Part 1

1. The Five rules of successful
investing – Part 1
By : Pat Dorsey

2. Chapter 1 : The Five rules of successful stock
investing.
• Starting the book with this chapter, it explains the following,
• Successful investing depends on personal discipline, not on whether the crowd agrees or
disagrees with you.
• Always have an investment philosophy and stick to it. Must do homework, stay patient and
insulate yourself from popular opinion rather getting frustrated and to start deviating from
personal investment philosophy you’re likely to get into trouble.
• Five rules recommend by the book are :
• Do your homework
• Find Economic Moats
• Have a margin of safety
• Hold for the long haul
• Know when to sell

3. Each points has its own meaning where we’ll learn in the upcoming chapters, but lets look at brief significance if each
point :
1. Do your homework – Unless you know the business inside & out, you shouldn’t buy the stock. You need to develop an understanding
of accounting, so that you can decide what financial shape is the co. is in.
2. Find Economic Moats – According to the book what “Moat” means is Differences to be good from the rest of the company, It also
means that relatively small number if companies who wish to retain above average create such advantages for them for better long-
term stock performance.
3. Have a margin of Safety - Margin of Safety tells us the differentiation between market price and an estimate of value. The size of the
Margin of safety should be larger for shakier firms with uncertain futures and smaller for solid firms. Use conservatism and discipline
when figuring out price you’re willing to pay for the stock.
4. Hold for the long haul - This point tells us the difference between trading frequently and holding the stock for the long – term,
Investing should be a long-term commitment because short term trading means that there is high risk for losing where one of the
drawbacks for short term trading are costs such as taxes and brokerage costs that begins to add up.
5. Know when to sell – We all want to hold on our investments forever but, few companies are worth holding for a decade. Furthermore,
we should know when we should sell the stocks, don’t sell just because the price has gone up or down, The key is to constantly
monitor the companies you own rather than the stocks you own. Let’s look at few questions before selling the stocks:
• Has the stock dropped?
• Has the stock skyrocketed?
• Did you make a mistake?
• Have the fundamentals deteriorated?
• Has the stock risen too far above its intrinsic value?
• Is there something better you can do with the money?
• Do you have too much money in one stock?

4. Chapter 2: Seven mistakes to avoid
Beginning with how this chapter helps us to understand how to avoid the most
common mistakes of investing. You will find many great stocks to pick to make up for
just few small errors. The mistakes that we should avoid are as followed :
1. Swinging the fences
2. Believing that it’s different this time
3. Falling in love with products
4. Panicking when the market is down
5. Trying to time the market
6. Ignoring valuation
7. Relaying on earnings for the whole story

5. Let’s look at each point more in detail:
• Swinging in the fences - This point tells us that how vital it is buying companies with great Economic Moats is rather
than picking and loading up your portfolio with risky or all or nothing stocks. This point also stresses on how small
growth stocks are giving worst returns over the long term. That is why finding a co. with great economic moat pays the
investor with tremendous returns.
• Believing that it’s different this time – According to this point, events happened in the past do give us knowledge about
the events to know and understand the future of the market, making any decision based on statements about the
markets such as “it’s really different this time “may be overwhelming, this point tells us not to rely on just verbal analysis
of anybody, but to know about the past and consider in the analysis.
• Falling in love with the product – Here the author tells us that it is one of the easiest ways to fall in investment traps,
because some co.’s even with great and innovative products there are still factors to consider to stay put in the co., are
the margins for the reducing ? Has the competition been intense, Has the profit been consistent?. We must look at
technology and innovation, but just relying on that is just risky, we must consider Economics at that state and in typical.
Here what fascinated me is that the author conveys us to ask questions such as “Is this an attractive business?”, “Would I
buy the whole co. if I could?”. If the answer is no, give the stock a pass, no matter how much you might like the firms
products.
• Panicking when the market is down – This point states that “stocks are generally more attractive when no one else
wants to buy them, not when barbers are giving stock tips “ . What I understood with this point is we as investors
should find the economic advantages of companies and have point of view about a co., even when nobody having a
trust on the co., if the factors match with our analysis, then we should go ahead no matter what and not follow herding.
It takes nerve going against the bulk. But that courage surely pays off if you have facts and opinion.

