Rule #1 Stock Screening

While there have been numerous successful value investors throughout the years, Warren Buffett is probably the most famous. According to Mr. Buffett, there are only two rules to investing: Rule #1: Don’t lose money, and Rule #2: Don’t forget rule #1. In a new book, “Rule #1” (2006, Crown Publishers), author Phil Town lays out an investment strategy that attempts to follow Mr. Buffett’s rules.

In this article we develop and apply a stock screen based on Town’s book “Rule #1.” Also, additional information on the Rule #1 methodology, including the backtesting results of our use of this screen, will appear in the October 2007 issue of the AAII Journal.

The Philosophy

A former green beret turned river guide, Phil Town was introduced to Rule #1 investing by a client who was almost killed during one of his guided river trips. Following the Rule #1 approach to investing, Town says he turned $1,000 into $1 million within five years.

The key, according to Town, is to purchase “wonderful companies” at attractive prices. Armed with the principles of Rule #1 investing and the array of quality free financial data and tools on the Internet, Town believes individual investors can easily outperform the market with just 15 minutes a week. Table 1 summarizes Town’s Rule #1 investing approach.

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Defining Wonderful Companies

Being able to obey Rule #1 of investing—not losing money—comes from “buying a wonderful business at an attractive price.” Wonderful, according to Town, is a subjective term. Wonderful businesses are those that follow Town’s “Four Ms”:

 

• meaning,
• moat,
• management, and
• margin of safety.

Meaning

Town feels that a company can only hold meaning to investors if they are willing to make that business their sole source of financial support for the next 100 years. To make this judgment requires a knowledge of what the company does and who is running it.

However, this does not mean you need to have detailed knowledge of the company’s manufacturing and distribution process. To find companies that may hold meaning for you, Town suggests looking at companies related to your work or hobbies and interests.

Table 1. Phil Town's Rule #1 Investing in Brief

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 See Member Benefits » Take a peek at all the member benefits AAII has to offer. AAII is a nonprofit association dedicated to investment education. 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 large portions of their holdings. Use technical analysis and charting tools 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%. Town states that there are only two times to sell: 1) when the business ceases to be “wonderful,” or 2) when the share price rises above the “sticker price” (fair value). Using technical analysis, Town trades in and out of companies until it is a true sell.

Moat

A moat for a company is similar to that surrounding a castle, but in this case is constructed of some minimum financial requirements. Companies with wide moats are better positioned to defend themselves from competitors. Furthermore, Town feels that wide moats make it easier to predict a company’s long-term prospects. As a rule, companies with wide moats also tend to be well known and among the top companies in their industry. If an industry is difficult to enter—has high barriers to entry—this is another means of protection for a company.

Most important, however, when searching for companies with wide moats, is to find companies that will be able to maintain that wide moat. A little later, we will discuss how Town identifies companies with wide and sustainable moats.

Management

Since Town takes the viewpoint that your investment in the wonderful business will be your sole means of financial support for the next 100 years, you need to have confidence in the people running the business. Town looks for CEOs who are owner-oriented and driven. He cites Microsoft’s Bill Gates and Berkshire Hathaway’s Warren Buffett as two archetypal owner-oriented corporate leaders.

All else being equal, Town believes an easy way to identify an owner-oriented CEO is by their attitude toward receiving stock options as part of their compensation. Refusing to accept stock options, Town feels, signals to shareholders that the CEO has a long-term view for running the company.

Another way to learn about a CEO’s attitude is by reading the annual letter to shareholders. While not every chief executive is as candid in the annual letter as Warren Buffett, Town does not want a CEO who whitewashes what happened over the last year. In Town’s opinion, owner-oriented CEOs will tell shareholders what went wrong in the last year, whose fault it was, and what they hope to do about it in the current year.

Margin of Safety

The first three Ms help investors to identify wonderful companies, which is the first step to Rule #1 investing. The other side of the coin is to buy these wonderful companies at attractive prices. This is where margin of safety comes into play.

As most investors know, there is sometimes a difference between how much something costs and its true value. Investing with a margin of safety forces us to quantify a company’s value and then buy it at a sufficient discount. In effect, the margin of safety is our investing life jacket. Even if our initial analysis was wrong and a company we buy turns out to be not-so-wonderful, buying a stock with a margin of safety protects us from losing money.

