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

by Peter Lynch

How much does the company owe, and how much does it own? Debt versus equity. It’s just the kind of thing a loan officer would want to know about you in deciding if you are a good credit risk.

One quick way to determine the financial strength of a company is to compare the equity to the debt on the right side of the balance sheet.

Among turnarounds and troubled companies, I pay special attention to the debt factor. More than anything else, it’s debt that determines which companies will survive and which will go bankrupt in a crisis. Young companies with heavy debts are always at risk.

It’s the kind of debt, as much as the actual amount, that separates the winners from the losers in a crisis. There’s bank debt and there’s funded debt.

Bank debt (the worst kind, and the kind that GCA had) is due on demand. It doesn’t have to come from a bank. It can also take the form of commercial paper, which is loaned from one company to another for short periods of time. The important thing is that it’s due very soon, and sometimes even “due on call.” That means that the lender can ask for his money back at the first sign of trouble. If the borrower can’t pay back the money, it’s off to Chapter 11. Creditors strip the company, and there’s nothing left for the shareholders after they get through with it.

Funded debt (the best kind, from the shareholder’s point of view) can never be called in no matter how bleak the situation, as long as the borrower continues to pay the interest. The principal may not be due for 15, 20, or 30 years. Funded debt usually takes the form of regular corporate bonds with long maturities. Corporate bonds may be upgraded or downgraded by the rating agencies depending on the financial health of the company, but whatever happens, the bondholders cannot demand immediate repayment of principal the way a bank can. Sometimes even the interest payments can be deferred. Funded debt gives companies time to wiggle out of trouble. (In on...

DIVIDENDS

One strong argument in favor of companies that pay dividends is that companies that don’t pay dividends have a sorry history of blowing the money on a string of stupid diworseifications.

Another argument in favor of dividend-paying stocks is that the presence of the dividend can keep the stock price from falling as far as it would if there were no dividend.

When a stock sells for $20, a $2 per share dividend results in a 10 percent yield, but drop the stock price to $10, and suddenly you’ve got a 20 percent yield. If investors are sure that the high yield will hold up, they’ll buy the stock just for that. This will put a floor under the stock price. Blue chips with long records of paying and raising dividends are the stocks people flock to in any sort of crisis.

DOES IT PAY?

If you do plan to buy a stock for its dividend, find out if the company is going to be able to pay it during recessions and bad times.

A company with a 20- or 30-year record of regularly raising the dividend is your best bet.

BOOK VALUE

The flaw is that the stated book value often bears little relationship to the actual worth of the company. It often understates or overstates reality by a large margin.

The closer you get to a finished product, the less predictable the resale value. You know how much cotton is worth, but who can be sure about an orange cotton shirt?

Overvalued assets on the left side of the balance sheet are especially treacherous when there’s a lot of debt on the right. Let’s say that a company shows $400 million in assets and $300 million in debts, resulting in a positive book value of $100 million. You know the debt part is a real number. But if the $400 million in assets will bring only $200 million in a bankruptcy sale, then the actual book value is a negative $100 million. The company is less than worthless.

When you buy a stock for its book value, you have to have a detailed understanding of what those values really are.

MORE HIDDEN ASSETS

Just as often as book value overstates true worth, it can understate true worth. This is where you get the greatest asset plays.

Companies that own natural resources—such as land, timber, oil, or precious metals—carry those assets on their book...

Sometimes the best way to invest in a company is to find the foreign owner of it. I realize this is easier said than done, but if you have any access to European companies, you can stumble onto some unbelievable situations. European companies in general are not well-analyzed, and in many cases they’re not analyzed at all. I discovered this on a fact-finding trip to Sweden, where Volvo and several other giants of Swedish industry were covered by one person who didn’t even have a computer.

It was there that I discovered you could buy the parent company for less than the value of its U.S. subsidiary, plus pick up numerous other attractive businesses—not to mention real estate—as part of the deal. While the U.S. stock went up only slightly, the price of the parent company’s stock doubled in two years.

CASH FLOW

Cash flow is the amount of money a company takes in as a result of doing business. All companies take in cash, but some have to spend more than others to get it.

That’s why I prefer to invest in companies that don’t depend on capital spending. The cash that comes in doesn’t have to struggle against the cash that goes out.

There’s no point getting bogged down in these calculations. But if cash flow is ever mentioned as a reason you’re supposed to buy a stock, make sure that it’s free cash flow that they’re talking about. Free cash flow is what’s left over after the normal capital spending is taken out. It’s the cash you’ve taken in that you don’t have to spend.

INVENTORIES

There’s a detailed note on inventories in the section called “management’s discussion of earnings” in the annual report. I always check to see if inventories are piling up. With a manufacturer or a retailer, an inventory buildup is usually a bad sign. When inventories grow faster than sales, it’s a red flag.

There are two basic accounting methods to compute the value of inventories, LIFO and FIFO. As much as this sounds like a pair of poodles, LIFO actually stands for “last in, first out,” and FIFO stands for “first in, and first out.” If Handy and Harman bought some gold thirty years ago for $40 an ounce, and yesterday they bought some gold for $400 an ounce, and today they sell some gold for $450 an ounce, t...

Two other popular accounting methods are GIGO (garbage in, garbage out), and FISH (first in, still here), which is what happens to a lot of inventories.

A company may brag that sales are up 10 percent, but if inventories are up 30 percent, you have to say to yourself: “Wait a second. Maybe they should have marked that stuff down and gotten rid of it. Since they didn’t get rid of it, they might have a problem next year, and a bigger problem the year after that. The new stuff they make will compete with the old stuff, and inventories will pile up even higher until they’re forced to cut prices, and that means less profit.”

