Rule #1 summary

You've heard the formula, “diversify and hold” a million times; it's supposedly the safest way to invest in the stock market. But it’s also problematic.

First, it would’ve failed for approximately more than half of the last century.

If you were to buy a business, rather than stocks, would your criteria for doing so be any different? Shrewd investors only invest in a company they’d like to own in the long term, so thinking about buying stocks as if you were to buy the company will guide you towards investing carefully.

When you consider buying stocks, you probably think it’s easy to get out quickly if the company is doing poorly. You could therefore be tempted to opt for a risky business, pay too much attention to one promising growth-rate in an average business, or even lose money in a market bubble.

Like moats around a castle, certain assets protect a company against competition and inflation. When investing, it’s a good bet to choose companies with one or more of these “moats.”

So what exactly do moats do? A moat enables a company to dominate a market, increase its prices to keep up with inflation and produce enough profit to expand.

We’ve now seen what moats are and how they can help businesses become extremely successful. But how can you know if a company has one? Well, you can be sure that a company has a moat if they score well on five specific indicators for a minimum of ten years.

The best indicator of a wide moat is return on investment capital (ROIC) over at least a ten year period. ROIC is the rate of return a company makes from the money it invests in itself in a year. For example, say you invested $20 in stamps and then later sold them for $30. Your profit would be $10. The ROIC is the profit divided by the total you invested, which in this case would be 50 percent.

Let’s turn to three other ways to tell if a company has a moat, all of which are straightforward calculations.

The first calculation is figuring out if they’ve had at least a 10 percent increase in earnings per share (EPS) for approximately ten years.

When you’re considering which company to invest in, you can always refer to those Big Five criteria in the charts. But there’s something else that’s worth noting; how effective is the CEO you want to entrust your money to?

You need to opt for an owner-oriented CEO. They’ll make smart long-term decisions and inform the shareholders on what they need to know.

Remember the first blink in which we said that the Effective Market Theory is wrong?

Here’s why: contrary to the theory, price and value aren’t the same thing, and the key is to buy when the difference gives you an advantage. A stock’s price is what you pay, whereas its value is based on the money a business generates over time.