Screening: Rule #1 Investing

In establishing the Rule #1 approach, Town laid out a set of criteria that would help investors identify “wonderful companies”—those with meaning, a wide moat, and solid management—at a reasonable price—trading at less than 50% of their fair value or “sticker price.” Table 2 presents the approach for our Rule #1 Investing screen.

AAII’s Stock Investor Pro fundamental stock screening and research database program was used to perform the screening for this article. As of August 17, 2007, the database included 8,906 companies.

Table 2. Translating Style Into Screening: Rule #1 Investing

Exchange-Listed Town recommends investing in companies with sufficient liquidity; something many OTC stocks lack. Therefore, we omitted OTC stocks from our search. In addition, exchange-listed companies meet the listing requirements for the various exchanges, which establish minimums for company size, share availability, and financial strength. Non-ADRs ADRs, American depositary receipts, are securities typically issued by a U.S. bank in place of the foreign shares of a company held in trust by that bank. ADRs facilitate the trading of the shares of foreign companies in U.S. markets. Town does not explicitly state that he avoids ADRs, but oftentimes there are special tax and unique reporting issues related to foreign companies that may complicate matters. Therefore, we omitted ADRs from our search. Return on Invested Capital (ROIC) Learn More » Learning something new? AAII is a nonprofit association dedicated to investment education. Take a peek at all the member benefits AAII has to offer. The average annual ROIC over the last 10 years should be at least 10%. Most screening programs do not offer data going back 10 years. We looked for average annual ROIC of at least 10% over the last five years. We created a custom field for ROIC based on Town’s definition. Equity Growth The compound average annual growth rate in equity (or book value per share) over the last 10 years should be at least 10%. Most screening programs do not offer data going back 10 years. We looked for an average annual growth rate in equity of at least 10% over the last five years. This type of growth rate calculation will not be found in most screening programs, but you may be able to calculate the field yourself if the program allows for custom fields. We created a custom field for equity growth requiring positive common equity for the beginning and ending periods. Sales Growth The compound average annual growth rate in sales (revenue) over the last 10 years should be at least 10%. Most screening programs do not offer data going back 10 years. We looked for a compound average annual growth rate in sales of at least 10% over the last five years. Earnings Growth The average annual growth rate in earnings per share over the last 10 years should be at least 10%. Most screening programs do not offer data going back 10 years. We looked for a compound average annual growth rate in earnings per share from continuing operations of at least 10% over the last five years. Earnings from continuing operations provides the best indication of what the firm will earn going forward and excludes extraordinary, one-time charges companies sometimes use to manage earnings. Free Cash Flow Growth The compound average annual growth rate in free cash flow over the last 10 years should be at least 10%. Most screening programs do not offer data going back 10 years. We looked for a compound average annual growth rate in free cash flow per share of at least 10% over the last five years. See Member Benefits » Take a peek at all the member benefits AAII has to offer. AAII is a nonprofit association dedicated to investment education. Debt Town wants companies that can pay off their long-term debt with their current annual free cash flow within three years. This type of ratio will not be found in most screening programs, but you should be able to calculate the field yourself if the program you use allows for custom fields. Margin of Safety Town feels that the current price should be no more than 50% of the current “sticker price.” The sticker price is the “fair value” calculated by first estimating future earnings by projecting current earnings forward 10 years using the lesser of ROIC, equity growth, EPS growth, sales growth, free cash flow growth, or the analysts’ forecasted EPS growth rate (the Rule #1 growth rate); then estimating the future price-earnings ratio by doubling the lesser of the company’s average historical P/E or the Rule #1 growth rate; and finally calculating the forecasted future price by multiplying the future price-earnings ratio by the future earnings per share. The sticker price is the future price discounted back 10 years at 15% (Town’s minimum annual rate of return). This field will not be found with any popular screening programs. It is also unlikely you will be able to create this field yourself given its complexities.

Wide, Sustainable Moats: The “Big Five”

One of the things Town looks for in a company is a wide moat—something that will protect it from competition as well as make its future performance more predictable. However, in order for a wide moat to be useful to a company, it must also be sustainable in the long run. A company with a wide, sustainable moat is less likely to go out of business than a company without one.

To find companies with sustainable moats, Town uses five pieces of financial data, which he calls the Big Five numbers. They are:

• return on invested capital (ROIC),
• equity, or book value per share (BVPS) growth,
• sales growth,
• earnings per share (EPS) growth, and
• free cash flow (FCF) growth.

