investor is temperamental quality, not an intellectual quality. He says investors need to have a stable personality. This step also accounts for 90% of the investment success of any investor.
This is the hardest part of investing because it involves waiting and waiting is boring.
There are two things we wait for in this step.
- Waiting to buy
- Waiting to sell
Everything in the financial markets is about timing. The time (i.e. the price) you enter a contract and the time you get out.
Dr Santhi Heejebu, Treasure, Mankind The story of all of Us
Waiting to Buy
Great investors like Buffett only buy a company when it goes on sale. That cheap price is always accompanied by some short term hiccups either in the market, industry or the company. That hiccup is what is known as an Event.
We as rule 1 investors are waiting for that Event.
We are waiting for an Event that creates fear in fund managers who are getting really nervous about what is gonna happen the next quarter or even the next month. As the market starts to fall down, the people who run mutual funds get scared that they’re not getting out when their competitors are. They want to beat their competitors so they all rush to the exit.
For example, around October 2018, INR was at its lowest against USD and also oil prices were very high. These two events affect the expenses of IndiGo airlines and its Shares tanked during this time by as much as 60%. This event was also accompanied by airline struggling for its CEO and a couple of bad quarters because of rising expenses.
The price shot back to its original price in about 6 months. If one had purchased at it’s low and sold back at the intrinsic value they would’ve made 100% in just 6 months
If I had known this rule one process I would have bought a ton of shares of IndiGo. It was selling at unbelievably low prices. But very-unfortunately, I didn’t know about this process back then. However, I knew that it was selling very cheap. So I bought a small amount and quickly sold it long before it reached its intrinsic value. My Bad! Buffett has the following quotes when a wonderful company is selling way below its sticker price.
The trick is to be greedy when others are fearful and be fearful when others are greedy
Opportunities come infrequently when it rains gold put out the bucket, not the thimble.
Waiting to sell
Buy Right (Right company at Right Price) and Sit Tight.
Raamdeo Agrawal
After we have bought our wonderful companies at 50% of its Sticker Price, now it is time to sit on our asses and wait for the market to price it back to its intrinsic value. This is again very hard. It is not easy. The goal is to ignore all the noises from Media and focus on facts & figures from the quarterly statements. I repeat this is not easy. I am holding IndiGo (05-10-19) and day by day its price is increasing and it is very tempting to sell and book profits in fear of losing out.
As with Buying, we sell a stock when it is way overvalued then its intrinsic value. We sell when there is greed & euphoria in the stock.
Smart investors buy pessimism and sell optimism.
After selling we can buy back the same stock if it goes on sale again and repeat the process.
This step is very hard and it will take time to get better at it. This is the reason why Buffett says he feels lucky to get 1 or 2 stocks a year. Because he is waiting all the time. When Mohnish Pabrai was asked how many people does it take to manage a multi-billion dollar fund, his wife said 0.1!
Which is to say if we are doing this correctly we are not doing much most of the time. We are reading and expanding our circle of competence and knowing more about the industries and sectors we are competent in. Or we are just going about our lives.
Step 4: Repeat Until Filthy Rich
Just repeat the above process until filthy rich. You can sell one overvalued stock and buy another undervalued stock. You can increase the quantity as you gain confidence. Once you get the hang of valuing businesses you can not only find wonderful businesses but also businesses that are going to go bankrupt. You can learn about derivatives and profit from those bad companies by shorting their shares. Rakesh Jhunjhunwala does just this. He is a great investor as well as a great trader.
You can manage other people’s money. You can teach other people how to do this and create a business that way. There are lots of options.
So this was the “Rule 1 investing framework” in detail that I will use to invest my money. It is nothing but the grand old value investing that Ben Graham and Warren Buffett use. But previously I couldn’t understand it particularly calculating the intrinsic value part. Going through Phil’s free course made me understand the whole process and I am so grateful that I came across it.
I will be valuing business and buying shares based on this method. I will share the details of everything in the coming blog posts.
Thank you for reading the longest post of my website!