Phil Town’s Rule #1, Part #2

[This is the second installment of a review of Rule #1, by Phil Town. If you haven't already, you might want to read part 1 first.]

Rule#1 starts with a bang. From page 1:

This book is a simple guide to returns of 15 percent or more in the stock market, with almost no risk. In fact, Rule #1 investing is practically immune to the ups and downs of the stock market – and by the end of the book I’ll have proved it to you.

The First Amendment is a wondrous thing. You can say anything you want in a book (or a blog) and the worst thing that will happen to you is that people will think you are a jerk or an idiot. On the other hand, if Phil Town had started a mutual fund and put this paragraph at the start of his sales brochure, government regulators would have shut him down right away. (Although as a hedge fund he might have gotten away with it for a while. This is almost exactly what Bernie Madoff claimed to be delivering to his clients.)

As I wrote in part #1, there are lots of books that promise a formula for getting rich picking stocks. What makes Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! attractive as a victim of my scrutiny is that most of Town’s “simple strategy” is very specific. So specific, in fact, that I can program a computer to carry it out. I can go back in time and work out what stocks his system would have picked and track their performance. This is what is known in the investment biz as a backtest. It’s the first thing that would pop into the head of a pro being pitched on a system for picking stocks. It is pretty clear that Town’s mind is uncluttered by such concepts.

Town summarizes the core of his system, not all that gracefully, as four Ms: Meaning, Management, Moat, and Margin of Safety. Meaning and Management are squishy subjective things. And squishy subjective things annoy me. By Meaning, Town signifies both that you should understand the business of the company involved and that it should resonate with you in a vaguely moral way. And by Management he means that you should make sure that it has good management. I can’t teach my computer to simulate these two, so they get a free pass.

Moat turns out to be a set of ratios Town calls the Big Five. Four are growth rates: growth in sales, earnings, free cash flow, and book value. And the fifth, ROIC, is strongly associated with growth. (ROIC, according to Town, stands for Return On Investment Capital. Actual investment professionals believe it stands for Return On Invested Capital.)

Town says you should calculate each of the numbers three times, for one, five, and ten year time periods. Then, if a stock has a score of at least 10% on each of these fifteen numbers it is attractive enough to be further considered for purchase. I can only assume that his intent is that his reader should do this by hand, one stock at a time, which would eat up the weekly 15 minute time allotment pretty fast. But with access to the right tools, I can do 1000 stocks relatively easily.

Which is exactly what I did. I took the 1000 largest stocks in the US as of December 31, 2007 and found those that pass the Rule #1 Moat test. There are exactly 20 of them. Which means that only 1 in 50 stocks pass this screen, and there are more screens to come. Imagine what it would be like to use this system without automation, testing one stock at a time. And 12/31/07 is pretty typical. I tested the eight previous years and found, on average, 16 stocks that cleared the screen out of possible 1000.

Of course, the point is to find stocks that will go up, and on this score the screen is marginally better than throwing darts. The 20 stocks that cleared the hurdle at the end of 2007 lost an average of 34.67% in 2008. That’s actually not that bad, as the other 980 stocks gave up 37.53% on average. Including the other eight years of this decade the stocks that met the criteria to pass the Moat test returned an average of 4.29%, against 2.82% for the others. That ain’t terrible, but consider:

1) So few stocks clear the screen that one or two lucky picks can make the whole thing look good. In 2000 the screen only picked 5 names, but two of them, Paychex, up 83% for the year, and Concord EFS, up 71%, did very well. Kick out those two and the average return for the screened stocks for the whole nine years drops to 0.14%.

2) 4.29% is nothing like the 15% returns promised.

3) So few stocks clear this screen, and remember this is only part of the Simple Strategy, that a person has to wonder if this is really a practical methodology for an ordinary investor.

Next up, I will continue with Rule #1′s value screen, the Margin of Safety.

[Links to parts of this review: Part 1, Part 2, Part 3, Part 4, and Part 5]

No Comments

  • By chance, January 2, 2012 @ 3:15 pm

    one of your critiques is this would take a long time without automation? so would distributing your review here without computers and the internet. no one is doing this by hand. Also a screen with only a few stocks is a good thing. to have 100′s of choices only confusing the matter.

  • By Chris, February 23, 2012 @ 10:57 am

    Are you kidding me!? By just giving a “free pass” to 2 of the 4 Ms, you are skipping half the tests! You can’t do that just because they can’t be automated! Just the fact that you are doing that takes away any credibility you may have had and makes any of your results null and void. Maybe if you actually followed the system to backtest stocks, you would see that the system can work. Instead you are too hell bent on “proving” that this book is a scam.

  • By This cranky guy is goofy., May 31, 2012 @ 4:33 pm

    Here’s a funny thing to notice: this goofball who is blinded by his cynicism picked 2007 -2008 to test the returns. Guess what? The DJIA was 13,365 at the end of 2007 and at the end of 2008 was 8,579. He wanted it to fail so he picked the worst time to invest at all. All stocks dropped that year.

  • By Capt. Obvious, July 19, 2012 @ 2:34 am

    Hey Bad Money Advice…you really do give bad advice.

    What is Rule #1? That’s right, DON’T LOOSE MONEY! So, what do you think Rule #1 investors were doing from 2007 to 2008? Staying out of the market.

    Also, you didn’t read very well. Yes, he says 15 minutes a week, but that’s AFTER you’ve done your research and narrowed down your 4M companies. And you START with MEANINGFUL companies, not some automated system. Sure, you might come up with a company that could have had meaning to you, but in the purest since of Rule #1, you’ve already partially defeated the purpose.

    The real time it takes? I openly says it takes several hours of research PER company on your watch list.

    Stop giving bad advice…

  • By Captain Obvious, August 9, 2012 @ 12:06 am

    Funny, how you didnt mention the three indicators to tell if a rule #1 stock is going up or down..

  • By Rob, February 11, 2013 @ 11:17 pm

    Nice review. And I appreciate that you went back in time and evaluated the rule.
    Could you be able to share what automated tool did you use to find rule#1 companies?

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