6. • Trying to time the market – This point is my personal favorite area, where many of my personal investments were
affected, this point says that market timing is a myth and personally I strongly agree, There is no strategy when to
be in the market and when to be out of it, here the author talks about 3 issues :
o Timing the market is very difficult process, also when we try to do so we ignore the benefit of compounding.
o Bulk of returns from any given year comes from relatively few days in that year, The risk of not being int the market is high
for anyone looking to build wealth over a long period of time, we must stay put in the market for generating wealth from
the market.
o Here the author who is working with “Morningstar” tells us that from the past 2 decades none of the thousand funds
have made consistency to time the market and able to make returns.
• Ignoring Valuation – Personally I believe in valuations, where the author says that the only reason we should
ever buy the stock is that the business is worth more than it’s selling for, this problem is answered by
valuation, and not because a greater fool will pay more for these shares a few months down the road, the
best way to mitigate the investing risk is to pay careful attention to valuations.
• Relying on the earnings for the whole story – The author articulates that the cash flow is what matters and
not earnings. I am fond of this point because it is the cash flow that helps the co. to take significant decisions.
The statement of cash flows can yield a ton of insights into the true health of a business, here the author gave
us a hint i.e. If operating cash flow is stagnant or is shrinking even as earnings grow, it’s likely that something
is rotten.
If we can avoid these common mistakes we’ll be miles ahead of the average investors.

7. Chapter 3: Economic Moats
Investors often judge companies by looking at which ones have increased profits and
assuming the trend will persist in future. But often firms that look great from far away and
historically wind up performing poorly in the future, because the bigger the profits the
firms attract, the more the competition attracted by the firm. Believed by the author that
it’s the basic nature of any reasonably free market, capital always wants to parked at the
area of highest expected return, Therefore most profitable firms tend to become less
profitable over time as competitors chip away at their franchises.
The concept of Economic moat is crucial for anyone to realize that for a company,
Economic moat is the characteristics that helps the great performing companies to stay
that way. Here there are points in the book to analyze the economic moat, we must follow
these few steps:

8. • Evaluate the firm’s historical profitability, Has the firm been able to generate a solid return on its assets and on
shareholders equity? This is the true litmus test of whether a firm has built an economic moat around itself.
• If the firm has a solid return on capital and consistent profitability, we should assess the source of firm’s profits.
Ask questions to the company such as
o Why is the co. able to keep its competitors at the bay?
o What keeps its competitors from stealing its profits?
• Estimate how long the firm will be able to hold off its competitors, which is the co.’s competitive advantage
period. Some firms may fend off competitors for just a few years, and some may be able to do it for decades.
• Analyze the industry’s competitive structure. How do firms in this industry compete with one another? Is it an
attractive industry with many profitable firms or a hypercompetitive one in which participants struggle just to stay
afloat?
• Analyzing the economic moats is complicated because there are infinite number of solutions to the problem of
consistently making a buck when your competitor wants to take it away.
• Let’s look at above points more precisely:
• Evaluating Profitability - Observing this point tells us we need to look for hard evidence that a firm has an
economical moat by examining financial results. What we’re looking for are firms that can earn profits more
than cost of capital – companies must generate substantial cash relative to the amount of investments, which
means after deducting all the COSTS of capital especially dividends & interests, companies should still hold
cash to devote into its business for competitive advantage. To understand this we need to ask following
questions which are series of shortcuts they do a good job of identifying which firms have economic moats
and which ones don’t when they’re used together.

