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

The Little Book of Valuation – Book Review

Howdy friends! Hope you are all doing fine, staying healthy and sticking to your investing goals amidst all of the craziness in the world right now. As if things were not depressing enough with this COVID nonsense, the sky-high inflation rates, constant talk of interest rate hikes etc. the world now has a potential-war like situation in eastern Europe. I needed a distraction. So I decided to pick up a book on investing and read. No better way to enrich my knowledge and ignore everything else in the world.

We all know that investing is not an exact science. The process cannot be simply coined as a mathematical expression such as A + B = C. That said, it is not (or rather should not) be based on “hunches” and random guesses either. As an engineer, I like to treat the subject of making decisions based on rationality and through analytical arguments. This is why the subject of valuation interests me immensely.

Simply put, if you cannot ascertain the value of something you are about to purchase, you will make a huge mistake at some point.

So I picked up “The Little Book of Valuation” by Prof. Aswath Damodaran to refresh my understanding of the subject.

Who is Aswath Damodaran?

Prof. Damodaran teaches corporate finance and valuation at the Stern School of Business at NYU. If you follow finance content on Youtube, you may have run into his channel by accident. He also maintains a blog and his website is a treasure chest of all kinds of tools, spreadsheets and models that are available for FREE for anyone to use.

I cannot think of anyone who has written/spoken so eruditely on the subject of valuation. In fact, if you have not already done so, I *strongly encourage* you to go binge watch his playlist on Valuation. It might take a few watches, but you will learn a TON. It is certainly some of best finance content on Youtube, IMHO.

Initial impressions

The “little book” series are generally very good reads. They are concise, distilled and straight to the point. From that standpoint, the reader gains a lot from just a single read and does not need to spend a lot of time reading.

Valuation, however, is a very math-intensive subject. So I was not sure how such a complicated topic could be distilled down without losing the reader. To his credit, Prof. Damodaran does a fantastic job here. He first introduces the fundamentals of why valuation is important, followed by a discussion of valuation fundamentals and tools needed for the trade. Then there is a discussion on approaches to valuation, a walk through of how valuation can be applied to companies that are at various stages in their life-cycle and finally wrapping up with special cases in valuation.

Where valuations can go wrong

Source: Prof. Aswath Damodaran, slide-deck from Valuation class Spring ’22

So everyone understands that valuation is important, but the subject that does not get as much attention is where valuations can go wrong. Prof. Damodaran covers this subject first up. Here were some of my takeaways from the book:

• Valuation is hard and the odds of getting it wrong are very high.
• The investor’s personal biases and preconceptions impact his/her ability to value a company objectively. I have written about this subject previously on this blog.
• Valuation can be made over-complicated fairly quickly. If you can value a company using a model with three inputs, there is no point in using five inputs. Less is more. And while it might sound counter-intuitive, more research and data points can actually lead to more confusion.
• All valuation models are imprecise. We are not attempting to estimate the fair value of a stock up to 3 decimal places. The idea is to be close enough to the right answer and also add in a sufficient “buffer” (aka margin of safety)

Two approaches to valuation

In the chapters that follow, Prof. Damodaran goes into the aspects of HOW to go about doing valuation. Two primary approaches are discussed: intrinsic valuation and relative valuation. For intrinsic valuation, the value of an asset is determined by the looking at its future cash flows, its potential for growth and its associated risks. Prof. Damodaran focuses primarily on Discounted cash flow (DCF) valuation method here and discusses variations of this method. At its heart, the DCF method is ideal for estimating intrinsic value of an asset since it attempts to ascertain the present value of all estimated future cash flows discounted back at a risk-free rate. That statement in bold is the key, and the endeavor is to find a reliable method of estimating future cash flows for a specific duration AND also coming up with a fair risk-free rate.

Prof. Damodaran submits that while most discussions around valuation typically revolve around the DCF method, most assets in real-life are valued using relative valuation. For instance, if you are in the market for buying a house, you will look at the other similar sized houses in the neighborhood and come up with a “fair” value of the house you want to buy. Can one use a similar method for comparing stocks of two companies? The answer is yes, but with a few caveats:

• For a fair apples-to-apples comparison, the two companies that you are comparing need to be in the same sector.
• Then the question is what parameter one can use for the comparison. Common examples include multiples such as price to earnings multiple/ratio, price to book value, price to funds-from-operations (FFO) for REITs etc.
• Another variation is to look at a company’s multiple against the average of a group of companies within the same sector. The understanding being that by averaging, you are most likely going to be comparing the company of interest against a more “typical” company in the sector.

