How to Invest: A Basic Overview of Rule #1

Phil Town

August 22, 2014

Welcome to the Introduction to Rule #1 Investing. I’m Phil Town and this is Tutorial 1: Rule #1 Strategy- The Overview of the Basics.

This is part 1 of a 9-part series on How to Invest using Rule #1 strategies

Part 1 [You are Here]: Rule #1 Strategy- Overview of the Basics

Part 2: Meaning- The Three Circles

Part 3: Moat- A Durable Advantage

Part 4: Moat- The Big Four

Part 5: Management- Owner Oriented

Part 6: Margin of Safety- The Growth Rate

Part 7: Margin of Safety- Sticker Price and MOS

Part 8: Margin of Safety- Payback Time

Part 9: Zombie Value- Tangible Book Value

What is Rule #1 Investing All About?

Rule #1 Investing started with Warren Buffet who said that there are really just two rules of investing.

Rule 1: Don’t lose money.
Rule 2: Don’t forget rule number one.

So rule number one is about investing, not about speculating. Investing is about certainty.

Who Uses Rule #1 Investing Principles?

Who uses Rule #1 style investing anyway? Well, just about the best investors in the world are unanimously using this strategy.

It’s all about focusing on a couple of key things that we’re going to talk about. Ben Graham started it all. Warren Buffett is the most famous proponent to Rule #1 investing. Tom Knapp, Bill Ruane ran Sequoia fund, Charlie Munger of course, is still helping run Berkshire Hathaway. Eddie Lampert one of the best investors right now. Bill Ackman runs Pershing Square. Bill Nygren runs Oakmark Select and Whitney Tilson runs T3.

These guys are hedge fund managers, some of the best investors in the world. Rule #1 Investing is about focusing on not losing money, that’s the basic idea. Not losing money means first be certain of what you’re doing, and then go ahead and make the investment because guessing and hoping and wishing and praying and waiting is what most people are doing.

They just buy something and hope and wait. These are not Rule #1 strategies.

Investment Strategy: Always Be Certain

Warren Buffett said, “Be certain,” and here’s how you’re going to be certain. If you buy a wonderful business at an attractive price, you’re certain to make money. It’s essentially like buying a $10 dollar bill for five bucks. You focus on a couple of key things to make sure you know what you’re getting.

What’s a Wonderful Business?

What’s a wonderful business? First off, it’s an understandable business. Second, it has a durable competitive advantage, and third is that the CEO is someone who we believe is honest, very passionate about what they’re doing and they’re owner oriented. That means they have our best interests in mind.

What is an Attractive Price?

What’s an attractive price? Well, first you need to know the value of the business as a business. You can’t figure out the price until you know what its worth and then you buy it at a discount to its value.

So doesn’t everybody use these principles? Well, it’s amazing, Warren Buffett said, “It’s extraordinary to me that idea of buying dollar bills for $.50 cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records and it doesn’t make any difference. They just don’t seem able to grasp the concept, as simple as it is.”

We’re going to go back and make sure we understand it now.

The Four M’s: Meaning, Moat, Management, Margin of Safety

What’s a wonderful business? It’s understandable, we call that the meaning of the business. It’s durable, we call that the moat. Like the water around a castle protects it from attack. The CEO is honest, passionate, and owner-oriented, we call that management. Those are the first three M’s. We make sure that we understand all three M’s before we go forward, then we look at the price.

Ben Graham, who taught Warren Buffett how to do this said, “The three most important words in investing are Margin of Safety”.

Margin of Safety is a price we arrive at by looking at the sticker price, which is the value and then we look 50% below that to buy it or we look for a payback time of 8 years or less, we’ll discuss that in another tutorial, or we’re looking at 70% of tangible book value or less. We’ll take a look at that in another tutorial as well.

4 Straight Forward Steps to Becoming Wealthy

Find a wonderful business, and were going to do that by looking at meaning, moat, and management (M, M, M).
Know what it’s worth as a business.
Buy it at a discount to its value and that’s Margin of Safety (M).
So there’s the four M’s, meaning, moat, management, and margin of safety and you’re going to repeat that until we get rich.

Conclusion

So, this tutorial has been an overview of the basics, next the first M, meaning. Your homework is to memorize the 4 M’s. Meaning, moat, management, and margin of safety. Then think about this, what are you passionate about in your life? What do you love doing? What do you feel like you’re talented at? What do you love spending money on?

Think about that, that’s going to be something we talk about in the Tutorial 2: Meaning- The Three Circles.

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