9. • Does the firm generate Free Cash Flow? If so, how much? – First, we need to look at free cash flow – which is
Cashflow from operations (CFO) – Capital Expenditure, look for the line items “cash flow from operations” and
subtract the line labeled “capital expenditure”, which you can find under quarterly or annual filings. Firms that
generate free cash flow essentially have money left over after reinvesting whatever they need to keep their
businesses running effortlessly, in a sense free cash flow is money that could be extracted from the firm every
year without damaging the business.
Divide Free Cash Flow by sales, which tells you what proportion of each dollar in revenue can convert into excess
profits. Strong free cash flow is an excellent sign that a firm can has an economic moat.
• What are the firm’s Net Margins? – As we have seen free cash flow measures excess profitability from one
perspective, net margins define from another angle. Net margins are simply net profit divided by revenue. It tells
us how much profit the firms generate per dollar of sales. High net margin is in general is great for a co.
• What are returns on equity? – Return on equity is a percentage of net income divided by shareholder’s equity. It
measures profits per dollar the capital shareholders have invested in a co. High ROE is considered an economic
moat for a co.
• What are return on assets? – Return on Assets are Net Income as a percentage of a firm’s assets, and it measures how
efficiently a firm is translating its assets into profits.
When we’re looking for all this metric, we should look at these metrics for more than a year. A firm that has consistently
cracked out solid ROEs, good Free cash flows, decent margins over several years, is more likely to have an economic moat
more than a firm with unpredictable results. Consistency is more important when evaluating a company because it’s the
ability to keep competitors at bay, for an extended period. For evaluation 5 years is the time, but if we can go back 10
years. These benchmarks are rules of thumb and not hard and fast cut off.

10. • There are 5 ways an individual firm can build a sustainable competitive advantage:
1. Creating a real product differentiation through superior technology or features
2. Creating a recognized product differentiation through a trusted brand or reputation
3. Driving the costs down and offering a similar product or a service at a lower price.
4. Locking in customers by creating high switching costs.
5. Locking out competitors by creating high barriers to entry or high barriers to success.
Let’s understand all the pointers in wider sense:
• Real product differentiations – This is the most obvious type of economic moat; wouldn’t Customers pay more for
a better product or service?
Simply having better technology or more features is usually not a sustainable strategy because there are
competitors hoping to build mouse trap. Also charging a premium price for best product or service, firms
following this strategy always end up with limited market size. Many customers will be satisfied with a slightly
inferior product at a significantly lower price. The lesson learned here is although firms can occasionally
generate enormous profit and enormous stock returns by staying one step ahead of the technological curve,
these profits are usually short lived.

11. • Perceived Product differentiation – Often a firm with consistently better products or service creates a brand for
itself, and a strong brand constitutes a very wide economic moat, wonderful thing about that is customer
recognize your product or service as better than everyone else’s, it makes less of a difference whether the product
or service is different. The product of the brand should increase consumer’s willingness to pay.
What matters is not the existence of the brand, but rather how the brand is used to create excess profit.
Also, the durability of the brand is a critical component of any brand based economic moat.
• Driving Costs down – Offering similar product or service at lower cost can be powerful source of competitive
advantage, Low-cost strategies especially work well in markets such as commodity industries such as PCs and
airlines. Even in non-commodity markets, low-cost strategies work well and can bring large advantages if it is
sustainable and not temporary.
• Locking in Customers – Customer lock in or creating high switching costs can possibly be the cleverest type of
competitive advantage, this is because uncovering of a product or service requires deep understanding of the
firm’s operations, Cost advantages, brands, better products are all relatively easy ti spot from the outside but
knowing exactly what makes it tough for a customer to switch from one firm to another can be very difficult to
find out.

12. If you can make it difficult in terms of money or time for a customer to switch to a competing product, you can
charge your customers more and make more money – simple in theory, but difficult in practice. The most
noteworthy argument here is that a switching cost is not always monetary in fact it rarely is, often what discourages
customer is from dropping a product or service in favor of a competing one is time. Often learning a product or a
service can require a significant investment in time which means the benefit of a competing product must be very
large to induce a switch. Here are few questions for evidence of high switching cost –
o Does the firm’s product require a significant amount of client training? If so, customers will be reluctant to switch
and incur lost productivity during training period.
o Is the firm’s product or service will be tightly integrated into customer’s businesses? Firms don’t change vendors of
mission-critical (important to the business) products often because the costs of a failed switch may far outweigh
the benefit of using the new products or services.
o If the firm’s product or service is an industry standard? Customers feel pressure from their own clients or their
peers, to continue using well known and well-respected product or service.
o Is the benefit to be gained from switching small than the cost of switching? Bank customers often endure higher
fees because the lower fees they might get from moving to a competitive bank is less of a value than the potential
hassle of moving their account.
o Does the firm tend to sign long term contracts with the clients? This is often a sign that the client doesn’t want to
frequently switch vendors.