Each approach (intrinsic or relative) has its pros and cons. For instance, estimating future cash flows for growth companies or companies that are relatively early in the lifecycle is quite challenging (the book dedicates a whole chapter to this subject). Relative valuation is not perfect either regardless of whether you were comparing two companies or a company against a group of companies from the same sector. For instance, during the dot-com bubble in 1999-2000, several companies that were investing in internet were all ridiculously overvalued at the same time.

IMHO, when in doubt, it might be ideal to use a combination of both the approaches to determine if this is an ideal investing opportunity or if something looks fishy.

The chapters that follow go through several interesting case studies where DCF is performed to value companies. 3M (MMM) is picked as an example for the introduction to DCF. In the second half of the book, Prof. Damodaran then discusses how valuations can be performed for companies at various stages in their lifecycle. For his discussion, Prof. Damodaran picks Under Armour (ticker: UA) as an example of a company that is growing rapidly. As an example of a mature company, Prof. Damodaran picks Hormel Foods (ticker: HRL) and explains how valuation could be performed and discusses variations to the traditional DCF method. Finally for a declining business, Prof. Damodaran picks Las Vegas Sands Corp. (ticker: LVS) and explains how such a business should be valued.

In my view, this is where I really enjoyed reading the book and where all the learnings from the previous chapters were reinforced.

Special Cases

Prof. Damodaran dedicates the final half of the book towards companies where the traditional DCF valuation may not be applicable as readily. Three examples covered are: valuing a bank or a financial institution, valuing a cyclical company and finally valuing a company with a large amount of intangible assets (for eg. patents)

Valuing a bank or a financial firm using a method such as DCF tends to be tricky for several reasons: most banks or financial firms are under regulatory constraints, making them treat capital differently than the rest of the market. The standard accounting rules for banks are slightly different as compared to other companies in the market. The treatment of debt within a bank is different as compared to a regular company. In a bank’s case, debt is more like raw material used to fund something else and as a result the process of determining the cost of capital becomes tricky. Finally, it is hard to estimate free cash flows because the aspect of defining net capital expenditure or working capital for a bank or an insurance company can be tricky. In this chapter, Prof. Damodaran introduces the aspect of Gordon Growth Model or Dividend Discount Model as an alternative to estimate fair value. For a more rigorous discussion of the subject, I point the interested reader to this page.

Valuing cyclical companies such as those belonging in the industrial sector or companies that are dependent on commodity prices is not as straightforward. For instance, for companies that rely on natural resources such as oil, how can we factor in the situation where we can potentially run out of this resource completely in our fair-value estimation? To deal with fluctuations in commodity prices, Prof. Damodaran recommends using the normalized commodity prices and earnings for such companies. Choosing this can make a critical difference in our estimation of a fair value. For instance, if the current price for a barrel of oil is $50, but our estimate for normalized price for a barrel of oil is $100, the company we are trying to value may look overvalued simply because of our chosen normalized price of that commodity.

Summary

While I am a huge fan of Prof. Damodaran’s lectures and his thoughts on the subject of valuation, my overall sense was that I was a bit disappointed with this book.

The book covers the subject of Discounted Cash Flow valuation method in sufficient detail. The associated case studies using real public companies is also very enriching and rewarding. The book does a great job of laying down the foundation material explaining the WHY of valuation and the common pitfalls with valuation.

Where the book loses its shine is when it starts covering the subject of HOW valuation is performed. I got a sense that a lot of “dense” material was crammed into a few pages to meet the requirements of being “A little book”. Valuation is a math-heavy topic and topics that involve mathematics simply cannot be distilled down. Doing so complicates things for the reader instead of making the material simpler.

As an engineer, I did not find any issue with following the math. I quite enjoyed it on the contrary. I just wished it was given enough “love” in the book :).

Where this book excels is when it covers the subject of valuing companies at different stages in their life cycles and also the special cases where DCF cannot be readily applicable. I thoroughly enjoyed those chapters and gained some interesting insights for me ponder over further.

Have you read this book? What are your thoughts regarding it? Let me know in the comments below.