If you want to learn how to invest but do not like to read books I recommend reading only this book ‘Invested‘ by Danielle Town and Phil Town. ‘Invested‘ was probably the most influential book on me that I have ever read. Not to mention the most interesting book about investing.
Most books about investing usually contain a lot of examples than not always are interesting. However, this book tells a story about how Danielle hated numbers, and hated investing, yet learned to be proficient in it in one year.
This book also helps you to build an investment checklist that you can use for all of your investments.
About Danielle and Phil Towns
The story revolves around daughter and father – Danielle and Phil with occasional mentions of Warren Buffer and Charlie Munger.
Danielle was a lawyer but was stressed out by the job and was keeping herself functioning with the help of medication. This was the main driver of why she wanted to change her profession.
Right now Danielle has her own website dannieletown.com in which you can find her blog and a lot of useful information.
Phil Town was an investor for a long time and has written a few of his own books. He was teaching others and decided to help Danielle to learn investing. You can find more information about him on his website ruleoneinvesting.com.
Alternatives to stock investments
As Daniele hated investing and wanted to do nothing close to it she explored all the other options before she finally tried investing in stocks.
A few of the options:
Inflation effect on savings
If you keep your money in your safe, bank account, a sock, or anywhere without it being invested – you lose money.
Average annual inflation for the last 30 years is 2.3%. This means that if you kept your money in your bank account for 30 years it would lose 50% of its value due to inflation.
Every other option than losing money is better than doing nothing with it.
Mutual funds
Mutual funds are a terrible investment for most people:
- High entry price – 250.000 USD
- They get paid even if they lose money
- You pay for the privilege of working with a hedge fund
They charge you 3% plus you have to include 2.3% of inflation. In total it is 5.3% gone. What is worse is that they get paid even if they lose money.
They are still valid because most 401k requires to be invested in mutual funds. Other than that they should not exist at all and I believe the system will change eventually.
Market index funds
One of the options that were deemed as bad in the book was market indexes. Personally, I disagree with this and I think Warren Buffet is right when he says that for the average person, it is best to invest in the market index funds like S&P 500.
The main point against this investment type was that if the stock market is overvalued then it might not be a good idea to invest in index funds. Currently, it is overvalued.
You read about it in my other article – ‘Is the stock market overvalued?‘.
Exchange-traded funds (ETFs)
The funds are a lot like Mutual funds. The difference is that they are traded publicly. In the book, it is mentioned that they have 3% fees. However, this is not entirely true. For example, I can invest in my bank‘s ETF without any fees.
The question is are they any good?
Robo-advisors
Recently Robo-advisors were introduced to the market where computer helps you invest according to your risk tolerance.
That downside is that they take 2.5% fees. Of course, this also does not guarantee any returns.
Charlie Munger‘s 4 rules
A lot of attention in the book is given to the 4 rules of Charlie Munger. Charlie and Warren Buffet uses these 4 principles for their own investing.
I believe it is worth knowing the rules as both of the investors are elite in what they do. This can help you create your own investment checklist.
Rule No 1. Being capable of understanding the business
At first, you should focus on 1 or 2 industries that you have knowledge of. Think of companies that you already have an opinion about. That‘s a great start.
This is called a circle of competence. You know about these industries more because of your personal experience.
You can do an exercise that would take around 15 minutes. A Venn diagram of competence requires you to draw 3 overlapping circles. In these 3 circles, you write what you are passionate about, what you vote for with your money, and where you make your money.
Everything that overlaps is your circle of competence. However, you then narrow it down to only 1 which would be your circle of competence for investing. This is one of the first things you should include in your investment checklist.
You choose it by eliminating everything from your list one by one. For example, if startups were in your circle of confidence you should eliminate it as after the IPO around 80% of the companies lose in value from their starting valuation.
Rule No 2. Business with intrinsic characteristics that gives a durable competitive advantage
A durable competitive advantage can also be called a moat. It protects businesses against competition and can even help them grow during recessions.
You want to protect your investments with companies that have a moat. Your investment checklist should definately include this part.
There are 5 (and a half) moats that can protect a business:
- Brand
It is considered a moat when you think of a product and you associate it with a company.
- Switching
Switching is considered in cases when it is hard for a customer to switch to another brand. Usually, because they are used to it and there would be some learning curve to use another.
- Network effect
When you have followers on Facebook it can be hard to transfer them to Twitter.
- Toll bridge
When a company has a monopoly it is considered a toll bridge. This usually happens with the government’s intervention when it gives a lot of power to one company.
- Secret
Companies with ‚secret‘ moat are considered drug development companies. It takes a very long time to develop drugs and they are protected by law for a lot of years.
- Price
When a company can offer products at a lower price that others cannot compete with.
The big 4 numbers
As it can be hard to determine which companies have moats just by reading about them there are also some numbers in the company’s balance sheet that can tell you if the company has a moat or not. In total it is only 4 numbers that you need to check.
| Number | Where to find it | Description |
| Net income (Net profit or Net earning) | Income statement | It shows a profit after all costs have been deducted. |
| Book value (Equity) + Dividends | Book value can be found in the Balance sheet and dividends can be found in the Cash flow statement. | This shows the value of a business if all of its assets were sold before any dividends were paid out. |
| Sales (Revenue) | Income statement | This shows what the company earned from selling. |
| Operating cash | Cash flow statement | This shows the actual cash earned from the business operations. |
You can find historic numbers in macrotrends.net instead of reviewing all the income statements one by one.
