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My recommendation: 7/10

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Summary of notes and ideas

After 10 years of investing and reaping 15 percent a year, Doug loses half his money in a market crash. Susan, a Rule #1 investor, does not. She then teaches Doug about Rule #1, and from the end of the tenth year onward, they both manage to make 15 percent a year. Twenty years from now, Doug has $420,000; Susan has $840,000. This means Doug has $63,000 a year to live on while Susan is living comfortably on $126,000 a year. The permanent $63,000-per year difference in annual income 20 years later is Doug’s one-time violation of Rule #1.

As Rule #1 investors, we’re going to own only a few businesses. Since that’s the case, we must prepare ourselves to be certain we own the right few businesses—businesses that won’t lose our money.

Obviously, you want a company that will be a winner—a business that will continue to grow for decades into the future. But if you can’t predict with a high degree of certainty that it’ll be a winner, then its future isn’t predictable, and as a Rule #1 investor, you don’t buy a company with an uncertain future.

This chapter begins a learning process that will enable you to know if a business will succeed and continue to perform well for at least the next 20 years. For a company to have that degree of predictability, it must possess some sort of lasting competitive edge, or, as Mr. Buffett puts it, a “durable competitive advantage that protects it from attack, like a moat protects a castle.” In other words, we’re looking for a business that has a great big, wide, hard-to-get-across-and-attack-the-castle Moat. We want massive protection from the attacking competitors who want a piece of the action.

A company with a wide sustainable Moat is much less likely to go out of business than a company without one. Its earnings are also much more predictable over the long term. Therefore, companies with sustainable Moats make for more predictable investments.

But remember, we don’t buy stocks, we buy businesses. As business buyers, we must understand that there are many forces affecting stock prices—forces that often have nothing to do with the quality of the company or the width of its Moat.

Remember: All of these Big Five numbers should be equal to or greater than 10 percent per year for the last 10 years. We must also look at the five-year and one-year numbers, and compare those to the 10-year numbers to make sure business isn’t slowing down.

Return on investment capital (ROIC) is the rate of return a business makes on the cash it invests in itself every year. For example, let’s say your kids finance a lemonade-stand business with $200 to get it up and running. Their “investment capital” is the $200. After a week, the kids come back in the house with $300. After subtracting their expenses of $200 they paid for supplies, salaries, and flyers they made at Kinko’s, their profit is $100. Their ROIC is their profit divided by their invested capital. In this case they did great: $100 divided by $200 is 50 percent.

ROIC is not the only number we need to look at to confirm we have a company with a very wide Moat. We also need to know that the business is growing for the benefit of us, the owners. For that information, we have to look at four growth rates: (1) sales growth rate; (2) earnings per share growth rate; (3) equity growth rate; and (4) free cash growth rate.

Equity alone isn’t nearly as revealing as equity growth rate, which is why we focus more on the growth rate than on the numbers from which we derive the growth.

In the 1934 edition of Security Analysis, author Benjamin Graham explains that most businesses are not able to accumulate much of an equity surplus because they spend everything they earn to maintain the status quo by replacing and/or keeping up with what they need to stay in business (equipment, R&D, and so on). Noting this, Warren Buffett began looking for the exception: a business that accumulates more and more surplus every year. Finding these exceptions is the key to Rule #1 investing, so we look for businesses that accumulate surplus. That’s why we track equity growth; it’s a very good sign that the business is exceptional. Equity, or book value per share, is also an excellent indicator of the long-term growth of what Mr. Buffett calls intrinsic value and what I call the “Sticker Price”—the rational value of a business. In the Berkshire Hathaway chairman’s letter of February 2005, Mr. Buffett writes, “Despite their shortcomings, yearly calculations of book value are useful at Berkshire as a slightly understated gauge for measuring the long-term rate of increase of our intrinsic value.”

But businesses can manipulate those ratios for lots of good and bad reasons. It’s better to just know how long it would take to pay the debt off, and keep that number reasonably conservative.