13. • Locking out competitors – This is the fifth strategy that firms can use to generate lasting competitive advantage. If
it is executed well, it can generate years of strong profits, if it is done too well it can invite the scrutiny of the
government on antitrust grounds. Such as Microsoft. Most obvious way to lock out competitors is regulatory
exclusivity, Licenses and such are powerful discouragement to competitors. However, although patents and
licenses, can do a great job of keeping competitors at bay and maintaining high profit margins, they can also be
brief. A much durable strategy for locking out competitors is network effect; A strong network becomes much
more valuable as the number of users increases much like a telephone network. Companies that have network
protecting their competitive positions tend to have much stronger economic moats.
• How long will it last? – This point talks about the longevity of an economic moat, so we know how long a firm is
likely to keep its competitors at bay. Think about an economic moat in 2 dimensions.
o Depth – how much money the firm can make?
o Width – how long the firm can sustain above average profits?
Technology firms have very deep but narrow moats, so they’re incredibly profitable for a relatively short period of
time, until the competitor builds a better product. Estimating how long the moat will last is tough stuff but you need
to give at least some thought, even if you can’t come with precise answer just being able to separate firms into 3
buckets – a few years, several years and many years is very useful.
• Industry Analysis – Our last step to investigate the industry in which the firm operates.
o First, get a rough sense of the industry so you can classify it. Are sales for the firms in the industry generally
increasing or decreasing?
o Are firms consistently profitable or does the industry go through periodic cycles when most firms lose money?
o Is the industry dominated by a few large players or is it full of firms that are roughly the same size?
o How profitable is the average firms – are operating margins high or low?
o An easy way to do this is to look at companies in the industry you’re researching sorted by sales or market cap.

14. Chapter 4: The language of investing
This chapter helps us to understand what financial statements
contains and how does it help us to understand a business, we’ll
look at the three main financial statement fit together by
describing what’s in them ,As an investor our main interest is
mainly going to be in Balance Sheet, Income statement, Cash
Flow statement which are the windows into the corporate
performance, they’re the place to start when you’re analyzing the
co.

15. As per the book all these statements can be found in 3 major filings which are an annual report, 10-K filing, 10-Q
filing.
• The book suggests to think three statements like this :
o The balance sheet is a co.’s credit report because it tells you how much the company owns (assets) relative to
what it owes (liabilities), at a specific period, it tells you strong framework and foundation of the business is.
o The income statement meanwhile tells you how a co. made or lost in accounting profits during a year or a
quarter, unlike the balance sheet which is a snapshot of the co.’s financial position at a particular period of
time, income statement records revenue and expenses over a set period, specifically a fiscal year.
o Finally, there’s a statement of cash flow, which records all the cash that came into the company and all the
cash that went out of the company, The statement of cash flows ties income statement and balance sheet
together.

16. Also, in this chapter it explains the meaning of accrual accounting which companies is record sales when a service or
a good is provided to the buyer, regardless of when the buyer pays, as long as the co. is certain that the buyer will
pay the bill, the co. posts the sale in income statement.
• The cash flow statement is concerned only when cash is received and when it goes out of the book.
• The key takeaway here is that the income statement and cash flow statement can tell different stories about a
business, because they’re constructed using different set of rules. The income statement strives to match
revenues with expenses as closely as possible, but the cash flow statement cares only about the money that go in
and out,
• The difference between accounting profit and cash profit is the key to understanding almost everything there is to
know about how a business works.