The Five Rules For Successful Stock Investing – Book Review

Dear Readers,

As I have stated multiple times in this blog, I have derived (and continue to derive) almost all of my knowledge about investing by reading books. I feel this is a far better medium of learning the tricks of the trade. It also comes as no surprise that the most successful investors of our times are also voracious book readers. This was perhaps my biggest motivation when I started my investing book review series on this blog. I do not want this to be a quantitative exercise where I mindlessly read dozens of books every year. I really want to discuss these books and my takeaways from them.

I picked up the “The Five Rules of Successful Stock investing” at a Half-Price-Books store when I wanted to kill some time one afternoon. I had not heard about this book previously. I also did not know who Pat Dorsey was. But the title “Director of Stock Analysis” at Morningstar stood out at me. Morningstar is a pretty reputable agency in the investing world. So clearly, this person knows a thing or two about stock investing. A quick glance at the table of contents and I was sold. It seemed like the author wanted to cover a wide array of topics related to successful stock picking, ranging from diving into the financial statements, to analyzing businesses, to stock valuation (discounted cash flow). What was impressive was a complete section (and subsections) dedicated to each sector to discuss nuances of that sector.

I am relatively younger in my investing journey and I certainly cannot claim to know the intricacies of each sector. But a whirlwind tutorial on these subjects would be incredibly useful. I am happy to say that the book did not disappoint one bit! In this review, I will cover the five rules (as stated in the book) superficially and then also discuss aspects of the book , beyond the rules, which I think would be useful to the reader. I also look at certain shortcomings of the book in order to complete a well-rounded review. Lets do this!

The five rules

The author sets the stage perfectly with the very first chapter titled “Picking Great Stocks is Tough”. This is followed by the first line in the chapter which reads “Successful investing is simple, but it is not easy”. These are profound statements and I am glad that the author starts the discussion with these statements.

The founding tenets of successful investing are simple to understand i.e. the what of successful investing is not particularly hard to grasp. The approach to successful investing i.e. the how, is reasonably hard to grasp for the layman but not impossible by any stretch of imagination. However, the discipline to stick with these learnings through all types of market gyrations is incredibly hard. And for that reason: Successful investing is simple, but it is not easy.

This background is important to understand the five rules that are laid out in the book. The five rules are:

1. Doing your homework.
2. Finding companies with strong competitive advantages (or economic moats)
3. Having a margin of safety
4. Holding for the long-term
5. Knowing when to sell

Once again, the fives rules as stipulated are non-controversial. Almost all successful investors will agree with them. But how should one go about doing their homework? How can one identify companies with strong competitive moats? How can one have a margin of safety in their investments? It is these hows that the author spends considerable time over in this book.

Rule 1: Doing your homework

Dorsey wastes no time and dives straight into the financial statements, explaining how each of the three statements are constructed using first a hypothetical example and then a examples from real businesses. I particularly liked the explanation from a standpoint a hypothetical example. This brings readers from different backgrounds on the same level playing field and keeps the discussion simple to understand.

In addition to the financial statements, Dorsey also dedicates three more chapters towards analysis of businesses. This covers a wide range of topics ranging from analyzing growth, evaluating profitability, determining overall financial health, constructing a bear case as a part of the investment thesis etc. There is an entire chapter dedicated to analyzing the quality of management, a subject that is vastly under-discussed in the investing community.

Among these chapters, there is a chapter titled “Avoiding Financial Fakery” which I found to be particularly enjoyable and enlightening because it discusses various examples of financial engineering/aggressive accounting tactics that companies employ as a part of their financial statements. Dorsey discusses some of these tricks and also highlights some red flags to watch out for when studying businesses.

