The Five Rules for Successful

Stock Investing
Morningstar’s Guide to Building Wealth and Winning in the Market

by Pat Dorsey
John Wiley & Sons © 2004
364 pages

Focus Take-Aways
Leadership & Mgt.
• Successful investing takes preparation and study. Sharpen your pencils.
Strategy
• Buy stock in companies with sustainable economic or competitive advantages.
Sales & Marketing
• Pay attention to the risk-return tradeoff and don’t just chase high returns.
Corporate Finance

Human Resources
• Plan your exit strategy and don’t hesitate to cut your losses by selling.

Technology & Production • Investing is a business; don’t let your emotions carry you away.
Small Business • Market timing is a losing strategy. Invest for the long haul.
Economics & Politics
• Nothing really changes in the market, so don’t kid yourself into believing that rules
Industries & Regions which were valid in the past are no longer valid.
Career Development • Be skeptical about earnings numbers, which may be the product of accounting
Personal Finance legerdemain. Instead, watch the cash.
Concepts & Trends • Value is all that matters in the long run — and value means a sound underlying
business at a good price.
• Don’t just learn about businesses; learn about industry sectors.

Rating (10 is best)

Overall Applicability Innovation Style

7 9 5 7

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 Relevance
What You Will Learn
In this Abstract, you will learn: 1) Solid wisdom about investing; 2) How to pick
stocks; 3) How to value companies; and 4) How to recognize economic and competitive
advantages in various industries.

Recommendation
The best investing principles, as clearly reiterated here, are stable and evergreen. As an
investor, you’ll welcome author Pat Dorsey’s unambiguous, straightforward presentation
of the always valid wisdom of the markets. This conveniently organized book offers
several chapters of general relevance to investors in all markets and industries, including
an industry-by-industry examination of the determinants of value. The title is cute, but
the content isn’t about the title’s rules — it is about learning and obeying the basics of
stock investing. getAbstract.com recommends the author’s long term perspective. Many
of the directions he sets for potential investments could still be valid years hence.

Abstract
Rule 1: Do Your Homework
Homework is the anchor of a sound investing strategy. Conduct thorough research to
achieve an in-depth understanding of a company or industry before you invest in it.
If you don’t have time to be that diligent, don’t buy stocks. It’s that simple. You can’t
“Think back to the make consistent profits in the market without research. You win or lose according to
Internet mania of whether you do the work or not. When you buy a stock, someone is selling it, probably
the late 1990s. a professional investor or an institution directed by people who understand the stock
Wonderful (but
boring) businesses thoroughly. If you buy from people who know more than you about what they’re selling,
such as insurance and you sell to people who know more than you about what they’re buying, you’ll end
companies, banks up knowing much more than they do about being broke. Doing homework helps you buy
and real estate
stocks traded at
stock in good, solid businesses and ensures that you won’t buy stocks when the price is
incredibly low in free fall. It will help you avoid frequent, costly trades and resist the market’s manias
valuations, even and dips so that you buy — and sell — strategically.
though the intrinsic
worth of these
businesses hadn’t
Seven Investing Sins
really changed.” You can commit far more than seven sins in investing, but these are the most deadly:
1. Trying to hit home runs — Every generation confronts a stock that everyone looks
back at years later, saying, “I could have bought it cheap.” In the ‘50s, it was Xerox.
In the ‘80s, it was Microsoft. Many investors think that success means getting in on
the ground floor of the next big thing. Wrong. The successful investor buys strong
“At the same time, companies at fair prices to hit solid singles and doubles, not to swing for home runs.
companies that
2. Believing that the rules have changed — The basics of investing never change. Trees
had not a prayer
of turning a profit don’t grow to the sky. What goes up will come down, though the reverse is not neces-
were being sarily true. During the 1990s, many people said valuation levels no longer mattered
accorded billion- because of the Internet. Then the crash came and no one said that anymore.
dollar valuations.”
3. Believing in a wonderful product — Don’t assume that having a great product or
service means a company is a great investment. It’s one thing to have a great com-
modity. It’s another thing to run a great business. Don’t confuse the two.
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 4. Running with the pack — If you have done your homework and know that a company
has a great product and the stock is selling for a fair price, or even a bargain, then
“Few investors — don’t be deterred if the market panics and runs away. An old saw advises, “Buy when
and, sometimes, there’s blood in the streets.” Put other people’s fear to work for you.
fund managers — 5. Timing the market — Never, never, never even try. It doesn’t work.
can articulate their
investment philos- 6. Ignoring valuation — If you make valuation your portfolio’s cornerstone, you won’t
ophy.” buy overpriced stocks (at least not often). It provides a basic risk control discipline.
7. Watching earnings — At the end of the day, week, year or your investing life, cash is
what counts. Earnings numbers are like the hand the magician waves for you to watch
while the other hand performs the nitty-gritty task required. Cash is the nitty-gritty.

