Part 1 of my writing on Phil Town focused on the Four M’s of investing. In this second part, we’ll dive into what he calls the “Big Five” numbers and dealing with fear in the market. The Big Five are what Phil believes to be the key numbers to focus on in order to draw an intelligent conclusion in a potential investment. And I have to say I agree with him.
The Big Five Numbers
After the qualitative factors of the four M’s discussed earlier, it’s time to confirm that strength of the business. In the author’s own words, the Big Five are a huge clue to whether the business is predictable and can be trusted to deliver expected rates of return in the future.
REMEMBER: All of these Big Five numbers should be equal to or greater than 10 percent per year for the last 10 years.
#1: ROIC
Return on invested capital (ROIC) is the return rate a business generates on the capital invested in itself every year. Let’s say you invest $200 into starting a lemonade stand. The invested capital is now $200. After one year of operation, the business has made $300. The lemonade stand (like any business) has running costs. In our case the lemon, sugar, sunshade and perhaps chairs to be put on the patio next to the stand. These running costs are $200. The bottom line or profit after running costs is $100. The return on invested capital is the net profit divided by invested capital, which gives our lemonade stand a ROIC of 50% (100 / 200).
The example given is simple, but the concept applies to any business. Most businesses have a mix of both equity and debt as their invested capital. Therefore, to figure out the invested capital in a business, go to the balance sheet and add together the two line items: Shareholders Equity & Long-Term Debt. This gives us the invested capital number. To figure out ROIC, go to the income statement, take the net profit number and divide it by the invested capital. Most businesses are not particularly good at generating consistent high ROIC. I’ve written a separate post on the topic here.
#2: Growth of Equity
A personal net worth is calculated by taking what you own, eg. your house, your car, vintage baseball card collection etc. and subtracting your liabilities such as mortgage, credit card debt etc. from it. If I have $100,000 in an asset such as a house, and $50,000 of debt, my net worth is $50,000. Equity (also referred to as shareholders equity) is the net worth of the business. This number is reported in the balance sheet as a separate line item.
We want to see equity growing at 10% or more, for many many years. Remember the Oracle: If you’re not willing to hold a stock for 10 years, don’t even think about owning it for ten minutes. This way of thinking already puts us in a long-term mindset, and thus we’re already thinking differently than the majority of market participants. Since we’re going to be long-term holders of the business, we want our stake (shareholders equity), the net worth of our business to have a proven track record of growth. 10% or more year over year.
#3: Growth of Cash
If the business has consistently good ROIC (10% or more) every year, as well as growing equity, we should see the cash line item in the balance sheet grow consistently as well. The only reason we invest our hard earned cash in the first place, is for it to generate more cash for us in the future. Bad businesses usually find it difficult to generate any cash, so we’ll stick with businesses that do.
A good business generating healthy cash each year will have you sleeping well. It will sell its products and services while you focus on what’s important to you.
#4 & 5: Growth of Sales & EPS
Sales is what is known as the “top line” and is the first line item in the income statement. A good business is one with growing sales. Prolonged sales decline is a sign of stiffening competition, which pushes margins lower. Ultimately this will translate to diminishing investment returns, so all else being equal, you want a growing business, not a dying one.
Earnings per share (EPS) is the net profit divided by the shares outstanding. This is what people call the “bottom line”. This number is widely reported and you’ll find it through just a simple Google search. All things being equal, growing sales should translate to growing profits. The reason we look into growing EPS instead of just net income is the following: The amount of shares outstanding may change over the years through buybacks, stock splits or just plain dilution (a massive red flag by the way!). A consistently growing EPS of 10% or higher is a more realistic metric than just growth in net income. Remember, we are the business owners with a set amount of stock. We want the per-share profitability to be growing.
A Few Words on Debt
Most businesses have debt, there’s no way around it. But debt is also what gets businesses in trouble. I haven’t heard of a debt free business going bankrupt. A business that needs increasing debt injections just to compete is not a good business.
Always look for the line item “Long-Term Debt” on the balance sheet. If this number is growing yearly while the Big Five numbers remain unimpressive, don’t even think about it! You’ll thank yourself in the end.
Removing Fear
So now that the you’ve concluded that the Four M’s and Big Five meet your criteria. Great! Then you’ll quickly realize an all too common reality for intelligent investors: The businesses that meet your criteria are not on sale. Remember, we are looking to buy “below retail” with the insistence on a margin of safety. What do we do? We put the business on a watchlist for later when it goes on sale. Philip Carret, a great investor in his own right was asked on TV what is the most important lesson he’s learned from his multi-decade career. In one word he answered: Patience.