The Rule on Debt: To determine whether a business’s debt is reasonable, find out if it can pay off its debt within three years by dividing total long-term debt by current free cash flow.

While I don’t consider debt the “sixth number” to evaluate, you’ll want to consider debt when you’re reviewing the financial strength of a business. Besides, you’ll come across debt numbers when you’re looking at the balance sheet and wonder what to do with them. Once you’ve said yes to the Five Numbers, go ahead and make sure the debt load is reasonable. Simply divide a company’s total long-term debt by its current free cash flow.

Paying dividends is not an indication of slow growth or fast growth. It’s just a choice being made by Management about how best to manage the owners’ cash. Many fast-growth companies do pay a dividend. Whether a company pays a dividend should have no bearing on how you apply Rule #1.

Consistent growth rates and a solid ROIC allow us to put this business forward as a candidate for our approval. At least with good historical consistency we can hope for a steady future based on expectations that the business will continue to do what it’s been doing. We can continue investigating Garmin because it has a stable past. In GM’s case, it has a persistently bad past. Hoping that GM will stop doing what it’s been doing and become a completely different business requires too much faith in GM’s claim that it sees a bright future for itself.

Consistent growth rates and a solid ROIC allow us to put this business forward as a candidate for our approval. At least with good historical consistency we can hope for a steady future based on expectations that the business will continue to do what it’s been doing. We can continue investigating Garmin because it has a stable past. In GM’s case, it has a persistently bad past. Hoping that GM will stop doing what it’s been doing and become a completely different business requires too much faith in GM’s claim that it sees a bright future for itself.

Warren Buffett clarifies this point when he describes how an owner-oriented CEO should run his business. As he said in his 2004 shareholder letter, “My message to [the CEOs] is simple: Run your business as if it were the only asset your family will own over the next 100 years.”

Once you’ve read the articles, read his or her annual letters to shareholders on company websites. Again, you’re looking for a CEO who’s telling you what you need to know. They usually put their BAG in their letters, too. After you read the articles and letters, you have to decide whether it’s all talk or whether they’re walking the walk.

A business’s annual report is required to disclose options deals to owners. Look in the index to the financial statements under the heading “Notes to the Consolidated Financial Statements.” Simply scroll down to near the end of the notes and you’ll find a section called “Stock Options.” That’s where you can read about how a business structures its options. This level of evaluating a business is more for advanced Rule #1 investors, however. As a beginner, don’t feel as if you need to understand options and how they should be structured within a company. At a basic level, check to see if the business structures a logical and appropriate “strike price” (the fixed price at which a company official who owns options can buy the stock during a set period). It should reflect success for owners. And, second, see if the company enforces a ban on the CEO quickly disposing of any shares purchased through options, thereby helping to ensure that the CEO sees the world as a long-term owner. Your goal in conducting this type of analysis is to filter out any business being run by a bunch of mercenaries who’re in it for the quick buck.

And here is what Ben Graham said about 50 years earlier: “In the short run the stock market is a voting machine but in the long run it’s a weighing machine.” This is Warren Buffett: “The basic ideas of investing are to look at stocks as businesses, use market fluctuations to your advantage and seek a Margin of Safety. That’s what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing.”

But still, the goal of every Rule #1 investment is to never sell. Don’t lose sight of this concept, since it’s part of the mindset you must adopt for purposes of finding and buying wonderful companies.

A good rule of thumb for dealing with a bouncy free cash flow is the following: If, during your analysis of a potentially wonderful company, its free cash flow is either all over the board, or has recently taken a dive, check out the company’s “Operating Cash Flow,” which will also be on the Cash Flow Statement. Operating cash flow is the cash the business creates from profitable operations before it buys equipment that it needs to replace or pays out a bunch of money in dividends. You want to see its operating cash flow growing from year to year. While free cash flow can jump around as the Management decides to put more or less money into capital projects, operating cash flow should be more steady—and hopefully on an upward trend.

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