Phil Town’s Rule #1, Part #3

[This is part 3 of a multi-part review of Phil Town's book Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week! If you haven't already, you might want to read Part 1 and/or Part 2 first.]

Last time I walked through the third of Town’s Four Ms. Today it’s the turn of the fourth, Margin of Safety. As a concept and phrase, margin of safety has a long and august history. Benjamin Graham, Warren Buffet’s mentor and the founding father of modern value investing, coined it in the 1930s. The idea is that if you buy a stock at enough of a discount it is hard for things to go wrong. To be specific, if you buy it for less than liquidation value, the value of the company’s tangible assets less its debts, then the worst case scenario is that the company will go out of business, auction off what it owns, and make you whole. That is quite a safety net.

Graham was writing and investing in the Great Depression and its aftermath. Even by today’s measures, the bargains available in the stock market in the 1930s and 1940s were inexplicable. Stocks that sold for less than book value were common. So when Graham talked about margin of safety he was making a pretty convincing “what’s the worst that could happen?” argument. Buy something for half of what it is really worth, and even assuming things go badly, you have a big cushion to fall back on.

Things have changed a lot since the concept of margin of safety was born. Looking for stocks you can buy for less than liquidation value is not a viable strategy. When Town talks about a margin of safety he is not suggesting that there is a liquidation value safety net, he is just making the argument that if a stock is cheap enough the cards are stacked in your favor. That is not a terrible way to invest, but it is not about safety. What he is saying is that you should buy cheap stocks because they tend to go up. Which is true. The trick is deciding which stocks are the really cheap ones.

There are lots of ways to do this, ranging from the exquisitely complex to the brutally simple. Entire books have been written on the topic. Town’s methodology is definitely on the simple side, although still more bother than it is worth.

The most annoying part of his valuation method is that he calls the value that gets calculated for the stock not the “true value” or “fair value” but “sticker price.” What could be more jarringly inappropriate? A sticker price is what a car manufacturer puts on the sheet of paper glued to the window of a new car in the forlorn hope that somebody, somewhere, will pay that much for it. Why not just call it the “unrealistic goal price?”

In a nutshell, Town instructs the reader to value a stock as follows. 1) Project earnings per share ten years from now. 2) Project a price/earnings ratio for ten years from now. 3) Use the future earnings and future price/earnings ratio to back out a price for the stock in ten years. 4) Discount that back into today’s dollars.

I will not repeat Town’s specific instructions for coming up with earnings projections, future P/E ratios, and the like. Suffice it to say that all are somewhat questionable, often obscure, and easily expressed as computer code I can use to test it.

Backtesting this value portion of Rule #1 is actually easier than the growth part. With fewer numbers as inputs, it runs faster and lets more stocks pass. But passing stocks are still pretty rare. Only 45 of the 1000 met the cutoff on December 31, 2007. That’s more than passed the growth test, but it’s still fewer than 1 in 20. (Again, running this without computer automation would be at best torturous.) And how did the passing stocks do? Not so great. The 45 lost an average of 47.19% during 2008, against an average loss of merely 37.01% for the other 955.

For the nine years 2000-2008, Town’s Margin of Safety screen selected an average of 51 stocks at the start of each year and on average they lost 0.27% over the next 12 months. The stocks that did not make the cut rose an average of 3.00%. That’s really pretty dismal. Any worse and I might suggest that shorting these names was a reasonable strategy.

Of course, Margin of Safety is not meant as a stand-alone. Town would have you invest in stocks that pass both the growth (Moat) and value (Margin of Safety) screens. So how many stocks passed both screens as of 12/31/07? Just one: Cognizant Technology. It lost 46.78% last year.

Overall, of the nine years of the sample, four (2000, 2002, 2004, and 2007) had no stocks at all that passed the two screens. The other five years had a grand total of 11 names that qualified. As it happens, some of those picks did pretty well. Others did poorly, but the average annual return was 14.77%, a little more than 10% better than the unselected members of the 1000 did in the same years.

And so what? This is hardly an actionable plan for putting your money to work in the stock market, given that there is nothing at all to buy half the time. And finding these needles in a haystack is not really practical without specialized software. Nor is this, with such a tiny sample, evidence that Rule #1 works after all. And Town is not done yet. There are still more parts to this “simple strategy for successful investing in only 15 minutes a week.” Stay tuned.

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

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