For many people searching how to invest, they aren’t always looking for a step-by-step method. They’re looking for a philosophy. One of the best (if not the best) investing philosophies is Rule one investing (sometimes stylized as Rule 1 investing). So what makes Rule one investing so effective?
What if I told you that almost every successful investor followed one simple philosophy? Investors like Warren Buffett, Mohnish Pabrai, Charlie Munger, John Bogle and Burton Malkiel all follow one simple investing philosophy: Rule One Investing.
What is Rule one investing?
Rule 1 investing has its name origins in a quote from Warren Buffett:
There’s only two rules when investing, Rule 1: don’t loose money, Rule 2: don’t forget rule number one!
Hence, author and investor Phil Town coined the term, which it has been known as since.
Essentially, rule one follows (and explains) the principles behind the book “The Intelligent Investor” by famed investor Benjamin Graham, who taught Warren Buffett how to invest.
It outlines the basics of investing, with an emphasis on how to find a great company at a great price, without wasting your money.
What are the specifics of Rule 1 investing?
The specifics can be broken down into 6 main categories:
- How to understand a business (and make sure you do)
- How to make sure that it’s protected from its competition
- How to be sure that the management has integrity and talent
- How to find a good stock
- How to get it at the best price possible
- Wise words
How to understand a business
A wise investor once told me “Risk [when investing] comes from not understanding what you’re doing!” By this, he was referring to not understanding the business you are investing in.
Key point: When you’re investing, think of it as though you yourself is going to buy the whole business, not just a few percent. When Warren Buffett goes in and invests in a company, he pretends as though he’s buying the whole company, even if he’s only buying, say, 10% of it.
To know whether or not you fully understand a business or not, you can use this simple checklist:
- What are the main sources of income?
- Who are the C-level executives and what is their past?
- What are the main areas the business operates? (Eg. aviation materials, train materials construction materials etc.)
- Debt ratios?
- What’s their mission?
- Competitors?
- Outlook for the next quarter/year/decade
- Whether they met/surpassed/didn’t meet their previous outlook(s)
If you can’t tell me (the truth) about all of these, you should refrain from investing in those companies!
You should be able to tell me the answer to any of those questions, if I came up to you in the street and posed that question to you. (You should be able to do that at about the same speed as if I were to ask you, your name!)
If you can, great! If you can’t, either find out, or don’t!
Protection from the competition
You wouldn’t buy a company that does the same as its competition, would you? Of course not! So you wouldn’t want to do the same to your investments portfolio!
Rule one investors refer to this as a company’s “Moat” (yes, like the ones that castles have).
A moat is essentially a competitive advantage that is what sets it out from its competitors. For example, Credit Agricole (one of my own personal stock holdings) has a moat of the fact that it is the only bank in France to serve rural communities (something that the other two major banks fail to accomplish).
Essentially, you need to study, not only the business you want to invest in, but also its rivals. You want to ask yourself whilst you’re doing this (writing down the questions and answers whilst you do this may help too!) “What does this company do differently? What does it do that the others don’t?” and questions like that.
You may also find (as I did), that a competitor of the company you are researching actually has a better moat and better everything! This means that you have potentially just made yourself a lot of money down the road.
Management
Management is a key focus point for Rule one investing. The management are like your minions, they work hard, whilst you play.
Rule one investing states that your management needs to have two things: Integrity and faith in the company.
Integrity
Does the management have integrity? This is one of the biggest questions in rule 1 investing.
Whilst you probably won’t be able to sit down and have a three course meal with the management, as Warren Buffett does, you can still conduct your research.
Look at their annual shareholder letter that they send out to all of their investors (normally accessible through their website’s corporate page). You should read through the past three years’ letters, whilst you are reading the CEO letter, ask yourself “Does this sound like a sales pitch?” If yes, run as fast as you can, if no, you are probably in safe hands.
Also research the CEO in some detail. is he/she the kind of person you’d like as an inlaw? Would you approve of your son/daughter bringing them home and saying “This is my boyfriend/girlfriend!” If you would, then fine, if you wouldn’t, run away!
Faith in the company
There’s an old adage that goes “Speak with actions not words”, this adage is one of the most important things when investing.
In rule one investing, faith isn’t measured in words (no, they’re worthless without something to back them up), they’re measured in the CEO’s stock portfolio.
If the CEO (and other C-level executives) hold stock in their own company, this sends positive signals to investors, especially those who follow rule one investing!
Why? Because this shows that the C-level executives have faith in their management. They’re willing to risk their own money (and wealth) by owning this company, so they’re probably not going to be corrupt and try to put the company out of business.
How to find a good stock
Finding a good stock is like finding the Holy Grail. The whole point of rule 1 investing is to find an already undervalued stock, that you can buy on sale for even cheaper!
Always focus on an industry that you know a lot about. For me, that was aviation and banking, as I grew up with my father working for a bank and e wanting to be a pilot, so I spent a lot of time researching aircraft, airlines, aircraft manufacturers etc.
You need to find something that works for you. If you like cars, and know a lot about them, consider investing in car dealerships, car manufacturers and maybe even mechanics that specialize on certain types of cars! Find whatever works for you.
Rule one investing states that if you aren’t already an expert on that industry before you consider doing research on it, that you should not invest by a long shot!
How to get it at the best price
The aim of rule one investing is to essentially find buy a $1 bill for 50 cents. Obviously, if you can get it a bit lower than 50 cents, the better off you’d be!
There are two main ways you can get a lower price for the stock: wait for a recession or wait for devastating news to hit.
Waiting for a recession is the favorite of rule one investing as it tends to happen in a regular cycle. Roughly every ten years, there is a stock market crash of some form or another. It is during a recession, where the whole market is down, and the price continues to tumble out of control.
Rule one investing states that it is here where an investor comes in. He or she comes in and purchases a large stake in the companies that they have heavily researched.
Another tried and true method for rule one investing is using the news to their end. The news is probably one of the biggest factors that affect stock prices on a day-to-day stock valuations.
Most of the time, these day-to-day fluctuations are minimal, and often don’t do a great deal. However, from time to time, there is a breaking story, that makes the stock price collapse. This, again, is where rule one investing comes into place, and the rule one investor comes in and buys a large portion of the company.
One of the best examples of this is the collapse of Chipotle’s stock price after a string of food poisonings due to unhygienic practices.
Wise words
Warren Buffett put rule one investing in the best way possible:
You are investing for the long term. You are aiming to get the best price possible for the best stock possible. When you are investing long term, you are aiming to hold the stock for the next 10 years or so. If you can’t see yourself holding the stock for the next ten years, don’t invest in it!
That quote essentially sums up all of rule one investing in a nutshell. Day trading doesn’t focus on the wealth impacts of investing, merely the bottom line and profit margins.
If you are going to take anything away from this article about rule 1 investing, that quote is it!
Have you ever tried rule 1 investing? What is your favorite part of rule 1 investing? Would you recommend it? Tell me in the comments!
