Rule #1: Phil Town on Investing

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.

New Speaking Dates, and More

I just posted new speaking dates for November and December.  Click here to view.

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Update: I've also added a Facebook Page where you can add me.

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.

The Real Culprits

I've hammered the borrowers for creating the mess we are in without much enthusiastic support from you all.  I don't blame you for wanting the bad guy to be the banks.  They are an easy target.  Greed trumps all. 

Since the mid-1990s there has been a concerted effort on the part of politicians and policy makers to force banks to relax their lending standards.  The crowbar that was used to open the bank vault was the charge of racial discrimination in lending.  A Boston Fed study seemed to show that racial discrimination was the single factor that resulted in banks lending less to blacks than to other races.  The authors of the study below debunks that study, but from the date that it was blessed by the Fed, banks that wished to keep their standards for lending were in deep trouble. 

DJIA Estimates and What's Coming Next with the Market

DJIA ESTIMATES
2/3RDS ARE OVERVALUED IF ANALYSTS AND HISTORICAL PE ARE CORRECT
AVG PE IS 15 - WHICH IS ALSO THE AVERAGE HISTORICAL PE
IF SOLD AT VALUE AVG PE IS 11
14% OVERVALUED
IF AT LOWISH PE OF 9 DJIA WOULD BE DOWN AN ADDITIONAL 40%
CURRENT DJIA 9447.  DOWN 40% MEANS DJIA OF 5668

Here are some estimates that might help you put the stock market in perspective in the weeks and months to come.  From the turn of the century the Dow Jones Industrial Average has had an average ratio between the prices of the stocks in the DJIA and their earnings of about 15.  That means that the price of the these 30 stocks averaged about 15 times their trailing 12 months earnings. 

During the last 11 decades (from 1900-2008) the DJIA PE ratio fell to at or below 10 at least once in 7 of those decades.  That means that the stock market seriously crashed one or more times in two thirds of the decades in the last 108 years. 

It has not crashed that hard since the early 1980s. This means we are way overdue for a big one.

Don't Be Stupid

I can't believe so many people objected to this bailout plan.  They wrote their congressperson and complained that they weren't getting their mortgage reduced but that banks were getting free money and that that wasn't fair since the banks are the ones that caused the problem.

Are they joking? 

This whole mess happened because millions of ordinary people bit off more than they could chew by buying a home, or upgrading their home, or buying a bigger home, or buying a second home with cheap loans that were being handed out liberally.  Now the borrower wants to blame the lenders.  That is simply stupid.