Most of your biggest investment returns will be made in the waiting, not in the action of buying. If there’s nothing intelligent to do, it’s best to do nothing. You never know when, but at some point Mr. Market will give you the opportunity you’ve been waiting for. During these times the market is fearful. Will you have the courage to act?
The way to deal with fear is the following: As you see the price of your target company come lower and lower, towards your margin of safety price, make the decision to buy in chunks. You should only be investing in situations on which you have high certainty in anyway. As the price hits the margin of safety price, put in a quarter of your intended investment. Trying to catch a bottom is an attempt to time the market, so don’t aim to do so. If the price falls further, and there’s no news from the company, gradually keep increasing your buying in quarter chunks. This will push down your average buying price, and if you’ve done good valuation, your return will be phenomenal.
Small Difference in Price: Massive Difference in Returns
To illustrate, Lets say you have $10,000 to invest. You’ve determined the value of a company to be around $20. As the price hits $10, you make your first buy with $2500. The price drops further, now at $9, you buy a second time. A third time, the price falls to $8 and then finally down to $7. In each drop, you put a quarter of the intended investment capital to work. This gives us an average buying price of $8,35. Let’s assume your valuation was correct, and in three years, the stock is at its true value at around $20. What was your return on the $10,000? The answer: 33%. If your average buying price was $10, the return would be 26%, still awesome in its own right. But what difference does the small price difference make?
In the “worse” scenario, $10,000 (26%) turns into $20,000. A nice double.
In the better scenario, $10,000 (33%) turns into $23,526. This may not seem like a big difference, but this mental framework of buying is the secret into skyrocketing your returns. The added benefit is a much bigger margin of safety, and as you keep buying, fear should not be an issue since you’ve done your homework. The magic truly starts to work the more years you compound, and go from 6-figures and beyond. In a same example, $100K would turn into $200K and $235K respectively, a difference of an average annual salary. You are free to use your imagination what happens if the intrinsic value expands during your holding period.
Waiting For The Event
Even though a company may have a wonderful track record, at some point, it will run into what Phil calls “An Event”.
The event is a catalyst that sends the stock price down. The key is knowing how to differentiate between a short-term hurdle or long-term decline. Remember, institutions have short time horizons. If they know the company will not make the expected earnings for the upcoming year, they are forced to sell. This disturbance creates a situation with more sellers than buyers, pushing the price down. Since our time horizons are far longer, this is an opportunity to get in at a margin of safety price. The short-lived dive in March of 2020 is an excellent example of this. These events can happen in the entire market as a whole, but it happens far more frequently in individual companies and industries independent of how the broader stock market is performing.
Conclusion and “Critique”
To conclude, Phil Town is an excellent teacher. I honestly don’t have any personal critique regarding the books or his techniques, but I’ll force myself to write a few points which may be regarded as such.
- The books seem almost “too simple”.
To those who have been conditioned to believe investing is something to be avoided or left to “professionals”, Mr. Town’s advice may seem “too simple” to be real. Is it really this “easy”? At the end of the day, believe what you want to believe. Charlie Munger has said investing is “simple, but not easy“. Intelligent investing is a skill like any other, and I believe it’s learnable. But keep in mind, there is an entire industry with a lot at stake in keeping you unenlightened.
- The Temperament Question
Li Lu, another famous investor stated in a speech that maybe 5% of all market participants invest like value investors. The teachings, sound in logic as they may be, are difficult to put into practice when the time calls. Buffett has said that the most important quality in investing is not intellectual, but temperamental. If you don’t feel confident in your stock picking abilities or you’re uninterested in the subject, you should still park your money in index funds. But even with indexing, aim to buy them intelligently; buy more when the index is down and less when it’s hitting new highs. I recommend the S&P 500 for the long-term, but feel free to look at other options.
I’ve noticed a pattern with individuals in their interest in investing. The more they learn about it, the more interested they get in the subject. This is great, and I believe the starting point due to a lack of knowledge is the biggest first hinder. My journey started in 2016 with practically zero knowledge. I still have the same enthusiasm as I did at the start, and this blog is a testament to that.
So buy Phil’s books, check out his website, and subscribe to his Youtube channel!
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Sir John Templeton – Wisdom From Global Value Investing Legend
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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