What you want to see in these 4 numbers is a 10% growth in each of them. However, tread lightly as they show the past and there might be some changes happening in the company that indicates that these numbers might change in the future.
After you see what are these growth rates you then have to take an educated guess about what is the growth rate of the company taking into account all the other things you find about it. It is called the Windage growth rate.
You should not simply make an average of the big 4 numbers. You can come up with this number after researching the company, what it does and what it is planning to do.
These 4 numbers should be noted in your investment checklist as well.
Rule No 3. Management with integrity and talent
When choosing a company you want it to be simple and easily managed so that any idiot could run it because one day an idiot will run it.
However, there are some criteria you can investigate the current management of the company and determine if the current CEO knows what he or she is doing and predict how long will they stay in their position.
- Biography (do they have needed experience?)
- Management style (how they run the company?)
- Founder (Is the founder still managing the company?)
- Board of directors (Who are they and how much impact do they do?)
- Ownership (Does the CEO has his money on the line?)
Reading about the manager of the company should be included in your investment checklist.
Management numbers to check
After you do a background check you can also check some numbers to determine if the CEO knows what he or she is doing.
| Number | Formula | Where to find it | Description |
| Return on Equity | Return on Equity = Net income / by Equity | Net income is found on the income statement. Equity – balance sheet. | This number shows how well the managers spend our invested money. The drawback is that this number can be engineered by borrowing money. That is why we have to look into the return on invested capital. |
| Return on Invested Capital | Return on Invested Capital = Net income / (Equity + Debt) | Net income is found on the income statement. Equity – balance sheet. Debt – balance sheet. | This shows us the same thing as Return on Equity but it also includes the debt that the company has. It is best if you see both of these numbers with an average of 15% growth or better for at least 10 years. |
| Debt | Years to pay debt = Debt/Net Income | Net income – income statement. Debt – balance sheet. | Debt generally is bad and a lot of long-term debt can cause management to declare bankruptcy. We want to see a company be able to pay off its debt in 1 or 2 years with its earnings. |
To remember all of these things it is best to make yourself an investment checklist of what you need to check so you would not forget. You should not make a checklist so huge that you would need to research a company for a month but a simple and neat investment checklist can save you a lot of trouble.
Rule No 4. Buy at a price that gives a margin of safety
To buy a company you need to determine the price that makes sense, the one that seems to be on sale. That is called the margin of safety. This is the last thing that can protect you if you made a mistake in previous steps.
3 methods you should use to determine a share price
- Ten Cap price (based on owners earnings)
Capitalization rate (ten cap for short) is a method that Warren Buffet uses. It means the money you receive for the money you own each year. And the ratio between them is the return on investment.
Buffer and Munger require that the average return rate would be at least 10%. That is why this method is called Ten Cap.
The math is simple here – you should multiply the owner’s earnings by ten. This is the price you should be paying for a company.
The downside of this method is that opportunity to buy a company at this price comes once in 30 years according to Phil Towns.
The formula for the owner’s earnings is:
Owners earnings = Net Income + Depreciation and Amortization + Net Charge: Accounts receivable + Net Charge: Accounts payable + income tax + Maintenance capital expenditures
- Payback Time price (based on free cash flow)
This method is great for those who are buying to keep stock. It shows how many years it takes for the investment to pay for itself or in other words to double your money.
The Payback Time price is calculated by compounding Free cash flow by the Windage growth rate for 8 years.
You will have to sum all the compounded free cash flow in the 8 years period and the price you get is what you can pay for the company.
Both of the metrics in this formula cannot be found on the income statement, however, you can calculate them. The windage rate was explained before and the Free cash flow formula is much simpler than Owner’s earnings.
Free cash flow = Net cash flow from operating activities – Purchase of property and equipment – Any other capital expenditures for maintenance and growth
- The margin of safety valuation (based on earnings)
This method focuses you evaluating what you would have to pay today for future earnings including the risk of getting that money in the future.
The margin of safety is quite hard to calculate so I will go step by step. First, these are the numbers that you will need:
- Earning per share (EPS) – you can find this in the income statement.
- Windage growth rate – I have mentioned this rate before and how to calculate it.
- Windage Price-to-Earnings (P/E) ratio – is calculated by multiplying the Windage growth rate by 2 or by or using the highest P/E ratio from the last 10 years (You can find it anywhere on the internet). Use the lowest of the 2 numbers.
- Minimum Acceptable Rate of Return (MARR) – as the name suggests you have to think of a number that is worthwhile for you for all the work you put into researching your investments. The book suggests using 15%.
That is all for the numbers you will need. However, there are 4 steps you need to do to calculate the margin of safety.
