Rulers: 6 Critical Rule #1 Principles

RULE ONE INvesting LLC

RULERS: 6 CRITICAL RULE #1 PRINCIPLES

The following 6 principles come from the Rule #1 tradition of investing started by Ben Graham and David Dodd in 1930, carried on by Warren Buffett and Charlie Munger from the 1950’s to today and currently practiced by hedge fund managers like Bill Ackman, David Einhorn and Mohnish Pabrai, in my view among the best investors in the world. These principles delineate the strategy of the few professionals who can show audited returns in excess of 20% a year for this last decade. Rule #1® says to invest only when you know you aren’t going to lose money and these six principles are always at the front of my mind to help me avoid violating The Rule.

1. RATIONAL: Stay Rational

Easier said than done when you are investing real money. Money you can't afford to lose tends to be 'hot' or emotional. Pro gamblers try to avoid sitting down with more than they can lose but anyone investing all of their own hard-earned money is always sitting down with more than they can lose. Fear of losing more than you can afford to lose tends to make the mind go irrational. You start guessing. You can't tell the difference between a good idea and a bad idea. Investing decisions are not life and death decisions (unless you've embezzled $100 million or so) but still, remaining rational in the face of intense emotions is an art that is learned in the trenches. They don't teach this at business school because they can't generate real emotions in a classroom setting. Staying rational is an art that the best investors in the world have learned. They have the ability to separate their emotions, block them off and operate on pure reason. If A, then B. If B, then C. Therefore, if A, then C. Using our rational mind is a huge advantage in a marketplace that dominated from time to time by irrationality.

2. UNDERSTAND: Stick With What You Know

Warren Buffett calls this his ‘Circle of Competence’. You have to focus your attention on industries that you are comfortable with. Imagine that you’re going to actually own and operate a business. Could you do that in the industry you’re thinking of making an investment in? If not, seriously consider doing a lot of reading and digging before you jump in on a new stock investment in an unfamiliar industry. Use the Three-Circle Exercise on the www.ruleoneinvesting.com website to help you find the industries you already know a lot about. Those industries are a great place to focus and from that beginning you can expand your own ‘circle of competence’ over time. Or, for a great shortcut, simply find out what the great Rule #1® investors are buying and then 10Ks and analyst reports on that company and its competition. Do that and you’ll be an expert in a few weeks.

When doing your research, follow the 4M’s: Meaning, Moat, Management and Margin of Safety. We want to understand the industry, have a durable competitive advantage, a CEO who is honest, stakeholder oriented and passionate about his Big Audacious Goal and we want to buy with a big discount to the real value of the business.

3. LOVE: Put your money where your values are

Most of us have the intention of being good people and making the world a better place but most people forget that how they invest their money is a huge vote for the values of the businesses that get the money. If you don’t think your money vote counts, think again: 85% of the money in the stock market is ‘little guy’ money, our money, from our 401(k), IRA, KEOUGH and 529 Plans. The money you leave in those retirement plans is managed by people who don’t know what you value or how you want the world to look in 20 years; they are going to vote for what they hope will make money. Almost without exception, ‘morality’ is not an item on the fund manager’s checklist. They consistently vote for CEO’s who have jacked up their payday at the expense of their employees, they assume if its legal its moral, their ‘long term’ investing horizon is calculated in weeks, not years. However, the money they invest is a big part in determining the winners and losers of the future; in business, its not the best company that wins, its the one that gets the money.

We believe you should vote for the future you want to see by putting your money into businesses you love, companies you understand, run by a CEO you admire. Investing your money with love and rationality turns investing from a job into a passion, makes you an involved and focused investor and can have a big impact on your portfolio rate of return.

4. EVENT: Buy Fear, Sell Greed

An “Event” is an unexpected change in the world that creates uncertainty about the short-term future earnings of a business. Uncertainty creates fear. When prices of stocks are set by the most fearful or the greediest investors, those who are fully in the sway of emotion, it’s clear that the market prices are often far from rational. The big players in the market - mutual fund managers, pension fund managers, insurance fund managers and bank fund managers - are not the most cold-blooded rational creatures on the planet. Many of them got their jobs by political pull or a streak of good luck rather than any particular investing expertise. Their jobs depend more on raising money than making it. They’ve learned to follow 'tried and true' investing strategies like diversification and rebalancing, strategies that guarantee mediocrity and market returns but which trickle off the tongue of the fund salesmen and administrators sweet as honey. But when a stock begins to crash they stampede like the cattle they are because they know their only salvation lies in getting out before the rest of the herd. Losses don't matter; only losses greater than the rest of the herd matter. Staying in the middle of the herd means safety; lose money, but don't lose more than most and you'll be okay. Your job is to buy from the herd as late in the stampede as you can manage. Wait for an Event. Wait for the price drop. Buy fear. Sell greed.

5. REDUCE BASIS: Get your money off the table

This is the unsung hero of the Rule #1 saga: You can lower your basis (the money you have in this investment) with ‘return OF capital’ cash flow strategies from dividends or buybacks or derivatives. The less money you have on the table, the lower your risk of being wrong. If I buy KO at $32, sell puts and calls as appropriate and take the dividend in cash, within five years it’s likely I can drive my basis down to $23. In that time, the dividend will rise from $1 to $1.60. The ROI on the money I still have in the investment becomes $1.60/$23; about 7%. In tenth year the dividend is likely to have risen to $2.60, my adjusted basis (what I have left on the table after return of capital from dividends and derivatives) might be about $12 and the return on my cash goes to 21%. And each year thereafter the basis goes down as the cash comes in and the return on remaining cash goes up. When my basis goes to zero, where is my market risk? If I start spending the money to live on instead of reinvesting it, then the basis stays the same but the return still goes up because KO increases its dividend every year by 10% and I can usually sell a LEAPS put for more return of cash. In essence, I’ve created for my retirement a kind of special bond – one that is backed by one of the best companies in the world and yet pays out based on an ever increasing coupon rate, one that within ten years is over 20% a year and rising. No retiree with his money in that sort of a long bond will ever have to fear the effects of inflation on a fixed income because his income is rising faster than any sustainable inflation rate and his money is denominated in shares, not currency. Reduction of basis gets us to nirvana for our future retirement portfolio.

6. STORY: Create A Great Story

Every great investment begins with a great story. A ‘story’ in Rule #1® investing is a kind of thesis about why this is a great business, why it’s on sale and why we are entering the investment with a specific strategy. ‘Story’ is critical because I can evaluate my story to see if it’s rational and if I have a company I understand, that I love, that is on sale from an Event and that I can get a fast return of capital from basis reduction strategies. Story is critical because if and when the story changes, then my investment reasoning and rationale may no longer be true and that means I ma may have to get out.

Rational, Understand, Love, Event, Reduce, Story. RULERS. Keep these six principles in mind the next time you are tempted to get emotional and follow the crowd into the hot stock you know nothing about. Or worse, you give your money to someone else just to make money and not for the love of the business and the people who are in it.

NOW GO PLAY!