The Stockpiling Approach to Stock Trading

In the September/October 2007 issue of Computerized Investing we highlighted the investing strategy outlined in Phil Town’s book “Rule #1” (Crown Publishers, 2006). Rule #1 investors seek out companies that offer a margin of safety by trading at a discount to calculated “fair value.” Town’s follow-up to “Rule #1,” the just-released book “Payback Time” (Crown Business, 2010), tries to benefit from the lessons learned from the market meltdown of late 2008 and early 2009.

Echoing many of the sentiments outlined with Rule #1, this book encourages investors to treat investments like they would a small business they owned. Town recommends very little diversification and buying more shares as prices fall (stockpiling). He advocates this as a long-term trading strategy based on the theory that if you are buying shares as the price falls, you need to have time to wait for the price to rise.

While Town has no real performance data to back up his strategy (aside from examples of successful trades made by Warren Buffett), it is an interesting idea that warrants a closer look. This article summarizes the principles in “Payback Time.”

Rule #1 versus Stockpiling

For those who have read Town’s first book, or the articles on it in previous issues of Computerized Investing, part one of this new strategy will sound very similar to the Rule #1 trading strategy. Town says the new approach varies in the timing of buying and selling stocks. Table 1 outlines the two strategies.

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Rule #1 recommended that traders follow “big mutual fund money” in and out of the market using stochastics, MACD and the moving average (see the feature article “Trading Rule #1 Stocks” in the July/August 2008 issue of Computerized Investing for a discussion of this trading strategy). Town calls Rule #1 a short-term strategy that requires little knowledge about individual businesses and industries.

Stockpiling is a long-term strategy where you need to know about a business and its industry. Town allows the purchase of stocks that do not meet all five of the Rule #1 Growth Criteria, which requires greater than 10% annual average growth in five figures: return on invested capital, equity (book value per share), sales, earnings per share, and free cash flow.

Town uses the Rule #1 concepts of sticker price and margin of safety in tandem with the newly introduced concept of “payback time” to evaluate stocks.

The sticker price is the “fair value” estimate of a company. It is calculated by first estimating future earnings by projecting current earnings forward 10 years using the lesser of the five growth criteria mentioned above, or analysts’ forecasted earnings growth rate (also called the Rule #1 growth rate). Then the future price-earnings ratio (P/E) is estimated by doubling the lesser of the company’s average historical price-earnings ratio or the Rule #1 growth rate. Finally, the forecasted future price is calculated 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). See Table 2 for an illustration of the formula.

Margin of safety says the current price should be no more than 50% of the sticker price.

Payback time is the amount of time it will take an investor to get his investment back. Town says that investors should expect a payback time of less than 10 years.

Step One: Find It

Using the same three M’s discussed in Rule #1 to identify companies (meaning, management and moat), Town screens a universe of stocks to narrow the field.

To find meaning, Town suggests finding where your talent, passion and money intersect. These will be the industries and sectors you will further research to learn about major competitors and trends. Most stock screening programs, including AAII’s Stock Investor Pro, allow you to search the database of stocks by industry and sector.

Next, Town suggests reading letters to shareholders and articles about CEOs and learning more about compensation packages to decide if the management component is in place. Town looks for CEOs who have “skin in the game,” who are passionate about their businesses and are honest with shareholders even when things are not going well.

Finally, a moat helps determine a company’s ability to maintain a competitive advantage. Town quantifies moat using the “Big Five Plus Debt.” That is, companies with a large (or wide) moat will have high return on invested capital (ROIC); high growth in forecasted earnings, sales, equity and cash; and low debt levels. (For more detailed descriptions of these data points, see the feature article “Rule #1 Stock Screening” in the September/October 2007 issue of Computerized Investing).

For the Stockpiling approach, Town is looking for most of the Big Five Elements Plus Debt criteria to be met. Big Five elements must be higher than 10% and debt levels must be able to be paid off in three years or less (long-term debt no more than three times free cash flow).

Companies to Avoid

Town discusses “red flags” that can eliminate companies from consideration. They include:

• a business with which you have limited knowledge;
• A business with no moat that has to compete on price—difficult to maintain over time;
• A CEO that is not a good leader, does not have a good vision for the future and does not take a financial interest in the company;
• A debt level that is too high;
• Companies that have to deal with trade unions (since their interest is only on the employees, no matter the impact on the company’s profits); and
• Technology companies—as a rule, Town avoids tech firms as their product cycle revolves around destroying one product to create another.

