Rule #1: An Investment Methodology

This investment book is written by Phil Town. It is essentially based on value investing and fundamental analysis with some modifications from the author.

The Excerpt

4M – Meaning, Moat, Management, Margin of Safety.

i) Meaning – Passion, Talent, Money.

View equity investment like buying into a company as if we depend on it for the next 100 years, not as just buying a share.

ii) Moat – The Big Five Numbers (Return on Investment Capital Growth Rate, Equity Growth Rate, EPS Growth Rate, Revenue Growth Rate, Free Cash Flow Growth Rate). Growth rate must be at least 10% per annum. Compare the growth rates for the last 10 years, 5 years and 1 year to see whether they are deteriorating. Lastly, debt must be within manageable level.

iii) Management – Read the previous year annual reports to see whether the CEO of the company has delivered what he had promised. Preferably a Level 5 (a term coined by Jim Collins) CEO.

iv) Margin of Safety – At least 50% discount to the sticker price.

Calculate the Sticker Price (Intrinsic value) & Margin of Safety (MOS)

After passing the 4M examination, we must determine the right price to buy. These steps are basically the essence of the entire book.

a) Get the current EPS.

b) Determine the Equity Growth Rate – either from historical data or from industry estimation, whichever is lower.

c) Determine the future P/E ratio – 2 x Equity Growth Rate of (b) or from historical data, whichever is lower.

d) Determine the minimum rate of return – 15%.

e) Determine the Sticker Price – ¼ of (future P/E ratio x current EPS).

f) Determine the MOS – 50% off the Sticker Price. Buy if it is less than 50%.

The 3 Tools (Technical Analysis)

i) Stochastic

ii) Moving Average – 10 days.

iii) MACD – Standard is 12-26-9, preferred is 8-17-9 version.

Even though the share price is at 50% off the sticker price now, individual investors should wait for the right moment. This means waiting for these 3 indicators to show positive signals. These indicators are used by institutional players to determine the right time to buy or to sell a stock. Individual investors should use these indicators to see whether the institutional players are buying or selling their holdings and thus making their own buy and sell decisions accordingly and timely.

Sell only when the share price has reached the sticker price (annually adjusted, roughly up 100% from MOS price). Or, when all the 3 indicators show negative signals. Buy back only when the price has dropped more than 20% from the selling price PROVIDED all the fundamentals are still the same and you had bought at 50% MOS price INITIALLY. Of course, don't forget the 3 indicators.

The author also ruled out the significance of dividend payment. He said it is better for the money to be retained in the company to grow the business than returning the profit as a way of dividend to you because this will save you from the headache of finding another company to reinvest the dividend received.

Although I must admit the author's way of calculating the intrinsic value is great (not many investment books teach you how to do this), it is always difficult to find a stock that is showing all the characteristics of Rule #1 investing. The journey of investing never stop. Seek and ye shall find.