Rule 2: Economic Moats

Yes, we all love to invest in companies with a decent economic moat. But how does one identify a moat? Dorsey spends a chapter discussing this subject. The discussion is centered around finding answers to some key questions:

• Is the company profitable? If yes, on what basis? Is it able to generate cash flow consistently? What are the firm’s net margins like? What about Return on Equity (ROE), Return on Assets (ROA) and Return on Invested Capital (ROIC)?
• What is the source of the company’s profitability? How are they using it keep competition away? What is the basis of the moat? Is it through real product differentiation? Or through perceived product differentiation? Is the company exception at keeping costs down? Is the basis for the moat centered around locking in customers and/or locking out competitors?
• What does the competitive advantage period like? Applicable for the next 5 years? 10 years? longer?
• What is the nature of the sector itself? Highly competitive? Does it exhibit Monopoly/Duopoly-like characteristics?

Rule 3: Having a margin of safety

The discussion shifts into the second aspect of investing: now that we have identified a good business with a strong economic moat and high-quality characteristics, what is a reasonable price to pay to buy a piece of such a business i.e. how do we value businesses. Dorsey dedicates two chapters to this subject, with the first one discussing the importance of valuation and discussion around using price multiples for relative valuation.

The second chapter is solely focused on the subject of discounted cash flow model of valuation and finally winds up with a discussion of margin of safety. While the discussion around discounted cash flow is not as rigorous as that of Aswath Damodaran’s Little Book of Valuation, it is by no means a bad place to start for someone who has no background on the subject. In fact, an investor would do completely fine with the knowledge gained from reading this chapter and applying it in their valuation exercises.

Rules 4 and 5: Holding long-term and knowing when to sell

From what I could tell, I did not see dedicated chapters for these rules, however these rules are discussed implicitly throughout the book i.e. default stance is to always hold for the long run, but watch out for warning signals at every step and use this a criteria to sell if you are seeing red flags that are contrary to your investment thesis for the business.

The 10-minute quick test

Dorsey recommends the following question checklist to quick evaluate if a business is worth analyzing further:

1. Does the firm pass a minimum quality hurdle? i.e. avoid penny stocks, recent IPOs and other speculative investments.
2. Has the company every made an operating profit?
3. Does the company generate consistent cash flow from operations?
4. Are ROE consistently > 10%, with reasonable leverage?
5. Is earnings growth consistent or erratic?
6. How clean is the balance sheet?
   • Is the firm in a stable sector?
   • Has debt been going up or down as a % of the total assets?
   • Do you understand the nature of the debt?
7. Does the firm generate free cash flow?
8. How much “other” is there? i.e. does the company have dubious accounting practices, hidden details in footnotes that are hard to decipher etc.
9. Has the number of shares outstanding increased markedly over the past few years?

A Guided Tour of the Market

The discussion then shifts into walking the reader through the various sectors in the market and includes details about the peculiarities regarding each sector. The book dedicates 12 chapters covering sectors such as Healthcare, Consumer services, Software, Energy, Utilities, Hardware, Industrials, Banks, Business services, Asset Management companies, Media, Telecom and Consumer Goods. IMO, this discussion in these chapters is what makes this book really special. While certain examples and associated data is dated, the fundamentals around what makes each sector different and how to analyze and value companies in each sector are still applicable today.

The one sector that I did not see being covered in this book is REITs and that is a minor criticism for what is otherwise a pretty exhaustive list. I have been frequently keeping this book and specifically these chapters at an arm’s length away from me on my desk, because I need to constantly revisit a particular chapter when I am doing a deep-dive on any business.

Summary

There is so much to like about this book. It does a very good job of covering a wide range of topics for the beginner investor, but also keeps the experienced investor hooked on with discussions of topics that are rarely discussed elsewhere. I think this book makes a great accompaniment to Peter Lynch’s One up on Wall Street in that it can motivate the average layman and make him/her confident in investing in individual stocks and doing so with a winning mindset i.e. as a long-term investor.

Have you read this book? Did you have any other takeaways from this? Please share your thoughts in the comments below!

Cheers!

LWD

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