Step Two: Value It

Valuation of stocks is the most important part of Town’s process, but it is also the most difficult: The market value of a stock does not always match its “fair value.” You might find a wonderful company, but if the stock price is too high, you will not have a wonderful investment.

Town’s Rule #1 strategy looks for stocks trading at a 50% or more discount to their perceived “sticker prices.” This allows you to be “wrong” in your valuation, but still end up buying a stock at a discount. Town assumes that investors who use the Stockpiling approach have more industry knowledge and experience and can lower their margin of safety as they become better at the valuation system. However, he advises not going below 20% when discounting the sticker price.

A Rule #1 screen is already built in Stock Investor Pro, as well as fields based on Town’s sticker price. Modifying this screen to identify companies that meet at least four of Town’s six Big Five Plus Debt criteria and have a current stock price that is no more than 80% of the sticker price, we arrive at 42 companies using data as of January 15, 2010. Table 3 lists the 25 companies passing our Stockpiling screen with the lowest price as a percentage of sticker price. There does not seem to be much industry concentration among the top ranking stocks. Table 4 shows the screen criteria as used in Stock Investor Pro.

Using the Rule #1 Calculator

If you are not a subscriber of Stock Investor Pro, you can use a free Java-based calculator provided on Town’s Web site www.ruleoneinvesting.com to calculate sticker price (requires site registration). It requires you to plug in underlying variables to arrive at a sticker price. With data from the MSN Money Web site (money.msn.com), we used the free calculator to estimate the sticker price for FLIR Systems, a company that passed our Stockpiling screen. Table 2 shows the calculations performed.

Using Payback Value

Another way to value a stock is to look at it’s payback value.

FLIR has a market capitalization of $4.6 billion and trailing 12-month net income of $235.3 million with an estimated earnings growth rate of 17.4% per year (according to MSN Money). We want to see how long it will take FLIR to earn its value (market cap) by growing earnings at 17.4% per year. We do this for about 10 years, and then add the results.

The calculation shows that it will take nine years to make $5.14 billion, which is more than the current market capitalization. Town looks for a payback time of less than 10 years.

Data Source Variations

Looking at Table 2, you can see the sticker price for FLIR is calculated as $47.27 using MSN Money data. Why the difference from the sticker price of $57.03 in Table 3 using Stock Investor Pro data? Mostly it has to do with how certain numbers are calculated in Stock Investor Pro, such as average five-year price-earnings ratio. This variable is computed by averaging the annual high and low price-earnings ratios over the last five years. In addition, using Stock Investor Pro, the Rule #1 growth rate is calculated as the lesser of the “Big Five”: sales growth, equity growth, free cash flow growth, consensus estimated earnings growth, and returns on invested capital. Table 2 calculates the Rule #1 growth rate using historical and estimated earnings growth, mainly because it’s easier to find this data online.

Finally, the forward growth rates are slightly different due to data sources for consensus estimate data. This shows that your data source is important when calculating this information. It may be wise to use multiple sources to find multiple sticker prices and then choose a value within the range.

Step Three: Watch It

After you have evaluated all of the stocks you are considering for purchase, the next step is to create a watchlist. You can do this at AAII.com (www.aaii.com/myportfolio) and at many free financial Web sites, or in Excel.

Now you wait. Patience is the key as you wait for the stock to fall below your “stockpile price.” Town gives little guidance for choosing a stockpile price, generally saying it could be the margin of safety price, the payback time price, or even a price in between. However, it should never be higher than your margin of safety price. You must continue to pay attention to the stock by reading financial statements and press releases to be sure the fundamentals of a company have not changed.

You may have to adjust your stockpile price or calculate a new payback time value as the company announces quarterly financial results and the Big Five Plus Debt numbers change. If at any point the stock’s fundamentals change and it is not a good investment candidate anymore, Town counsels that you drop it from your watchlist and start over.