On the bright side, if a company has been depressed and the inventories are beginning to be depleted, it’s the first evidence that things have turned around.

PENSION PLANS

As more companies reward their employees with stock options and pension benefits, investors are well-advised to consider the consequences. Companies don’t have to have pension plans, but if they do, the plans must comply with federal regulations. These plans are absolute obligations to pay—like bonds. (In profit-sharing plans there’s no such obligation: no profits, no sharing.)

Even if a company goes bankrupt and ceases normal operations, it must continue to support the pension plan. Before I invest in a turnaround, I always check to make sure the company doesn’t have a...

GROWTH RATE

That “growth” is synonymous with “expansion” is one of the most popular misconceptions on Wall Street, leading people to overlook the really great growth companies such as Philip Morris.

The key to it is that Philip Morris can increase earnings by lowering costs and especially by raising prices. That’s the only growth rate that really counts: earnings.

If you find a business that can get away with raising prices year after year without losing customers (an addictive product such as cigarettes fills the bill), you’ve got a terrific investment.

One more thing about growth rate: all else being equal, a 20-percent grower selling at 20 times earnings (a p/e of 20) is a much better buy than a 10-percent grower selling at 10 times earnings (a p/e of 10). This may sound like an esoteric point, but it’s important to understand what happens to the earnings of the faster growers that propels the stock price. Look at the widening gap in earnings between a 20-percent grower and a 10-percent grower that both start off with the same $1 a share in earnings: COMPANY A (20% EARNINGS GROWTH) COMPANY B (10% EARNINGS GROWTH) BASE YEAR $1.00 A SHARE $1.00 A SHARE Year 1 $1.20 $1.10 Year 2 $1.44 $1.21 Year 3 $1.73 $1.33 Year 4 $2.07 $1.46 Year 5 $2.49 $1.61 Year 7 $3.58 $1.95 Year 10 $6.19 $2.59 At the beginning of our exercise, Company A is selling for $20 a share (20 times earnings of $1), and by the end it sells for $123.80 (20 times earnings of $6.19). Company B starts out selling for $10 a share (10 times earnings of $1) and ends up selling for $26 (10 times earnings of $2.60).

THE BOTTOM LINE

So what is the real bottom line? It’s the final number at the end of an income statement: profit after taxes.

The company with the highest profit margin is by definition the lowest-cost operator, and the low-cost operator has a better chance of surviving if business conditions deteriorate.

Without getting bogged down in the technicalities, pretax profit margin is one more factor to consider in evaluating a company’s staying power in hard times. This gets very tricky, because on the upswing, as business improves, the companies with the lowest profit margins are the biggest beneficiaries. Consider what happens to $100 in sales to our two companies in these two hypothetical situations: COMPANY A STATUS QUO BUSINESS IMPROVES $100 in sales $110.00 in sales (prices up 10%) $88 in costs $92.40 in costs (up 5%) $12 pretax profit $17.60 pretax profit COMPANY B STATUS QUO BUSINESS IMPROVES $100 in sales $110.00 in sales (up 10%) $98 in costs $102.90 in costs (up 5%) $2 pretax profit $7.10 pretax profit In the recovery, Company A’s profits have increased almost 50 percent, while Company B’s profits have more than tripled. This explains why depressed enterprises on the edge of disaster can become very big winners on the rebound. It happens again and again in the auto, chemical, paper, airline, steel, electronics, and nonferrous metals industries. The same potential exists in such currently depressed industries as nursing homes, natural gas producers, and many retailers.

What you want, then, is a relatively high profit-margin in a long-term stock that you plan to hold through good times and bad, and a relatively low profit-margin in a successful turnaround.

Every few months it’s worthwhile to recheck the company story. This may involve reading the latest Value Line, or the quarterly report, and inquiring about the earnings and whether the earnings are holding up as expected. It may involve checking the stores to see that the merchandise is still attractive, and that there’s an aura of prosperity. Have any new cards turned over? With fast growers, especially, you have to ask yourself what will keep them growing.

There are three phases to a growth company’s life: the start-up phase, during which it works out the kinks in the basic business; the rapid expansion phase, during which it moves into new markets; and the mature phase, also known as the saturation phase, when it begins to prepare for the fact that there’s no easy way to continue to expand. Each of these phases may last several years. The first phase is the riskiest for the investor, because the success of the enterprise isn’t yet established. The second phase is the safest, and also where the most money is made, because the company is growing simply by duplicating its successful formula. The third phase is the most problematic, because the company runs into its limitations. Other ways must be found to increase earnings.

STOCKS IN GENERAL • The p/e ratio. Is it high or low for this particular company and for similar companies in the same industry. • The percentage of institutional ownership. The lower the better. • Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs. • The record of earnings growth to date and whether the earnings are sporadic or consistent. (The only category where earnings may not be important is in the asset play.) • Whether the company has a strong balance sheet or a weak balance sheet (debt-to-equity ratio) and how it’s rated for financial strength. • The cash position. With $16 in net cash, I know Ford is unlikely to drop below $16 a share. That’s the floor on the stock.

SLOW GROWERS • Since you buy these for the dividends (why else would you own them?) you want to check to see if dividends have always been paid, and whether they are routinely raised. • When possible, find out what percentage of the earnings are being paid out as dividends. If it’s a low percentage, then the company has a cushion in hard times. It can earn less money and still retain the dividend. If it’s a high percentage, then the dividend is riskier.