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The Science of Hitting
The Science of Hitting
Articles (511) 

Review - The Five Rules for Successful Stock Investing

October 31, 2012 | About:

I recently picked up Pat Dorsey’s “The Five Rules For Successful Stock Investing” due to a recommendation from a fellow investor; for anybody familiar with Mr. Dorsey, it’s probably not too surprising that the book ended up being a great read. As the former director of stock analysis at Morningstar (and now the vice chairman and director of research and strategy at Sanibel Captiva Trust Company), it’s safe to say that he’s someone with experience in equity analysis.

In the early chapters, Mr. Dorsey’s book is focused on the basic principles that are commonly found in other “how-to” books and familiar to GuruFocus readers – the importance of focusing on the long-term fundamentals (and sustainability) of a business, demanding an adequate margin of safety, the importance of compounding, etc. And while these topics are well versed among more experienced value investors, my personal opinion is that continually pounding such core tenants into your brain every year or so is worth the few hours required to do so.

One area of particular relevance (and somewhere that Mr. Dorsey has clearly spent considerable time focusing on) is the importance of economic moats; in the book, there’s a solid mix between assessing the quantitative indicators (ROA, ROE, ROC, etc.) and understanding the qualitative characteristics (real product differentiation, perceived product differentiation due to brand equity, cost leadership, customer lock-in, and barriers to entry are discussed in depth) that can signal a company’s sustainable competitive positioning within a market. As I noted above, in the early chapters the book is comparable to other books targeting the novice investor; in this section, Mr. Dorsey beings to clearly differentiate “The Five Rules For Successful Stock Investing” from the other “how-to” guides most often cited.

Many of the sections, such as those focused on management analysis and questionable accounting, build into a chapter called “The 10 Minute Test.” Collectively, the topics addressed throughout these chapters provide a solid foundation for an investment checklist – which I consider to be fundamental in developing a consistent approach to security analysis; for an investor looking to add a few bullet points to their list, this is a one stop shop for often-overlooked questions that could help you avoid a serious mistake down the road (for example, focusing on the relationship between accounts receivable and the allowance for doubtful accounts over time).

As the book gets past the language of investing and the fundamentals of financial accounting (financial statement analysis), we move into the meat of individual company analysis and valuation. Without getting into too much detail (interested readers should grab a copy of the book), Mr. Dorsey’s section on valuation advocates a discounted cash flow model based upon historic growth rates, with the discount rate discussion simplified into a talk about risk (meaning permanent impairment of capital) and understanding the factors that should cause the rate to be adjusted higher or lower (as he notes, it is an inexact science - there’s no “right” discount rate for a company).

While I agree with the approach as he presents (it is simply a two stage DCF, similar to the reverse DCF favored by Montier in “The Dangers of DCF”), I take one issue with his emphasis on growth rates – for a book that leaves no stone unturned, I think that Mr. Dorsey was a bit too concise in his discussion on the perils of grabbing a 5 or 10 year historic earnings growth rate and plugging that into a model. As becomes clear with a bit of modeling, the growth rate (particular for the terminal value via the perpetual growth rate) assumed in the model will have a material impact on the intrinsic value spit back out; when one considers the plethora of issues that can come with simply clinging to historic growth rates (the impact of one-time charges, M&A, the stage of the business cycle, and the reliance on two arbitrary years rather than normalized earnings, to name a few), it creates some serious problems that can result in false optimism among novice investors set free with financial models (as Warren once said, “beware of geeks bearing formulas”).

Beyond that one small issue (one that I likely take to heart only because I’ve seen it abused time and time again), there’s no question that this book is a must reader for beginners and seasoned value investors alike. The second half of the book is a guided tour of individual market sectors, and provides a great starting point for expanding ones circle of competence into unchartered waters. Collectively, the two halves provide a complete guide to the essential tenants of value investing that is essentially unrivaled in such an easy to read format (this book plus Lynch’s “One Up on Wall Street” should be required reading for beginners); I highly recommend that investors of all skill levels consider picking up a copy of this book.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.1/5 (17 votes)


Jayb718 - 6 years ago    Report SPAM
I've read it many times over the years. Really good book. Nice article.
The Science of Hitting
The Science of Hitting - 6 years ago    Report SPAM

Yeah, it really is - Dorsey is someone I'm starting to follow more and more, and I think for good reason; thanks for the kind words.

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