Rule 2: Find Protective Economic Barriers

A company that succeeds with a new product, service or business model may
establish a temporary advantage. Yet, capitalist enterprise makes it inevitable that other
entrepreneurs will try to emulate that success. McDonalds was first, but Burger King
“Don’t be afraid to soon followed. To be a good long-term investment, a firm must be able to defend itself
use fear to your
from competition by erecting a competitive barrier or “economic moat.” These firms
advantage.”
have great moats:
• Dell — Its substantial moat is low cost and an unrivalled Internet selling platform.
• eBay — This online auction service benefits from the network effect. People use it
because people use it. People don’t use its competitors because other people don’t use
them. If you want to auction your sofa online, why use any other site?
• Comcast — This company controls cable access to a third of U.S. households, giving
it heavy negotiating clout with those who sell TV programs or gear.
“Focus on free • Wal-Mart — The giant chain holds patents on some of its business processes; it has
cash flow, net mar- economies of mind-boggling scale, a well-recognized brand name and more.
gins, return on
equity and return The best economic moats derive from:
on assets.”
• Differentiation — A unique product or a unique brand.
• Low costs — A culture that continues to reduce costs not just below competitors’
prices, but also below yesterday’s prices.
• Switching costs — Changing products is so expensive or inconvenient that custom-
ers are unlikely to switch. For example, the “QWERTY” keyboard layout is hard to
learn and slower than a competing layout, but switching is so time consuming and
inconvenient that few people even try.
• Barriers to entry — A patent keeps competitors at bay for its duration. Exclusive
“Constructing a
convincing bear
contracts with critically important suppliers, regulatory protections and economies
case is especially of scale all can help establish barriers to keep competitors out of your business.
important for those
who like to buy Rule 3: Build a “Margin of Safety” by Determining a Company’s True Worth
high-quality com- Your goal is to pay less for a stock than its real value. To do that, you must identify its
panies that have real value. Your “margin of safety” resides in the difference between your sense of the
hit temporary
speed bumps, stock’s value and what the market charges for it. To begin, track the company’s quarterly
because what and annual financial statements, including its balance sheet of assets and liabilities,
looks like a speed its income statement and, most importantly, its cash flow statement. The cash flow
bump may very
well be a road-
statement eliminates most of the non-cash revenues and expenses shown on the income
block on closer statement and focuses on cash inflow and outflow.
inspection.”
Do not take accounting at face value. Companies use many accounting tactics to
make their earnings look good, because that is where investors and journalists focus.
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 Companies accomplish this with several quite legitimate, albeit arguably misleading,
techniques. With careful analysis, you can see through most accounting tricks. Watch
“Executives who for these tactics:
complain about
how undervalued • Accounts Receivable — Most companies sell on credit, shipping goods to customers
their firm’s shares and expecting payment in 30, 60 or 90 days. If a company sells a product for cash,
are or who opine
accounting registers that a product left inventory and enters a corresponding sum in
about its true
worth are probably the cash account. If a company sells for credit, the accounting shows that a product
more concerned left inventory and enters a corresponding amount of money in accounts receivable,
with the value of not the cash account. When the buyer pays, the accountants subtract from accounts
their options than
with making solid, receivable and add to cash. As an investor, watch accounts receivable carefully. If the
long-term busi- firm shows a big increase in sales and accounts receivable, but not such a big increase
ness decisions.” in cash, it may be a risky investment. Some companies boost sales artificially by
offering very generous credit terms to customers who are unlikely to pay. They ship
the product and list the sale as an account receivable, through they may never collect.
As an investor, you want to pay for performance, not for prestidigitation.
• Nonrecurring charges — Accounting regulations allow companies to book one-of-a-
kind expenses as “nonrecurring charges,” which do not affect the income statement.
Companies with clever accountants and cooperative auditors often book ordinary
“An earnings yield expenses as nonrecurring, thus making earnings look better. Pay close, skeptical
or cash return
above current
attention to nonrecurring charges. Be wary if a firm makes a habit of taking them.
bond rates can • Earnings growth is bigger than sales growth — This may reveal that a firm is getting
indicate an under- more efficient and is extracting more value from each sale. Or, it may unveil a firm
valued stock.”
that uses accounting legerdemain to make earnings look better than reality merits.
• Gains on pensions and investments — Companies can include investment and pen-
sion fund gains in their earnings statements. Firms keep accounts on the performance