Step Four: Buy It

When the price falls below your stockpile price you buy it. The amount of money you invest is calculated as a percentage of the total amount you have to invest. Town recommends starting with 25% of your total capital for the first purchase because you will buy more as the price falls. This will lead to a highly concentrated portfolio, adding to the importance of your confidence in your analysis and knowledge of the company and its industry.

Town believes that a small initial capital investment spread among too many companies leads to high commissions that eat profits. He suggests owning very few stocks, which also makes it easier to stay on top of company developments. Town recommends having at least $20,000 available before you begin to diversify to multiple holdings.

Step Five: Own It

Town implores investors to stand firm and not sell just because the price falls. If you believe in your analysis and valuation, Town says you have nothing to worry about.

Step Six: Stockpile It

After you buy the stock, you must continue to monitor it and make adjustments to your valuations to know when (and if) you should buy more shares. You can change your stockpile price as you see fit, but it should always be below the margin of safety price, and the payback time should always be less than 10 years.

But, how do you know when the low price is low enough? What if you bought all of your stock, but the price moves even lower? Should you wait to buy to see if the price can go even lower, potentially missing out on the stock’s downward movement? Town uses two methods as aids during the stockpiling phase: monthly allocation of capital (MAC) and floors and ceilings (FAC).

Monthly Allocation of Capital (MAC)

This is a pretty simple method for stockpiling. Town suggests picking one day each month (i.e., the 10th) to purchase shares if the price is below your stockpile price. If it is not, do nothing and wait until the 10th of the next month. This method is good for investors with a small amount of capital to start.

Floors and Ceilings (FAC)

The floors and ceilings method uses price patterns to decide when to buy. A price floor is created when the price bounces up from the same price level, but does not break through it. A ceiling forms when a stock’s price reaches a level that it bounces up against, but does not break though. These are horizontal lines on a price chart. Eventually, the stock may break through the ceiling, turning it into the new floor (and so on).

Town also discusses trendlines and support and resistance. Trendlines are drawn diagonally on price charts to highlight price swings within a given price range due to supply and demand. Support is the price level at which demand is strong enough to prevent the price from declining further, while resistance is the price level at which selling is strong enough to prevent the price from rising further. Technical traders will use breakouts from these support and resistance lines as signals to buy and sell.

Town admits that it is hard to place trendlines and floors and ceilings on stock charts accurately, but that the more practice you have with it, the better you will become. In the end, he believes that as long as you have chosen an appropriate stockpile price, these tools are icing on the cake.

Step Seven: Sell It

Town gives only three reasons for selling your stocks:

1. Sell when you need the money.
2. Sell when the fundamentals change for the worse.
3. Sell when the price vastly exceeds an optimistic but realistic value.

Town points out that wonderful businesses sometimes become not-so-wonderful. However, this doesn’t happen overnight, which is why thoughtful analysis of the business and the industry is important. Monitoring the Big Five Plus Debt numbers is a good way to identify companies that are slipping.

Town tries to be conservative when valuing a company, yet he still builds in a margin of safety by buying at a discount to the sticker price. However, when he sells, he relaxes this valuation in order to let stock prices increase. He creates a new “seller price” following the same method he uses to arrive at the sticker price. This time he uses a price-earnings ratio that is at the optimistic end of the historical range along with an optimistic estimated growth rate. He also uses payback time to arrive at a price that would take 10 to 12 years to pay off, assuming his wonderful business grows fast. Once he has a seller price for his business, he sells when the stock price exceeds it by 20%.

Step Eight: Repeat Until Rich

This last step is fairly cheeky. The point is that when you have more funds for investing, you can continue to stockpile stocks you already own, or start from step one and find new companies for investment. However, Town is adamant about investing in very few companies and concentrating your investment dollars. He believes you only need to research and keep up with a few companies, and aim to become an expert along the way.

Conclusion

Phil Town’s new book is meant to be a strategy for the post-meltdown market—when good companies are on sale. His stockpiling tricks are not new; however, the approach is easier said than done. Buying more of a stock as the price falls requires nerves of steel and unwavering confidence in your analysis.

Investors may be leery of Town’s advice to minimize diversification as well. Putting all of your eggs (or in this case, your retirement money) in one basket could lead to disaster if your analysis proves incorrect or an unpredictable event strikes a company.