ROIC

In Town’s opinion, return on invested capital (ROIC) is the most important of the Big Five numbers. It is the rate of return a business makes on the money it invests in itself each year. Town defines ROIC as:

 

Net Operating Profit After Taxes (NOPAT)
Equity + Debt

 

NOPAT is simply operating income less taxes. It is different from net income in that it does not consider interest expense.

Town states that a strong ROIC is an indication that the company’s management is on the side of its owners. Town requires that all of the Big Five figures should be at least 10% per year for the last 10 years. However, most screening programs on the market today only cover five or seven years of financial statement data.

The screening package you are using may or may not include ROIC. If it does, the figure may not be calculated in the same manner described here. However, if your screening program allows you to create custom fields, you may be able to recreate it. Our screen looked for an average ROIC over the last five years of at least 10%.

Equity Growth

Equity is what the company would have left if it were to sell off all its assets and pay off all its liabilities using the account value on the books. Town also refers to equity as the book value or liquidation value of a company. In addition, book value (equity) can be viewed in the context of “retained earnings.” Companies create equity by issuing stock or by being profitable and not paying out profits as dividends.

Companies that grow book value normally do so by being profitable and retaining earnings. As retained earnings increase, companies can use this “surplus” (as Town calls it) to increase their market share or develop new products. While most screening services will include equity or book value per share, it is unlikely that they will calculate the growth of these balance sheet items. However, you should be able to create a custom field if your screening service offers this functionality.

Our screen looked for compound average annual equity growth of at least 10% over the last five years.

Sales & Earnings Growth

While oftentimes company analysis only focuses on the bottom line—what the company earns—Town reminds us not to forget that the top line—sales or revenues—powers the bottom line.

For both sales and earnings growth, Town again requires compound average annual growth of at least 10% over the last 10 years. Both earnings and sales growth should be available in the majority of screening services. However, many will only offer growth data covering the last three or five years.

Our screen looked for compound average annual growth rates for both sales and earnings per share of at least 10% over the last five years.

Free Cash Flow Growth

Cash flow growth helps to determine whether a company is increasing its cash position with its profits or has only paper profits. Free cash flow is what a company has left over from cash flow from operations after covering all of its expenses, including capital expenditures (buying new equipment, etc.). Depending on the definition you use, free cash flow may also be after the payment of dividends. Town, on the other hand, says that free cash flow is what the company has left over to pay dividends or to grow its business.

Our screen looked for compound average annual free cash flow growth of at least 10% over the last five years.

Debt

While he doesn’t make it one of the Big Five numbers, Town says that it is important that a company’s debt level is not too high. Rule #1 investors are trying to find stable, predictable companies. For companies saddled with a high debt load, a downturn in the economy or any other “blips” could force the company to sell off assets to cover its debt obligations, which could have a negative impact on the company’s future.

Ideally, Town would like companies to have no debt, but he is more interested in whether a company can pay off its debt quickly. As a rule, then, he feels that a company has a “reasonable” level of debt if its current annual free cash flows can pay off its long-term debt obligations within three years. In other words:

Long-Term Debt    Annual Free Cash Flow

3

It is doubtful that any screening service you may use would offer such a screening variable. However, it is a fairly straightforward calculation using popular data points, so you should be able to create a custom field (if your screening program allows you to do so).

Our screening required companies to have long-term debt for the most recent fiscal quarter that is no more than three times its free cash flow for the last four quarters (trailing 12 months).

Calculating the MOS Price

Once an investor finds a company that satisfies Town’s 10% requirement for the Big Five numbers and has a reasonable level of debt, he must now make sure it satisfies the last M of investing—margin of safety: Buy a dollar of value for no more than 50 cents. This margin of safety, it is hoped, will protect investors if the company turns out to be not-so-wonderful.

In order to arrive at Town’s margin of safety (MOS) price, an investor must first determine the “true” value of the company—the “sticker price.” From there, the MOS price is merely one-half the sticker price.

Sticker Price

To arrive at the sticker price, Town uses four pieces of information:

• current earnings per share (EPS),
• estimated EPS growth rate,
• estimated future price-earnings ratio (P/E), and
• minimum acceptable rate of return from this investment.

Current EPS

The first piece of information we need is the company’s earnings per share (EPS) for the latest 12 months (last four fiscal quarters), which is readily available at any number of financial Web sites. The current value of a company—as reflected in its stock price—is based on expectations of the company’s future earnings power. When calculating the sticker price, we want to know what the earnings per share will be in 10 years. Town bases this estimate on the current annual EPS and the estimated EPS growth rate.

