Rule #1: Phil Town on Investing

The Ceiling (and What's Coming Next for Banks)

Recently I received an interesting comment from Hanno:

It seems that we reached the Ceiling right now. If we look at the Dow in a 10 year history chart, we can see, that it was going down for over a year. This rebound we are seeing now is not lasting. The charts show it in the little time-frame: If the value goes down straight and also very much than there is always a counter motion following. This is what we can see now with the big indices. The 8000 points at the Dow seem to be the Ceiling of it. Well, I think, that we will going to hit the 200 day MA in the next 2-3 months. So we will be in a sideway until then. If this happens, than this could be the sign of a lasting rebound in the next half year from then. But mention folks, this is just my opinion. And I am not sure but this mess could be finished at the end of this year. We will see.

My response:

We've been right on about 8000 as a ceiling.  There are ways to make money when you have that situation, but they more advanced.  We'll get in to that sort of thing in the future sometime, but for right now the 8000 ceiling is holding. 

Meanwhile, the banks are doing better, but commercial real estate is the next shoe and it's going to drop this year.  Banks are carrying big portfolios of commercial real estate loans and no one knows what they are worth right now.

Here's the problem:

Is it Fear, or is it Greed?

I got this comment from JNS on April 2:

Phil, I keep hearing the words, "be greedy when others are fearful and fearful when others are greedy". Doesn't this market seem like we should be fearful? This bull-run seems mis-leading when most stocks seem overpriced based on The Rule #1 principals. In this case, what can one stockpile?

I love the point about overpriced stocks.  Even though the market price has dropped 45% from its high, we can't assume things are on sale any more than we would if we saw an "ON SALE 45% OFF" at a jewelry store.  We have to ask, "45% off of what?" 

Please pay attention to JNS's point and do a solid Rule #1 valuation.  That said, there are things on sale if you know where to look.  But that requires you build an expertise in a few industries in the market so you can know when you know. 

So where to look now?  We look where there is great fear.  And where is that?  Certainly in the financial stocks, right?  And all over the retail market.  Restaurants.  Clothing stores.  Auto related. 

And what to look for?  Durability.  A business that will definitely be here in 20 years.

So tell me, JNS, what area of the market are you deeply interested in?  And in that area, are there values much higher than prices or is it the other way round?

Now go play.

For Those with 401(k)s: is Now a Good Time to Re-enter?

I got this question last week from long-time reader, Jon:

Any tips on re-entry on company type plans for those who exiting with the tools in 2008? Whether we should look more at stockpiling a little at a time with some percentage of funds (whether the market is going up or down), or look at tools as an entry, such as a 200MA. The limits of moving funds within in these planes makes this process more difficult.

Wow, I hope you didn't miss my urge to buy back in a few weeks ago.  Now it's time to to check the arrows on your 401(k) funds (and shift to SPY if you can do it in your 401(k) and put 1% per year in your pocket instead of some fund managers).

There is no entry now, I think.  We're at the 8000 point on the Dow and it is shaping up to be a ceiling just as it was a floor for over a month.  All the tools are sliding to a sell signal.  So this is not an entry point.  If it pops out of 8000 and you're doing FACs, I'd hit it.  If you're doing arrows, you are looking to sell here sometime, because you got in at somewhere between 6700 (on two greens and my blog) and 7400. 

I'd say prepare to exit.  It's going down unless there is some really good news somewhere to stimulate a lot of money sitting on the sidelines.  If not, a lot of profit taking is already underway.

Now go play.

What to Do if You Don't Have the Money

A few days ago Hanno wrote me to ask how to stockpile or consume good businesses in this market if you have $1000 or $3000 to invest.  Let's start by reviewing the difference between trading a stock and stockpiling a business for someone with very little money:

Trading a stock using tools requires very little capital.  Read Rule #1 and go to it.  You can certainly do it with $1000, although with that small amount to invest you'll incur trading costs that chew up a lot of your profits. You move in with the Big Guys, you move out with the Big Guys. 

The problem with trading in this market, as some people learned in 2008, is that when you are trading against the trend you keep getting in just as the stock price turns and drops.  An unrelenting down trend will cause you to have many slightly losing trades - I call it "the death of a thousand cuts" in Rule #1. 

Trading in a market like this can be deadly depending on whether you are correctly determining the overall trend of your target stock.  In my next book, PAYBACK TIME (coming out September 2009), I show you how to find the points in time when the trend is changing.  It will help you trade better.

And stockpiling stocks?  PAYBACK TIME teaches  how to stockpile, to consume.  We very rarely get an opportunity to simply load up the truck and forget about it.  No trading required.  We are in one of those opportunities right now.  You can pick McDonalds, GE, Burlington Northern and many more, figure out the payback time for your investment, and buy in for the long term hold. 

