Rule #1

[Arif]

Disclamer: Not trolling and not advertising.

Has anyone read the book Rule #1? It goes into quite a bit of detail on investing in individual stocks that outperform the market and uses Warren Buffet as a model. Based on what I read so far here is what to look for:

1. Buy the business not the stock
2. Identify a moat around the business (sustainable advantage)- He breaks this down even further with the different types of moats.
3. Bet on the management of the company
4. Demand a margin of safety
5. Calculating the right price to pay for the business
6. Invest in a business that you have an interest in

There are a few more topics but to me these are the major ones. This is the first book that I've read on individual stocks that didn't go over board on things like discounted cashflows that make my eyes glaze over. Nothing earth shattering revelations but it is clear, concise and his explanations make sense.
I am going to try it with a hypothetical portfolio and see how it does.

Has anyone read this book and implemented it?

 

[wabmester]

How do you determine the right price to pay without discounted cash flows and stuff like that?

Buffett has a couple of advantages over us mere mortals.    His cash and reputation give him lots of financial leverage that we don't have.   And he usually buys private businesses, so he doesn't have to deal with market efficencies that bring prices up to "market value."

Also, when you buy a private business, you can do pretty extensive due diligence.   And you get to meet the management face-to-face.   Public stocks are comparitively opaque, and you only hear from the showmen CEOs.

 

[brewer12345]

I haven't read the book.

However, the only problem with an approach like the one outlined is that everyone wants to own that kind of business, so the prices are usually bid up to the stratosphere.  You have to have a thick skin to buy that kind of business when it will be attractively priced because that is when everyone will hate it and loudly proclaim their reasons for hating it.  I think that being able to ignore the herd and think/act on your own reasoning is not something that can be taught by a book.

 

[Arif]

How do you determine the right price to pay without discounted cash flows and stuff like that?

I might have mispoke about the discounted cashflow as I haven't gotten to the part of the book that addresses valuing a business.

Buffett has a couple of advantages over us mere mortals. His cash and reputation give him lots of financial leverage that we don't have. And he usually buys private businesses, so he doesn't have to deal with market efficencies that bring prices up to "market value."

How did he get those spectacular returns back when he was running his partnership in the 60s and 70s? As he has said before, it is far more difficlut to make great returns when you have so much money to invest. It gets harder to move the needle compared to investing a smaller pot of money.

However, the only problem with an approach like the one outlined is that everyone wants to own that kind of business, so the prices are usually bid up to the stratosphere. You have to have a thick skin to buy that kind of business when it will be attractively priced because that is when everyone will hate it and loudly proclaim their reasons for hating it. I think that being able to ignore the herd and think/act on your own reasoning is not something that can be taught by a book.

So do you believe the market is efficient and never overeacts to news about a company? While I am no expert or even a novice concerning individual stocks it does seem that sometimes the market punishes companies to a point that when they do beat estimates then the stock price rises and they fall back in the markets good grace. I am sure it takes a stomach of steel to ride that roller coaster but it can be done.

 

[haha]

Also, when you buy a private business, you can do pretty extensive due diligence.   

While this may be true of Buffet, IMO it is usually not true for a prospective small business investor. I think it is often pretty much the opposite. Absent fraud, which seems to be getting more common in public companies I will admit, the quality of mandated disclosure in the US for public companies is very high. So if you are disposed to do so, you can do a lot of DD without ever leaving your study.

Also, especially in the case of retailers it is easy to do as extensive field research as you might want to do. Of course, it makes no sense in the context of the typical investor’s over-diversified portfolio, but it can easily be done. One of my biggest hits ever was Ross Stores. In the 80s my wife liked to shop there. I started going with her. I looked at the filings, I talked to management, and I decided that with any luck at all they were going to make a lot of money. They did, and I did.

On the other hand, fraud is almost expected in selling small businesses. That is why sophisticated buyers mostly ignore what the owner's statements say, and try to do extensive sleuthing on their own.

I do agree with you that public financial companies are pretty much a black box. Still, you can make a rule to buy only those that are being bought by insiders. With a private business that you want to buy, by definition the insiders want out. All of them- else why wouldn't the controller or some other member of management buy it?

Ha

 

[brewer12345]

So do you believe the market is efficient and never overeacts to news about a company? While I am no expert or even a novice concerning individual stocks it does seem that sometimes the market punishes companies to a point that when they do beat estimates then the stock price rises and they fall back in the markets good grace. I am sure it takes a stomach of steel to ride that roller coaster but it can be done.

Of course the market over-reacts, and it tends to do so more with small cap companes than with large ones.  That's how I make the bulk of my returns.  The hard part is doing your research and then taking action even though everyone is screamming about how awful the company is, how it will never recover, the stock is a dog, etc.  Often these kinds of companies also attract a sizable short interest, and I have seen coordinated negative PR campaigns orchestrated by short sellers.  Take a look at the shenanigans that surrounded PLMD a few years ago, for example (and maybe google Manuel Asensio and Rocker Partners).

It can be done, but you need to be psychologically prepared and VERY sure of your analysis.

 

[unclemick]

Budweiser, Walmart, G.E. and Tyco - the rest of the world understands Rule #1 and sees exactly what Buffett sees when making huge bets recently.

Right

heh heh heh heh heh heh

 

[brewer12345]

I do agree with you that public financial companies are pretty much a black box.

The big ones are, but the small and midsize ones are usually transparent enough to get the analysis right if you understand how the business and their financial statements work.

 

[wabmester]

Often these kinds of companies also attract a sizable short interest, and I have seen coordinated negative PR campaigns orchestrated by short sellers.

I think short sellers are the best thing to happen to the markets, and I wish there were more of them.    Imagine a stock market in which every crime, every absurd compensation scheme, and every sordid management background was fully disclosed and publicized by the shorts!

 

[brewer12345]

I think short sellers are the best thing to happen to the markets, and I wish there were more of them.    Imagine a stock market in which every crime, every absurd compensation scheme, and every sordid management background was fully disclosed and publicized by the shorts!

I have n problem with legit short sellers (heck, that describes me). But when I see large naked short positions, outright falsehoods repeated endlessely online and even in print, stories planted by abusive shorts, illegal shorting ahead of an equity offering, and all the other sleazy crap that these guys do while the SEC looks the other way, I can't help but take a dim view on a lot of the shorting that goes on.

 

[Arif]

See this is why I stick with real estate

 

[brewer12345]

See this is why I stick with real estate 

If you are an active investor, it makes sense to stick with what you understand and have an edge on. You clearly are a proficient RE investor. I could probably learn, but as of now I haven't a clue.