Estimated EPS Growth Rate

Frequent investment disclaimers warn that past performance does not guarantee future performance. However, past performance provides perhaps the best indication of what may happen going forward. Therefore, when trying to predict future earnings growth—what Town terms his Rule #1 growth rate—Town looks at the Big Five numbers as a guide. However, he believes that the best indicator of future earnings growth is not the historical earnings growth rate. Instead, he gives priority to the historical annual growth rate in equity. Citing Benjamin Graham and Warren Buffett, Mr. Town explains that companies that are not able to grow their equity, or “surplus,” will not have the funds to expand their market share or to develop new products.

He looks at all the Big Five numbers, looking for consistency among the growth rates and a level of growth that the company can sustain over time. He also takes into account the earnings growth forecasts of analysts. However, throughout his book, the decision typically rests between the historical annual equity growth rate and the analysts’ forecasted earnings growth rate. For the sake of conservatism, Town uses the lower of the two and this is what he calls the Rule #1 growth rate.

With the current EPS and Rule #1 growth rate, investors can estimate what the company’s earnings will be in 10 years. Remember, earnings will be compounding over the period, such that:

Future EPS (in 10 years) = EPS 12m × [1 + (Rule #1 Growth Rate ÷ 100)]¹⁰

 

Estimated Future P/E

The next step is to estimate the multiple of earnings per share to assign a given company 10 years from now. Companies that the market thinks are going to grow rapidly tend to have high price-earnings ratios (P/Es). Likewise, the market sees little growth prospects (or higher risk) for companies with low P/Es. When trying to forecast a company’s future P/E, Town wants one that is “just right”—not too high, not too low.

Town compares a “default” P/E to the company’s average historical P/E and, again, uses the lower of the two as the estimated future P/E. He calculates the default P/E by doubling the Rule #1 growth rate. Therefore, if we believe a company’s earnings will grow by 10% a year for the next 10 years, according to Town we can also expect its P/E ratio to be around 20 in 10 years. The key assumption here is that the company will continue the rate of growth over the next 10 years.

In his examples, Town used the five-year average P/E and compared this to the default P/E. The lower of the default P/E or the historical P/E is used as the Rule #1 P/E.

Future Market Price

With the future earnings per share and the future price-earnings ratio, Town calculates the future market price using this common investment formula:

P/E × EPS = Price

Minimum Acceptable Rate of Return

Town expects a minimum annual rate of return of at least 15% from his investments. The sticker price is the maximum price we can pay for a stock and still get this minimum 15% annual return over the next 10 years. Therefore, he uses 15% to discount the future market price back 10 years to arrive at the sticker price. The formula is as follows:

Sticker Price

=

Future Market Price           (1.15)10

Margin of Safety

The final piece of the puzzle is the margin of safety (MOS) price. The margin of safety protects an investor in the event a wonderful company is, in fact, not quite so wonderful. Therefore, Town does not want to pay more than 50 cents for every dollar of a company’s value.

To calculate the margin of safety price, Town divides the sticker price by two:

MOS Price

=

Sticker Price           2

Given the complexities of arriving at the MOS price, you may have a hard time calculating it even if your screening service allows you to create custom fields.

Our screen looks for companies with a current stock price that is no more than 50% of the sticker price. The securities passing all of the filters of our Rule #1 investing screen as of August 17, 2006, are presented in Table 3.

An example of the various data calculations using one of the current passing companies, Travelzoo Inc. (TZOO), is provided in Table 4.

 

Table 4. Rule #1 Data Calculations for Travelzoo Inc.