But stockpiling takes some kind of cash flow and that's the rub for Hanno.  What to do if you don't have any?

Payback Time

The day after I told Manny (Kiplingers) to get in, the market shot up 500 points. Nice call on the market if I do say so myself.  And pure luck.  I was thinking it would continue down for a while.  But businesses are cheap and that’s what we really care about.  And now it's time to figure out what to buy.   You guys asked me about Apple, (AAPL), Altria (MO),  Verizon (VZ), AT&T (T), Microsoft (MSFT) & ConocoPhillips (COP).  I’ll dig in on these, but only after you tell me what they are worth and why.

As always, I want you to do the homework.  You sent me two opinions of value for AAPL – Charpe197 thinks $286 is retail.  Lynn suggests the right retail value is $151.  Since I didn’t see their work, I can’t say for sure why the difference in value, but I thought I’d add another layer of information for those of you who are looking to buy some businesses right now.

The Bottom

I just sent this email off to Manny Schiffres, the Editor of the Kiplinger Letter and my debate opponent on Closing Bell with Maria Bartiromo (and I copied Maria).  Manny rather sarcastically asked me to call him when we reached "the bottom".  Well, I called him, so to speak.

We're close enough to a bottom to be buyers.  But selectively and only in businesses we want to buy as they continue to go down. 

Keep in mind that we could easily see the Dow at 5000 or 2500, although I think they are going to swap out some of the Dow stocks to shore it up a bit and keep that from happening.  In any case, we buy in now and hope it goes down so we can buy in cheaper down the road. 

Here's the email:

Get a Long Term Picture

Yesterday I received a note from long-time Rule #1 Blog reader, Jon:

Phil,

Hopefully you can do updates like your "weeks and months to come" post to continue to talk about your experience with previous bear markets... Maybe you can talk more about accumulation strategies with the current market and if you see more likely opportunities for this in future months based on how bear markets work?

thanks,

jon

Will do.  This is a great market for buying companies.  Private ones.  Public ones.  We're funding new ones.  It's all the same thing.  When you guys get that there is no difference between buying a public company and a private company or a Micky D franchise or starting your own business, you will have the beginnings of being great investors. 

There is no one out there who thinks that this can't go a whole lot lower, and as long as they think that, it can.  The mainstream brokers are in shock.  Many will lose their jobs because people simply don't believe them any more. 

Back in the early 1980's when I started, the guy on the desk answering calls to pick up leads could sit all week and not get a single phone call from anyone who wanted to know about buying stocks.  That's where we are going, my friends. 

We're not there yet.  There are still lots and lots of people who think stock investing is about buying at all times and holding forever and they haven't given up yet.  But they are starting to.  If this market stays down like this for another year or two you are going to see the baby boomers decide that they need their money someplace else.  And then watch out below.

That said, I hope you've been looking for bargains.  The trick is to take a long term view of growth.  Don't use recession numbers to put a value on a business, but don't use crazy numbers either.  Get a long term picture.  What would you be willing to bet your financial future on?  Keep it that conservative.  And let me see what you're coming up with.

Now go play

The 4M Valuation Process Still Applies, Even in this Market

A few days ago, Nathan asked the following question -- which is echoed in a lot of emails I've received from RULE #1 investors:

Phil, I'm struggling with putting a value on a company right now b/c of how much the P/E and the growth rate we use affects the results. Should we stick to your standard way: using either the historical P/E or double the lowest growth rate (b/w historical and analyst projections), whichever is lower? That method is providing pretty high P/E ratios and, therefore, nice and high sticker prices for some companies. Should we slash the P/E ratio used in the calculation given the current market environment? If so, any rule as to how much?

I also wonder about the growth number that we use in the calculation. What should we do when analysts are predicting negative growth in 2009 for Rule #1 companies? Should we still consider it? If so, what number should we use for growth?

Thanks for all your help.

Here is my answer:

Nathan,

Let's go over the process of valuation:

1. Meaning:  You've got to know the business.

In a sketchy economic environment like the one we're in, it's even more important. 

Pay Attention Now

I don't do a lot of predicting about the market direction.  The market doesn't matter.  What matters is whether you are buying wonderful businesses and what price you are paying for what you are getting.  But the question keeps coming up about how far down this market can go before the bottom.

In the last 100 years, the market has gotten into single digit PE ratios at least once per decade in 7 of the last 11 decades.  We were there in the 70s repeatedly, and the last time was at the beginning of the 80s when I started investing.  Then double digit PEs for almost 30 years. 

So of the 4 decades when the market sustained moderate to high prices in the last 100 years, 3 of them just happened.  But now we're right at the bleeding edge of sliding into single digits on the DJIA.  So this is a kind of historic moment.  For the first time in over twenty years, we're starting to see very good businesses go on sale big time.  This is when great investors in the Rule #1 tradition load up the truck.

