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A short but detailed summary of Phil Town's Rule #1 methodology in
posted Nov 25 '13 by alex
A short but detailed summary of Phil Town's Rule #1 methodology in the American Association of Individual Investors by Wayne A. Thorp, CFA:


A quote:

Philosophy and Style

Invest in “wonderful companies” that have meaning to you, which you should be willing to rely on as your sole means of financial support for the next 100 years. Look for companies with financial strength, stability, and quality management whose share price is at least half their intrinsic value. Buying below intrinsic value provides a “margin of safety” that protects investors from incorrect analysis as well as unfavorable company developments, with subsequently less risk of a market overreaction on the downside. Town believes that, by following the Rule #1 approach, you can secure at least a 15% annual rate of return with a minimum level of risk.

Universe of Stocks

No restrictions, but Town suggests investing in companies that you know about or have meaning to you. In other words, companies that deal in areas related to your work, interests, hobbies, etc. In addition, he suggests avoiding “illiquid stocks”—those stocks with an average daily trading volume of less than 500,000 shares.

Criteria for Initial Consideration

- Minimum compound average annual growth of 10% in earnings per share, equity (book value per share), sales, and free cash flow over the last 10 years.
- Minimum average annual return on invested capital of 10% over the last 10 years.
- Manageable debt—the current level of long-term debt should not exceed three times the level of free cash flow over the last four fiscal quarters (trailing 12 months).
- Current share price should not be more than 50% of the company’s fair value, which Town refers to as the company’s “sticker price.”

Secondary Factors

- Look for corporate managers who are owner-oriented. As a rule, Town avoids companies with CEOs who accept stock options as compensation.
- Avoid companies where several insiders are selling significant portions of their holdings.
- Use technical analysis and charting tools—MACD, stochastics, and moving averages—to help time buy decisions.

Stock Monitoring and When to Sell

Town states “diversification spreads you too thin and guarantees a market rate of return,” so he instead focuses on only “a few” businesses in different sectors or industries. However, the number of companies you invest in is dictated by the amount of money you have to invest. Try to keep commissions as a percentage of your total amount invested below 0.5%.

In Town’s view, there are only two times to sell: 1) when the business ceases to be “wonderful,” and 2) when the share price rises above the “sticker price” (fair value).

Using MACD, stochastics, and moving averages, Town trades in and out of companies until it is a true sell.

If a stock’s market price reaches its sticker price, he sells and then watches to see if the price falls back to where it is at least 20% below the sticker price (and still meets the other criteria). He then uses the Three Tools to trade the stock again until it satisfies one of his sell rules.

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