Calculating ROIC for the last five years and the average ROIC over the last five years:   Y1 Y2 Y3 Y4 Y5 Income Statement                                                                                                Gross operating income ($ mil) 29.7 14.9 11.1 3.7 1.4 Income tax ($ mil) 14.2 7.9 5.1 1.7 0.6 Balance Sheet                                                                                                       Short-term debt ($ mil) 0.0 0.0 0.0 0.0 0.0 Long-term debt ($ mil) 0.0 0.0 0.0 0.0 0.0 Equity (common) ($ mil) 36.8 48.5 40.3 3.8 1.8 ROIC        =                        Gross operating income – Income tax                    Equity (common) + Short-term debt + Long-term debt × 100 ROIC Y1 = [(29.7 – 14.2) ÷ (36.8 + 0 + 0)] × 100 = 42.1% ROIC Y2 = [(14.9 – 7.9) ÷ (48.5 + 0 + 0)] × 100 = 14.4% ROIC Y3 = [(11.1 – 5.1) ÷ (40.3 + 0 + 0)] × 100 = 14.9% ROIC Y4 = [(3.7 – 1.7) ÷ (3.8 + 0 + 0)] × 100 = 52.6% ROIC Y5 = [(1.4 – 0.6) ÷ (1.8 + 0 + 0)] × 100 = 44.4% ROIC 5-yr avg = (ROIC Y1 + ROIC Y2 + ROIC Y3 + ROIC Y4 + ROIC Y5) ÷ 5 ROIC 5-yr avg = (42.1% + 14.4% + 14.9% + 52.6% + 44.4%) ÷ 5 = 33.7% See Member Benefits » Take a peek at all the member benefits AAII has to offer. AAII is a nonprofit association dedicated to investment education.     Calculating the five-year compound average growth rates for sales, EPS, equity, and free cash flow:   Y1 Y6 Sales ($ mil) 69.50 6.10 EPS-Continuing ($/shr) 1.08 0.02 Equity (common) ($ mil) 36.80 0.90 Free cash flow ($/shr) 1.03 0.03 Compound avg annual growth rate = {[(Ending value ÷ Beginning value) ^ (1 ÷ # of years)] – 1} × 100 Sales compound avg growth rate = {[(69.5 ÷ 6.1) ^ (1 ÷ 5)] – 1} × 100 = 62.7% EPS-cont compound avg growth rate = {[(1.08 ÷ 0.02) ^ (1 ÷ 5)] – 1} × 100 = 122.1% Equity compound avg growth rate = {[(36.8 ÷ 0.90) ^ (1 ÷ 5)] – 1} × 100 = 110.1% FCF/shr compound avg growth rate = {[(1.03 ÷ 0.03) ^ (1 ÷ 5)] – 1} × 100 = 102.8%   Calculating long-term debt-to-free-cash-flow:   Long-term debt Q1 ($ mil) 0.00 Free cash flow 12m ($/shr) 1.01 Average shares outstanding Q1 (mil) 15.25 Long-term debt-to-free-cash-flow per share = (Long-term debt Q1 ÷ Average shares Q1) ÷ Free cash flow per share 12m Long-term debt-to-free-cash-flow per share = (0.00 ÷ 15.25) ÷ 1.01 = 0.0   Calculating the sticker price: 1) EPS-continuing 12m ($/shr) 1.03     2) Rule #1 growth rate 20.0% <-- The lower of the historical equity and estimated EPS growth rates   Hist. equity compound avg growth rate 110.1%     Est. EPS growth rate (I/B/E/S) 20.0%     3) Future EPS (in 10 years) ($/shr) 6.38     EPS Y10 = EPS 12m × [1 + (Rule #1 growth rate ÷ 100)] ^10   EPS Y10 = 1.03 × [1 + (20 ÷ 100)] ^10 = 6.38   4) Estimated future P/E (x) 40 <-- The lower of the default P/E and the avg. historical P/E   Default P/E (Rule #1 growth rate × 2) 40     Avg. 5-yr historical P/E) 101     5) Future market price $255.20     Future market price = Future EPS × Estimated future P/E   Future market price = 6.38 × 40 = $255.20   6) Sticker price $63.08     Sticker price = Future market price ÷ [1+ (Minimum required annual return on investment ÷ 100)] ^ 10   Sticker price = $255.20 ÷ [1 + (15 ÷ 100)] ^10 = $63.08   Current stock price (8/17/2007 close) $17.20 Current price as % of sticker price 27.3 <-- Must be 50% or less to provide adequate margin of safety

Rule #1 Investing Screening Criteria for Use With AAII’s Stock Investor Pro
Data Category	Field	Operator	Factor	Compare to (Field, Value, Industry)
Company Information	Exchange ADR/ADS Stock	Note Equal Is False		Over the counter
Growth Rates	EPS Cont-Growth 5yr Sales-Growth 5yr Free Cash Flow-Growth 5yr	>= >= >=		10 10 10
Custom Fields*	ROIC-Avg 5yr Equity (Common)-Growth 5yr LT Debt-to-FCF Price	>= >= <= <=	0.5	10 10 3 Sticker Price
*A text file of the Custom Fields for use in Stock Investor Pro is available for download from ComputerizedInvesting.com at: www.aaii.com/ci/200709/rule1customfields.txt.