of set aside pension funds, although that performance depends on a set of assump-
tions about future returns. Companies can influence their earnings by changing their
assumptions about the future. This may seem blatant and obvious, but it’s surprisingly
common, and surprisingly few investors seem to notice or care. Notice. Care.
“Over the long
haul, a big part
• Earnings versus cash flow — Compare the bottom-line earnings number to the bot-
of successful tom-line cash flow number. If the earnings line shows impressive growth but the cash
investing is build- flow line does not, be very suspicious.
ing a mental data-
base of companies Follow the money. Use financial statements to trace a clear trail from sales to the bottom
and industries on
which you can
line. If the footnotes are confusing or something doesn’t make sense, there could be
draw as the need a problem with the company. You are investing in the future, so no matter how good
arises.” a stock’s track record is, consider future growth. If a company lacks an economic
moat, its future growth is uncertain. Beware of companies that grow by acquiring other
firms. The merged entity’s earnings will show growth, but it is sham growth. Despite
recent accounting reforms, accounting for mergers and acquisitions is a tricky, somewhat
confusing corner of financial analysis. Assume that any merger is unlikely to produce
positive economic results. To be a good investment, a firm needs solid growth in its own
underlying business. Cash is king in the world of investing. A company is only worth the
“Letting your cash it produces and will produce.
money compound
without paying Valuation
Uncle Sam every
year makes a huge What is a company really worth? For valuation discipline, keep these principles in mind:
difference.”
• Combined valuation approaches — When you are assessing a stock, no single metric
gives a complete and universally reliable picture.
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 • Price to sales (P/S) ratio — This is revealing for firms in cyclical industries or with
off-and-on earnings. Look for a P/S ratio lower than a firm’s historical average.
“Although the best • Price to book (P/B) ratio — This assesses financial service companies and compa-
biotech companies nies with substantial investments in hard assets, such as plants, equipment and real
can generate enor- estate. Expect firms with high return-on-earnings (ROE) to command a high P/B.
mous free cash
flow … most are • Price to earnings (P/E) ratio — Check P/E but recognize its limitations. The denomi-
too speculative for nator relies on an accounting number with plenty of slack. Compare a current P/E
all but the most to the company’s historic P/E record and to the market’s and industry’s P/E. A high
aggressive inves-
tors.”
P/E implies high expectations about growth. Paying a big price for future growth is
often a high-risk bet. When you see a low P/E ratio, even though the firm meets your
criteria for risk and performance, beware. Ask yourself why the P/E ratio is low.
The market is vast. Begin your search for good investments in these sectors:
• Financial firms — Banks, as Willie Sutton observed, are where the money is, so
consider financial firms carefully. Their accounting is quite specialized, so taking the
trouble to learn about it will give you an advantage over investors who don’t bother.
• Business services — This category includes everything from Moody’s, the credit
rating company, to Cintas, the uniform manufacturer. Even professional analysts
may overlook this sector, giving you an information advantage.
• Health care — Demographic, economic and technological trends favor this industry.
Tread carefully because some sectors are very regulated and some are very volatile.
“Others may try
to imitate Wal- • Media companies — These firms can establish very sustainable competitive advan-
Mart’s strategy in tages (wide, deep economic moats) and their subscribers pay in advance.
the short run but
lack the econo- Rules 4: Hold for the Long Term
mies of scale to
remain profitable
Once you have done your homework, learned and practiced valuation, and invested in
employing the the right stocks, you still must be strategic. When you trade for the short run, you lose
strategy in the long money in transactions fees and taxes. Frequent trading is an expensive fault. When you
run.” have the right stock, hold on to it for the long term. Patience is a profitable virtue.

Rule 5: Sell Smart

The flip side of hanging on, however, is selling strategically. The secret is to sell at
the right time. Following the company you are investing in, not just the stock itself, is
essential. When you want to sell a stock, screen the decision by asking yourself if the
purchase was an error, if the company’s basics have weakened, if the stock price has
climbed above its real worth, if you have a better investment opportunity and if you have
devoted too much of your portfolio to one investment. If the answers are yes, then you
have a case for selling. What distinguishes successful investors is knowing when to hold
‘em, and when to fold ‘em.

About The Author

Pat Dorsey, CFA, is director of stock analysis and head of the equity analysis team at
Morningstar, Inc., a Chicago research firm. He appears weekly on the Bulls and Bears
financial show on FOX News Channel.

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