Step 1. Calculate Future 10-Year earnings per share = EPS x (1 + Windage growth rate) [Repeat 10 times]
Step 2. Calculate Future 10-Year Share Price = Future 10-Year earning per share x Windage P/E ratio (Or P/E ratio)
Step 3. Sticker price = Future 10-Year Share Price / 4. If you want to use a different number for MARR than 15% then you should use this formula: Sticker price = Future 10-Year Share price / (1.15) by the power of Years
Step 4. Calculate Margin of Safety buy price = Sticker price / 2
As you can see that calculation is quite long, yet simple. You can read the book ‚Invested‘ to see that examples of where this formula is used.
Sometimes you can get very different results from the 3 valuations mentioned above. It is because they calculate completely different things. However, in most cases, Payback Time Price gives you the most accurate valuation.
Ten Cap price shows you if you found a winner to earn 10 times your money and the Margin of Safety valuation gives you a conservative price.
You should include at least one of these 3 valuations in your investment checklist if not all of them.
Story of a company
One of the main things for a new investor is to learn about a company. You should not invest just because you think the company is good or you heard that a lot of people are buying it.
After you have learned the finances you have to conclude what you found in a story. What you want is to create a story of a company why it is amazing and why you want to own it.
To tell a story of a company first you need to understand it. You can ask a question like What do they do or How do they do it?
When building your investment checklist you should consider adding this point as well.
Create a 2-minute story about why it is a good investment
In your short story, you should include things like companies mission, moat, management, and price. Also include an event that has put the company on sale and how the company will turn it around.
Find arguments why the company will not reach its goals
For the main reasons to own the company find the reasons not to own it. After that try to debate with yourself why these arguments are incorrect.
Imagine this process as debates or preparation for a court.
Voting for a mission
One interesting take on investing is that you do not just invest to earn money – you also invest because you believe in what the company does.
It is like voting. You have a limited amount of money that you can diversify to other companies. When you invest in a company you give it your money and trust that the company will make sound decisions with it for the company and for others.
Expensive errors to your investment checklist
Phil Town included some things that he has lost his money in the past. When it comes to money it is best to learn from other’s mistakes.
Meaning
In this category, all the errors are about not evaluating all the risks and not finding enough information about the company from the start.
Moat
All the mistakes in this category are made by falsely identifying the moat and overestimating it. This can happen if you did not do enough research or if you miscalculated the big 4 numbers.
Management
If you fail you get a good feeling about the CEO or calculate management numbers incorrectly you get a false image of the management.
This can be avoided if you pick simple companies that anyone can run.
Pricing
Errors associated with pricing comes from overpaying for a stock by buying it too early or you did not correctly evaluate the stock price.
Practice shares
If you are new to investing it can be hard to start buying shares mentally or even technically if you are not familiar with the platform that you are buying shares from.
This is why when a company is getting near your buying price it can be a good idea to buy a small number of shares with money that you would not be stressed out if you lost but yet would feel bad if you did.
If you do this before investing it will be much easier to do it for real when the time comes.
I would consider this point optional for your investment checklist as it will not generate value for your investment directly. It would help you to prepare mentally instead.
Other suggestions from the book
This amazing book had some other useful suggestions. I will mention some of them.
- Diversify your money between different industries
First, you should start with what you know best. However, when you learn you should expand and choose more industries to invest in. You can learn more about industries in my other article ‘Is the stock market overvalued?‘.
- Passive-aggressive strategy
Avoid buying everything that is overpriced. However, if the price is right start buying aggressively. As Warren Buffet said be fearful when others are greedy and be aggressive when others are fearful.
- Do not spend more than 10% of your money on one stock
When investing you should put most of your money into the companies that you believe in the most. However, it should not be more than 10%.
- Set up a whishlist
Make a table of companies that you have reviewed and what companies you want to buy. Also, include a short story of a few points about why you want to buy it and at what price.
Moreover, include a priority with each company in which you would buy companies if more than one company became on sale. You sort them by the order that you believe in the company.
- Buy in trenches
If an event happens that puts the company on sale then avoid putting all the money in it at once. Nobody can predict when the company has reached its peak or bottom. So, buying it in slices helps you when the company’s price will go beyond your buying price.
By doing this you will avoid getting angry at yourself for not timing your purchase perfectly and earn even more.
- Reducing your basis
When your company grows take out your starting investment, so that if anything happens at least you made your money back.
- Dividends
Who wouldn‘t want a cash flow coming to you every year? Well, there are people who invest solely for dividends. However, beware of the company that misses or reduces its dividends as the majority of people would see this is breaking their trust.
Because of that people start selling stock and then its price starts to drop. It is much harder to get that trust back once it was broken.
You should always look for companies that pay dividends without fail or even increased them for at least 10 years.
- Buybacks
Buybacks are a great sign for stock owners because once the stocks are bought back your share value instantly increases as there are fewer shares.
- When to sell?
The only time you would want to sell a company is when the story of the company changes and it does not seem like a good investment.
Checklist for further learning
- Calendar quarterly and annual reports to review your wishlist
- Once per quarter review your stories for the companies
- Watch market-wide indicators
- Read books about value investing
- Read the news about investing regularly (like Wall Street Journal)
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