A Guide for Novice Investors

Debashis Basu 12 April 2018

This is not a new book. It was published way back in 2004 by the fund rating company Morningstar. It has just been reissued jointly by Macmillan and Wiley as an Indian edition, given the huge popularity it enjoys. It is a classic which appeals to those interested in understanding ‘moats’ that protect businesses from competition and lead to long-term value creation. Every budding analyst, I come across, claims that he has read this book to become a better investor. So, what are these five rules?

1. Do Your Homework: This refers to the framework of investment knowledge required to analyse a business. This essentially includes knowledge of finance and investment accounting. Chapters 4-7 explain how to analyse companies.

2. Find Economic Moats: This is the most important part of the book. Dorsey suggests looking at quantitative factors like free cash flows, net margins and return on equity and return on assets, as a first step. The second step would be to try to find qualitative factors behind the numbers that create the moat, such as brands, technology, switching costs or low cost of operations.

3. Have a Margin of Safety: Even the world’s most wonderful business is a poor investment if purchased for too high a price. The book takes the reader through all the conventional measures of market valuation such as prices to sales, earnings and book value, earnings yield and price to earnings growth, etc. It ends with a little known measure—cash return—which is free cash flow to enterprise value and measures how efficiently the business is using its capital. A whole chapter is devoted to intrinsic value by the discounted cash flow method which, unfortunately, is of no practical utility.

4. Hold for the Long Haul: This is obvious, especially in the US, where taxes and trading costs can eat into a large part of your profits.

5. Know When To Sell: Dorsey promises to explain this later but I could not find any elaboration on this. I find this a most callous and egregious slip-up. He has several pages devoted to when not to sell which does not really help much.

After having explained these five points, about halfway through the book, Dorsey takes the readers through how to analyse two real companies. He picks up Advanced Micro Devices, a tech company, and Biomet, a maker of medical devices. This chapter gives readers a chance to put on an analyst’s cap. All this is in the first part of the book which also includes mistakes to avoid, how to spot financial fakery, a 10-minute test of an investment idea which will help you quickly reject stocks that are not worth researching, while filtering investment-worthy opportunities that demand further research.

There is a second part of the book which is a guided tour of individual sectors. This section is quite unique. Most books on investing show no awareness that each sector is different and may demand a different set of tools for analysis.

The sectors covered in this book are: healthcare, consumer services, business services, banks, asset management and insurance, software, hardware, media, telecom, consumer goods, industrial materials, energy and utilities. Dorsey explains how companies make money in each of these sectors and how moats get created. Of course, these are all US-centric factors; nevertheless, it helps to develop the right analytical approach. The Five Rules for Successful Stock Investing is a great book for beginners and a good refresher to leaf through every once in a while, even for seasoned professionals.

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