Phil Town, the author and advocate of the “Rule #1” value investing method, makes some fairly strong assertions in his book “Rule #1” of how effective this method is. That a disciplined Rule #1 investor can expect an average yearly compounded rate of return of at least 15%, which is nearly double the historical rate of the market, is a rather bold claim.

I conducted an experiment to test Mr. Town’s method. I already had researched all companies on the NYSE and NASDAQ to locate which ones have what is referred to as the “Big 5” numbers. These numbers are return on invested capital, and the following four growth rates: equity, cash flow, sales, and eps, and they must be over 10% for the past five years, three years, and one year to qualify. Possessing these numbers is a requisite in the book for investment eligibility. We will refer to companies that meet this criterion as “Rule #1 companies”. It is important to note that less than 1% of all publicly traded companies make the cut, hitting the Big 5 numbers is extremely difficult.

Since a current Rule #1 company must demonstrate this record of statistical excellence for at least five years to make the list, I went back to analyze the performance of each of these companies during the past five years (2005-2009) and added in the first two quarters of the volatile 2010. Here are the results: During this period, the Dow experienced a net loss of 1,009 points, 9.4% of its value. The few dozen Rule #1 companies were up 127.2%, for an average of 23.1% per year, over the five and half years. When the market opened for the first time in 2005 on January 3rd, the average share price for current Rule #1 companies was $34.79. At market close on June 30, 2010, the average share price for these same companies was $79.03.

This spectacular rate of return is even more impressive when the following is considered: This rate encompasses all current Rule #1 companies. It does not take into account the prescribed “buying in at a discount” which further keys the investor in on the best purchase of security. This process (explained in the book) isolates those Rule #1 companies that are currently selling at a share price well below its intrinsic value.

I do understand that this study is not a perfect test of Mr. Town’s 15% plus claim. What would be a more accurate test would be to take stocks that were Rule #1 companies as of January 1, 2005 and analyze their performance over the past five and a half years. Many, but not all, current Rule #1 companies had this status at the beginning of 2005, and obviously over time there are changes to the list. Although I admit this inherent flaw, I do believe the results are significant in this way: it speaks to the potential of this select group of businesses. Current Rule #1 companies could absolutely give us another 100% plus rate of return over the next five years; they already have done it once and they have the strongest fundamentals in place of all publicly traded companies, which is the vehicle for continued growth.