One Up On Wall Street: How To Use What You Already Know To Make Money In

by Peter Lynch

Today it’s worth reminding ourselves that bull markets don’t last forever and that patience is required in both directions.

Today it’s the Internet, and so far the Internet has passed me by. All along I’ve been technophobic. My experience shows you don’t have to be trendy to succeed as an investor.

In high-tech and dot.com circles, it’s not unusual for a newly launched public offering to rise tenfold in less time than it takes Stephen King to pen another thriller. These investments don’t require much patience. Before the Internet came along, companies had to grow their way into the billion-dollar ranks. Now they can reach billion-dollar valuations before they’ve turned a profit or, in some cases, before they’ve collected any revenues.

The mere appearance of a dot and a com, and the exciting concept behind it, is enough to convince today’s optimists to pay for a decade’s worth of growth and prosperity in advance. Subsequent buyers pay escalating prices based on the futuristic “fundamentals,” which improve with each uptick.

Does it make sense to invest in a dot.com at prices that already reflect years of rapid earnings growth that may or may not occur?

own stocks where results depend on ancient fundamentals:

If you can follow only one bit of data, follow the earnings—assuming the company in question has earnings. As you’ll see in this text, I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow, or next week is only a distraction.

Though the typical dot.com has no earnings as yet, you can do a thumbnail analysis that gives a general idea of what the company will need to earn in the future to justify the stock price today.

Brief explanation/example followed.

Whenever you invest in any company, you’re looking for its market cap to rise.

There are three ways to invest in this trend without having to buy into a hope and an extravagant market cap. The first is an offshoot of the old “picks and shovels” strategy:

Today, you can look for non-Internet companies that indirectly benefit from Internet traffic (package delivery is an obvious example); or you can invest in manufacturers of switches and related gizmos that keep the traffic moving.

The second is the so-called “free Internet play.” That’s where an Internet business is embedded in a non-Internet company with real earnings and a reasonable stock price.

The third is the tangential benefit, where an old-fashioned “brick and mortar” business benefits from using the Internet to cut costs, streamline operations, become more efficient, and therefore more profitable.

An amateur investor can pick tomorrow’s big winners by paying attention to new developments at the workplace, the mall, the auto showrooms, the restaurants, or anywhere a promising new enterprise makes its debut.

Liking a store, a product, or a restaurant is a good reason to get interested in a company and put it on your research list, but it’s not enough of a reason to own the stock! Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition, competitive position, plans for expansion, and so forth.

another key factor in the analysis is figuring out whether the company is nearing the end of its expansion phase—what

My clunkers remind me of an important point: You don’t need to make money on every stock you pick. In my experience, six out of ten winners in a portfolio can produce a satisfying result. Why is this? Your losses are limited to the amount you invest in each stock (it can’t go lower than zero), while your gains have no absolute limit.

Buying back shares brings up another important change in the market: the dividend becoming an endangered species.

In the not-so-distant past, when a mature, healthy company routinely raised the dividend, it was a sign of prosperity. Cutting a dividend or failing to raise it was a sign of trouble. Lately, healthy companies are skimping on their dividends and using the money to buy back their own shares, à la General Electric. Reducing the supply of shares increases the earnings per share, which eventually rewards shareholders, although they don’t reap the reward until they sell.

If anybody’s responsible for the disappearing dividend, it’s the U.S. government, which taxes corporate profits, then taxes corporate dividends at the full rate, for so-called unearned income. To help their shareholders avoid this double taxation, companies have abandoned the dividend in favor of the buyback strategy, which boosts the stock price. This strategy subjects shareholders to increased capital gains taxes if they sell their shares, but long-term capital gains are taxed at half the rate of ordinary income taxes.

It’s foolish to bet we’ve seen the last of the bears, which is why it’s important not to buy stocks or stock mutual funds with money you’ll need to spend in the next twelve months to pay college bills, wedding bills, or whatever. You don’t want to be forced to sell in a losing market to raise cash. When you’re a long-term investor, time is on your side.

The basic story remains simple and never-ending. Stocks aren’t lottery tickets. There’s a company attached to every share. Companies do better or they do worse. If a company does worse than before, its stock will fall. If a company does better, its stock will rise. If you own good companies that continue to increase their earnings, you’ll do well. Corporate profits are up fifty-five-fold since World War II, and the stock market is up sixtyfold. Four wars, nine recessions, eight presidents, and one impeachment didn’t change that.

My advice for the next decade: Keep on the lookout for tomorrow’s big baggers. You’re likely to find one.

When you sell in desperation, you always sell cheap.

