Daniel's notes on Rule #1

Myth 3. The Best Way to Minimize Risk Is to Diversify and Hold (for the Long Term). Diversify and hold. Everybody knows that's the safest way to invest in the stock market, right? But then again, at one time everybody knew the earth was flat. The fact is, a long-term diversified portfolio would have had a zero rate of return for 37 years from 1905 to 1942, for 18 years from 1965 to 1983, and from 2000 to 2005. Sixty years out of 100.

If you know how to inves —meaning you understand Rule #1 and know how to find a wonderful company at an attractive price—then you do not diversify your money into 50 stocks or an index mutual fund. You focus on a few businesses that you understand. You buy when the big guys—the fund managers who control the market—are fearful, and you sell when they're greedy. Shocking, no?

Today more than 80 percent of the money in the market is invested by fund managers (pension funds, banking funds, insurance funds, and mutual funds). This is what is known as "institutional money." Out of $17 trillion, the big guys manage more than $14 trillion of it. In other words, the fund managers are the market; when they move billions of dollars into a stock, the price of that stock goes up. When they take their money out, the price of that stock goes down. Their effect on the market is so huge that if they decide to sell suddenly, they can generate a massive crash. Understanding this fact is central to Rule #1: The fund managers control the price of almost all the stocks in the market, but they can't easily get out when they want to. You and I, however, can be in or out of the market within seconds.

If you don't think a total stock market meltdown can happen in a modern economy, think again. It just happened over the last ten years in Japan, whose stock market lost 85 percent of its value from 1992 to 2002. It hasn't recovered yet. And Japan's boomers are about ten years older than America's (political and economic factors prompted a baby boom in Japan prior to the start of World War II). If America's market tanks 85 percent, the Dow will be at 1500. It happened during the 1930s. It can happen again.

The word wonderful actually encompasses three simple elements that we'll explore in depth. First, wonderful implies that the business has Meaning to you — that you understand it enough to want to own the whole thing if you could, that you'd be proud to own it, and that the business reflects your values. On a second level, wonderful means that the business meets certain criteria in terms of financial strength and predictability; in particular, it must have a so-called Moat. And, third, it must have good Management.

It's not enough, however, for the business to be just wonderful. We need to buy this business at an attractive price. By "attractive" I mean we can buy the business with a very big Margin of Safety (MOS). To me a nice MOS is buying a dollar of value for fifty cents. So, once I know what a business is worth, I want to buy it for half that price. Obviously, doing that will make me very rich at some point.

Figuring out the value of a business is either easy or impossible. If a business is "wonderful," then by definition it's a business that's pre-dictable. If it's predictable, we can determine a value. If it's not a predictable business, it's impossible to know what it's worth.

In essence, Rule #1 is just about being a good shopper. If you're the type who waits to buy until there's a red-tag sale, where items get priced well below their actual values (you know that flatscreen TV is worth $5,000, but you can get it for $2,500), you're already set to be a good Rule #1 investor. All it takes is learning how to determine the values of wonderful companies and waiting for the market to sell you those companies at discounted prices.

In the process you'll be undertaking in finding wonderful companies at attractive prices, it helps to think of what I call "the Four Ms": Meaning, Moat, Management, and Margin of Safety. 1. Does the business have Meaning to you? 2. Does the business have a wide Moat? 3. Does the business have great Management? 4. Does the business have a big Margin of Safety?

The 10-10 Rule is just a way of thinking about investing. In fact, as you'll see, we might buy the business today and sell it in a month and then buy it back three months later and then sell it again a few weeks after that. The fact that we buy it as if we're going to keep it for ten years does not preclude us from buying and selling this business over and over.

Can you even imagine a business owner deciding to buy five more businesses to "lower his risk"? How crazy would that be? If his one business is too risky, why would diversifying into five more businesses make the first one less risky? If the first business is too risky, then he should sell it and get into a business he understands better. The 10-10 Rule helps us remember just how long we're "willing" to own this business so we're always thinking as a long-term investor.

If we don't understand what we're buying, the only thing we can know for certain is that we don't have a clue what's going to happen to this business in the future. And if we don't have a clue what's going to happen in the future, how are we going to figure out what this thing is worth today? Obviously, we need to understand the business so we can predict the future with some degree of certainty and then arrive at a value today. Just as obviously, it's a lot easier to understand businesses we already know a lot about than businesses we've never heard of. So we're going to start our search for a wonderful business by discovering the kinds of businesses we already understand.

Moat After wanting to invest in a business because you understand it and are proud to own it, the next question will be: Does this business have a wide moat? You need 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.

THE FIVE MOATS 1. Brand with price power: a product you're willing to pay more for because you know and trust it 2. IP, Secret: a business that has an intellectual property, patent or trade secret that makes direct competition illegal or very difficult 3. Monopoly: a business with exclusive control of a market—has the ability to collect a "toll" from anyone needing that service/product 4. Switching costs: a business that's so much a part of your life that switching isn't worth the trouble 5. Economies of scale: a business that can price products so low no one can compete