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]

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]

Phil Town’s Rule #1, Part #1

As cynical as I am, there are still forms of human gullibility that surprise me. For example, I am forced to conclude that those Nigerian emails promising tens of millions of dollars must somehow snare a few people, otherwise they wouldn’t get sent. And don’t get me started on Bernie Madoff. I guess it is my dim view of my fellow man that has me scratching my head. I just can’t believe anybody is really that optimistic.

So you will understand how stupefied I am at the sales of the many books that claim to contain a sure-fire way to get rich in the stock market. Individual titles come and go, but there always seems to be a few members of this sub-genre haunting the bestseller lists. (Although at the moment they are relatively less popular. Go figure.)

Hundreds of thousands of people spend hard earned money on these books. Difficult as it is for me to contemplate, it seems inevitable that some of those people read this blog. So with uncharacteristic patience, I am going to review one of the more popular of these tomes, Phil Town’s Rule #1, The Simple Strategy for Successful Investing in Only 15 Minutes a Week. I will do this in several installments, and, just to make it clear now, I will not have anything nice to say.

Hard sales figures for books are hard to come by, but it is clear that Mr. Town has done very well by this, his first book. He can safely be put into the growing club of those who have become rich by selling advice to others on how to become rich. Somebody should tell the Nigerian scammers about this. If only they charged money for their emails.

You do not need to open Rule #1 to know that it most certainly does not contain a recipe for wealth. None of these books do. They can’t. If this is not immediately obvious to you, consider the following.

Suppose you stumbled on a “simple strategy for successful investing” that allowed you to consistently make money in the stock market. Of course, you wish to profit from your discovery, and two possible ways to do that occur to you. You could a) make millions by writing a book that explains your method or b) make billions keeping your mouth shut and running a hedge fund. Which would you choose? Hint: a billion is a thousand millions.

Put another way, suppose you developed a way to play golf especially well. Would you teach it to others at the local country club or join the PGA Tour?

The bottom line is that everybody who can really beat the market does that for a living. They do not write books. And they rarely give interviews. In fact, people with effective schemes for making money in the stock market are generally very secretive about how they do what they do. If everybody knew and used the trick(s) they wouldn’t work so well. Indeed, Madoff could get away with what he did because it is common for hedge funds to disclose very little about what they do, even to their own investors.

Investing may be the ultimate “those that can, do, those that can’t, teach” subject. Because doing just pays so darn well. I know I am being a wet blanket. I just can’t help myself.

Still, I am sure that there is an optimistic fool or two reading this that hopes that maybe Rule #1 will be the exception. Town’s picture on the cover just looks so trustworthy. So in the rest of this series of posts I will methodically examine his simple strategy and I will show how Phil Town is the only person who will ever make a dime from it.

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

WSJ Article on New Advice Books

Today’s Wall Street Journal has a great item on the wave of new personal finance books now hitting the shelves and how the tone has changed from how to get rich to how to avoid going broke. In fact, it is more than tone, the content has shifted. There’s a great skewering of David Bach in the last few paragraphs for nearly pulling a 180 on his advice about home financing.

Further evidence of my thesis that these books just serve up what the readership demands, rather than any sort of objective reality.