Book Review: ‘The Five Rules for Successful Stock Investing,’ by Pat Dorsey

by: MagicDiligence

Not long ago, we reviewed Mary Buffett and David Clark's Warren Buffett and the Interpretation of Financial Statements, and concluded that, while possibly useful for beginners, experienced stock investors would dismiss the book as simplistic and having added nothing new. The review also mentioned that a good alternative for more experienced investors looking to add to their knowledge is Pat Dorsey's The Five Rules for Successful Stock Investing (2004). In this post, we'll take a look at that book.

The author, Pat Dorsey, is currently the Director of Equity Research for Morningstar. Historically, Morningstar has been known for their five-star scale of mutual fund ratings, but several years ago began applying the same scale to individual stocks. Since Morningstar's focus is on durable competitive advantage, the firm's investing philosophy correlates very well with that of the Magic Formula and of MagicDiligence. That makes the book particularly relevant and much of my stock analysis is based on techniques outlined in it.

The Five Rules is more or less, a two-part book. The first half deals covers the title, laying out the five rules for successful investing and then proceeding to expand on each of them. Without spoiling too much of the book, Dorsey's five rules are:

  1. Do your homework.
  2. Find economic moats.
  3. Have a margin of safety.
  4. Hold for the long haul.
  5. Know when to sell.

This first half of the book introduces the investor to the techniques of stock analysis. Topics covered include detailed explanations of each financial statement, the points of emphasis to look for in a good investment (such as growth potential and financial health), how to spot accounting blowups before they happen, how to value a stock, and so forth. For everyone interested in stock analysis, from 10-year pros to those just beginning to dip their toes in the market, these chapters contain invaluable and vital information. Almost every investor will learn something new about evaluating companies and valuing stocks. One particularly valuable chapter is titled, "The 10-Minute Test," which will help you quickly throw out stocks that are not worth your time, while highlighting investment opportunities that warrant additional research.

The second half of the book is equally useful. In this section, Dorsey calls upon Morningstar's sector analysts to lay out the intrinsic moat qualities and the factors that separate good and bad companies in a variety of sectors, including Health Care, Consumer Services, Media, Banks, and so on. It's no secret to MagicDiligence Members that some industries are inherently better investment hunting grounds than others, and this book explains why. For example, retail is generally a difficult place to invest - there are no customer switching costs, tons of competition, and constantly changing consumer trends. On the other hand, most medical device makers have very high switching costs, as surgeons are trained on one company's products and are loathe to learning the intricacies of a competing product, unless there is a very good reason to do so.

I’d like to conclude this review with a personal observation. Most investors routinely cite classic investing books like Ben Graham's The Intelligent Investor as the place to start for novice investors. I respectfully disagree. I've read many of those great classics, but no other book has explained the details of company and equity analysis as directly, or relevantly, as this book. This is one of the most overlooked investing books out there, and comes highly recommended to all investors.

Disclosure: Steve owns no position in any stocks discussed in this article.