I've been telling you to wait.  To stay in cash.  To protect yourself by being very careful about valuations.  You've been doing good.  You're ready.  Now is the time to begin consuming great businesses.

Valuation: Looking Back and Looking Forward

KYC30090 wrote a comment you can read from Oct 9th that included this thought: "Valuation is out of the book. Phil's method is growth and valuation which is totally thrown out of window. The method is backward looking as far as 10 years!! You can't even look back yesterday." 

I really want to address this for you guys.  I sort of suck at writing but I try to get out the ideas coherently.  What I tried to say in Rule #1 and on this blog is that you must follow the 4Ms: Meaning, Moat, Management, MOS.  All four of them. 

Part of the process is looking back ten years.  Twenty would be better.

And what are you looking for?  Coherence.  Predictability.  A solid return on the capital these guys are investing.  Low to no debt.  We want to see that this thing has a moat.  And we have to know what it is and that it's a durable moat.  And from those numbers and our expertise in this business and in this industry we can sometimes, SOMETIMES, come up with a solid value. From that we can derive a MOS price.

If You Get it Right, You Will Make Money

Especially now, guys, contrary to what KYC is suggesting, let me suggest that valuation is everything.  If you buy $10 of value and only pay $5 for it, you will make money.  I don't know when, but I know it's certain that you will make money. 

But something in what KYC says about looking backward is important: You can't drive the car by looking at the mirror.  The road ahead is different than the road behind.  The view out the front windshield of this sort of vehicle is always unclear in the short term, but should be quite clear in the long run.  It's sort of like the hood of the car is in the fog, but we can see that far down the road the fog clears and the road is there.  We might not stay on it perfectly because of the fog, but we can see we're headed in the generally right direction. 

Part of the issue of how well the car will do is how well the car is made and who is driving it.  You can know quite a lot about both of those things.  Meaning, Moat, Management.  But you can't know all.  So what to do when we're in a particularly foggy stretch?  Reduce your speed.

An Example: GOOG

In investing terms, to reduce your speed means to lower your expectations for this business for the long term.  If we've been expecting Google to grow at 22% with a 44 PE, slow down.  We're in the fog here.  Let's lower our expectations for the speed that Google can go down the road.  Take a look at the lowest growth expectations from analysts.  Look at the industry growth rate long term through good and bad time. 

I'm no expert on Goog.  When I own it I own it in my risky biz portfolio.  The most pessimistic analyst has 15%.  I'm quite sure that GOOG can grow slower than that in this mess. I'd be surprised if it grew it earnings at all.  But it has $12 billion in cash and almost no liabilities.  So let's assume it can grow long term at, say 12% and will handle a 24 PE.

What is the value then?  $280.  It's selling for $332, about 4 times its book value.  So it's not cheap if we reel our expectations in. 

Let's say we buy it somewhat below this low retail value.  Small MOS.  $250. We get 40 shares with $10,000.  And we're wrong in the short run.  The stock plummets to $200.  BUY MORE. Another $10,000.  50 shares.  And now it's at $100.  BUY MORE.  100 shares.  And finally it hits bottom at $50 and you buy another $10,000.  200 shares.  Assuming you bought $10,000 each time, you would have $40,000 in it and you own 390 shares.    Your average price was $102.

Let's assume Google survives the meltdown and comes out the other end a better company with a nice solid 12% long term growth rate and a 24 PE.  Five years down the road its earnings are nearly $30 a share; so by then your Yield is $30/$102 – about 33% per year and growing.  If you owned it all, you'd be making 33% a year on your investment in Google. 

It's turned into what Buffett calls an "Equity Bond".  But even better, the market has the stock at $600 again.  And your return is 600% in five years.  That is a compounded return of 43% per year.  And all that happened is that Google stock price melted down in a bad economy and then went back up when things straightened out.

Know Your Business

But is GOOG your bag, baby?  Or is it JNJ or Pfizer or MSFT or BNI?  What do you love?  What are you willing to dig into and learn about?   You want to be an expert on car credit deals?  Look at ACF. It's selling below book.  But know your business, gang.

Hang in there.  Today we really melted down.  We bounced off the floor from 2003.  If the low 8000's hold I'd start to consume if I were you.

I'm not, though.  The wild swings are gut wrenching.  I'm waiting and I'm gearing up to buy private companies.  It's a lot less volatile because there is no liquidity.  You think the deals look good in the public market?  You should see what we're seeing at our private equity company.  PE's are way into single digits and the businesses are rock solid.  This is going to be a very stressful but very good time if you know what you are doing.  I'd say a once-in-a-lifetime sort of time.

Stay tuned.  I'll write more about it as it unfolds.  And do you think valuation is important in buying a private company?  Duh!

Now go play.