Best book on stock market investing-”The Five Rules for Successful Stock Investing”

If you ever, EVER read one book on stock market investing let this be it. “The Five Rules for Successful Stock Investing” by author Pat Dorsey provides simple advice on how to evaluate businesses before buying their stock.

I rank this book over Benjamin Graham’s classic – “The intelligent investor” and Robert Hagstorm’s “The Warren Buffet Way”. People who know Warren Buffet know that he was a student of Benjamin Graham and Buffet acknowledges his knowledge and analytic skills to Graham.  Pat Dorsey though does not attribute his methods directly to Graham or Buffet, follows a fundamental analysis process very similar to Buffet. He thinks of stocks as businesses, looks for margin of safety, analyzes how much value the management is able to create from a dollar of capital etc., which is all very similar to Buffet. And this resemblance is quite OK!

Pat Dorsey offers his readers more than what the title claims as the ”The five rules”. The five principles outlined in this book are:
1) Do your homework – Understand the business of the firm, its regulatory and competitive landscape. Understand its customer’s needs, the value of the product or service of the firm, the competitive advantage it has, the company’s pricing power, the sources of revenue and expenses, the company’s investment, R&D needs etc.

2) Find economic moats – What makes this business stand out and keep competitors from eating into its market share for a long time? This is what is termed as “economic moat”, and the moats can take various forms depending on the industry and market.

3) Have a margin of safety – Value the business and buy the stock for 20-25% discount on the valuation price to provide room for any errors in valuation or oversight. Dorsey explains that for companies that have stable earnings and pay consistent dividends, and have little or no debt on their balance sheet, margin of safety can be given a little discount as against a cyclical company with volatile earnings or has a highly leveraged balance sheet.

4) Hold for the long haul – Just like a flower or fruit comes after sowing the seeds and years of water the plant, so also corporate profits and returns. So, don’t make your buy and sell decisions day-in and day-out.

5) Know when to sell – Don’t sell just because the market is over-valuing or under-valuing the company. Trust your judgment, and sell only when your target price is reached, or the fundamentals of the business has changed so much that if you hold onto the stock, future returns might not meet your expected rate of return.

What makes this book worth the price and more is not just the above stuff. Apart from the above 5 principles mentioned above, Dorsey has devoted almost second half of the book to highlighting the industries like Pharma and Banking where there are wide economic moats and there is a high probability of finding winning stocks. He goes on to elaborate the reasons for these economic moats, the capital financing structures (equity vs. debt) etc., and how the investor can use these factors to weed out unattractive industries and companies.

In this very readable book, the author takes time to explain the ropes and the pitfalls of investing including advising on potential red flags to watch out for. Dorsey tells the reader to use the ratios generally touted by Wall Street only after knowing the real meaning and source of the data, like “growth in earnings” can actually be numbers massaged through under-funding the pension plans or reducing R and D spending, and thus the investor has to look out for fine print. The author also advices on how to judge management behavior through analysing rational allocation of earnings, the sources of funds used (equity vs. debt), usage of stock options and cash in compensating executives and directors.

Not withstanding that Pat Dorsey is the Director of Equity Research of Morningstar, a very respected research and ratings firm, he is able to explain financial ideas and terminology in the language of a stock market newbie. Normally investing books end up being all theory and not immediately applicable to real life, or ends up treating investing as “trading” (frequent buying and selling) and go into technical analysis (think charts, trends), this book provides the reader a good ground in really the nuts and bolts of fundamental analysis and aids in uncovering the gems for value investing.

The kind of information written here is hard to come by and so money spent buying this book is probably going to be one of your best investments.

No related posts.