To all the dozens of lessons we’re supposed to have learned from October, I can add three: (1) don’t let nuisances ruin a good portfolio; (2) don’t let nuisances ruin a good vacation; and (3) never travel abroad when you’re light on cash.

But rule number one, in my book, is: Stop listening to professionals!

Dumb money is only dumb when it listens to the smart money.

Moreover, the nice thing about investing in familiar companies such as L’eggs or Dunkin’ Donuts is that when you try on the stockings or sip the coffee, you’re already doing the kind of fundamental analysis that they pay Wall Street analysts to do. Visiting stores and testing products is one of the critical elements of the analyst’s job.

Looking back on it, I realize there was less risk of losing all one’s money in the stock market of the 1950s than at any time before or since. This taught me not only that it’s difficult to predict markets, but also that small investors tend to be pessimistic and optimistic at precisely the wrong times, so it’s self-defeating to try to invest in good markets and get out of bad ones.

“Don’t gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”

Under the current system, a stock isn’t truly attractive until a number of large institutions have recognized its suitability and an equal number of respected Wall Street analysts (the researchers who track the various industries and companies) have put it on the recommended list. With so many people waiting for others to make the first move, it’s amazing that anything gets bought.

The stocks I try to buy are the very stocks that traditional fund managers try to overlook. In other words, I continue to think like an amateur as frequently as possible.

GOING IT ALONE

No one will tell me what to do, Im on my own unlike fund managers. The job is simplified for me.

Most important, you can find terrific opportunities in the neighborhood or at the workplace, months or even years before the news has reached the analysts and the fund managers they advise.

Investing in bonds, money-markets, or CDs are all different forms of investing in debt—for which one is paid interest.

However you figure it, there’s something to be said for the supposed dupes in this transaction. Investing in debt isn’t bad.

(Long-term T-bonds are the best way to play interest rates because they aren’t “callable”—or at least not until five years prior to maturity.

once again stocks were outperforming both money-market funds and long-term bonds. Over the long haul they always do. Historically, investing in stocks is undeniably more profitable than investing in debt.

The advantage of a 9.8 percent return from stocks over a 5 percent return from bonds may sound piddling to some, but consider this financial fable. If at the end of 1927 a modern Rip Van Winkle had gone to sleep for 60 years on $20,000 worth of corporate bonds, paying 5 percent compounded, he would have awakened with $373,584—enough for him to afford a nice condo, a Volvo, and a haircut; whereas if he’d invested in stocks, which returned 9.8 percent a year, he’d have $5,459,720. (Since Rip was asleep, neither the Crash of ’29 nor the ripple of ’87 would have scared him out of the market.)

In stocks you’ve got the company’s growth on your side. You’re a partner in a prosperous and expanding business. In bonds, you’re nothing more than the nearest source of spare change. When you lend money to somebody, the best you can hope for is to get it back, plus interest.

The point is that fortunes change, there’s no assurance that major companies won’t become minor, and there’s no such thing as a can’t-miss blue chip.

Historically, stocks are embraced as investments or dismissed as gambles in routine and circular fashion, and usually at the wrong times. Stocks are most likely to be accepted as prudent at the moment they’re not.

To me, an investment is simply a gamble in which you’ve managed to tilt the odds in your favor. It doesn’t matter whether it’s Atlantic City or the S&P 500 or the bond market.

Consistent winners also resign themselves to the fact that they’ll occasionally be dealt three aces and bet the limit, only to lose to a hidden royal flush. They accept their fate and go on to the next hand, confident that their basic method will reward them over time. People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game.

If seven out of ten of my stocks perform as expected, then I’m delighted. If six out of ten of my stocks perform as expected, then I’m thankful. Six out of ten is all it takes to produce an enviable record on Wall Street.

There’s no point in studying the financial section until you’ve looked into the nearest mirror. Before you buy a share of anything, there are three personal issues that ought to be addressed: (1) Do I own a house? (2) Do I need the money? and (3) Do I have the personal qualities that will bring me success in stocks? Whether stocks make good or bad investments depends more on your responses to these three questions than on anything you’ll read in The Wall Street Journal.

(1) DO I OWN A HOUSE?

Houses, like stocks, are most likely to be profitable when they’re held for a long period of time. Unlike stocks, houses are likely to be owned by the same person for a number of years—seven, I think, is the average.

No wonder people make money in the real estate market and lose money in the stock market. They spend months choosing their houses, and minutes choosing their stocks. In fact, they spend more time shopping for a good microwave oven than shopping for a good investment.

(2) DO I NEED THE MONEY?