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

by Peter Lynch

STALWARTS • These are big companies that aren’t likely to go out of business. The key issue is price, and the p/e ratio will tell you whether you are paying too much. • Check for possible diworseifications that may reduce earnings in the future. • Check the company’s long-term growth rate, and whether it has kept up the same momentum in recent years. • If you plan to h...

CYCLICALS • Keep a close watch on inventories, and the supply-demand relationship. Watch for new entrants into the market, which is usually a dangerous development. • Anticipate a shrinking p/e multiple over time as business recovers and investors look ahead to the end of the cycle, when peak earnings are achieved. • If you know your cyclical, you have an advantage in figuring out the cycles.

FAST GROWERS • Investigate whether the product that’s supposed to enrich the company is a major part of the company’s business. It was with L’eggs, but not with Lexan. • What the growth rate in earnings has been in recent years. (My favorites are the ones in the 20 to 25 percent range. I’m wary of companies that seem to be growing faster than 25 percent. Those 50 percenters usually are found in hot industries, and you know what that means.) • That the company has duplicated its successes in more than one city or town, to prove that expansion will work. • That the company still has room to grow. When I first visited Pic ’N’ Save, they were established in southern California and were just beginning to talk about expanding into northern California. There were forty-nine other states to go. Sears, on the other hand, is everywhere. • Whether the stock is selling at a p/e ratio at or near the growth rate. • Whether the expansion is speeding up (three new motels last year and five new motels this year) or slowing down (five last year and three this year). For stocks of companies such as Sensormatic Electronics, whose sales are primarily “one-shot” deals—as opposed to razor blades, which customers have to keep on buying—a slowdown in growth can be devastating. Sensormatic’s growth rate was spectacular in the late seventies and early eighties, but to increase earnings they had to sell more new systems each year than they had sold the year before. The revenue from the basic electron...

TURNAROUNDS • Most important, can the company survive a raid by its creditors? How much cash does the company have? How much debt? (Apple Computer had $200 million in cash and no debt at the time of its crisis, so once again you knew it wasn’t going out of business.) What is the debt structure, and how long can it operate in the red while working out its problems without going bankrupt? (International Harvester—now Navistar—was a potential turnaround that has disappointed investors, because the company printed and sold millions of new shares to raise capital. This dilution resulted in the company’s having turned around, but not the stock.) • If it’s bankrupt already, then what’s left for the shareholders? • How is the company supposed to be turning around? Has it rid itself of unprofitable divisions? This can make a big difference in earnings.

Texas Instruments was another classic turnaround. In October, 1983, the company announced it would leave the home-computer business (another hot industry with too many competitors). It had lost over $500 million from home computers in that year alone. Again, the decision made for big write-offs, but it meant that the company could concentrate on its strong semiconductor and defense-electronics businesses. The day after the announcement, TI stock spurted from $101 to $124. And four months later it was $176.

• Is business coming back? (This is what’s happening at Eastman Kodak, which has benefited from the new boom in film sales.) • Are costs being cut? If so, what will the effect be? (Chrysler cut costs drastically by closing plants. It also began to farm out the making of a lot of the parts it used to make itself, saving hundreds of millions in the process. It went from being one of the highest-cost producers of automobiles to one of the lowest.

ASSET PLAYS • What’s the value of the assets? Are there any hidden assets? • How much debt is there to detract from these assets? (Creditors are first in line.) • Is the company taking on new debt, making the assets less valuable? • Is there a raider in the wings to help shareholders reap the benefits of the assets?

Here are some pointers from this section: • Understand the nature of the companies you own and the specific reasons for holding the stock. (“It is really going up!” doesn’t count.) • By putting your stocks into categories you’ll have a better idea of what to expect from them. • Big companies have small moves, small companies have big moves. • Consider the size of a company if you expect it to profit from a specific product. • Look for small companies that are already profitable and have proven that their concept can be replicated. • Be suspicious of companies with growth rates of 50 to 100 percent a year. • Avoid hot stocks in hot industries. • Distrust diversifications, which usually turn out to be diworseifications. • Long shots almost never pay off. • It’s better to miss the first move in a stock and wait to see if a company’s plans are working out. • People get incredibly valuable fundamental information from their jobs that may not reach the professionals for months or even years. • Separate all stock tips from the tipper, even if the tipper is very smart, very rich, and his or her last tip went up. • Some stock tips, especially from an expert in the field, may turn out to be quite valuable. However, people in the paper industry normally give out tips on drug stocks, and people in the health care field never run out of tips on the coming takeovers in the paper industry. • Invest in simple companies that appear dull, mundane, out of favor, and haven’t caught the fancy ...

It’s only by sticking to a strategy through good years and bad that you’ll maximize your long-term gains.

By the way, when you are figuring out how you’re doing in stocks, don’t forget to include all the costs of subscriptions to newsletters, financial magazines, commissions, investment seminars, and long-distance calls to brokers.

The point is not to rely on any fixed number of stocks but rather to investigate how good they are, on a case-by-case basis.

In my view it’s best to own as many stocks as there are situations in which: (a) you’ve got an edge; and (b) you’ve uncovered an exciting prospect that passes all the tests of research. Maybe that’s a single stock, or maybe it’s a dozen stocks. Maybe you’ve decided to specialize in turnarounds or asset plays and you buy several of those; or perhaps you happen to know something special about a single turnaround or a single asset play. There’s no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors.

In small portfolios I’d be comfortable owning between three and ten stocks. There are several possible benefits: (1) If you are looking for tenbaggers, the more stocks you own the more likely that one of them will become a tenbagger. Among several fast growers that exhibit promising characteristics, the one that actually goes the furthest may be a surprise.

Since there’s no way to anticipate when pleasant surprises of various kinds might occur, you increase your odds of benefiting from one by owning several stocks.

(2) The more stocks you own, the more flexibility you have to rotate funds between them. This is an important part of my strategy.

Spreading your money among several categories of stocks is another way to minimize downside risk, as discussed in Chapter 3.

Slow growers are low-risk, low-gain because they’re not expected to do much and the stocks are usually priced accordingly. Stalwarts are low-risk, moderate gain.

Cyclicals may be low-risk and high-gain or high-risk and low-gain, depending on how adept you are at anticipating cycles. If you are right, you can get your tenbaggers here, and if you are wrong, you can lose 80–90 percent.

Meanwhile, additional tenbaggers are likely to come from fast growers or from turnarounds—both high-risk, high-gain categories. The higher the potential upside, the greater the potential downside, and if a fast grower falters or the troubled old turnaround has a relapse, the downside can be losing all your money.

Finally, your portfolio design may change as you get older. Younger investors with a lifetime of wage-earning ahead of them can afford to take more chances on tenbaggers than can older investors who must live off the income from their investments. Younger investors have more years in which they can experiment and make mistakes before they find the great stocks that make investing careers. The circumstances vary so widely from person to person that any further analysis of this point will have to come from you.

I’m constantly rechecking stocks and rechecking stories, adding and subtracting to my investments as things change. But I don’t go into cash—except to have enough of it around to cover anticipated redemptions. Going into cash would be getting out of the market. My idea is to stay in the market forever, and to rotate stocks depending on the fundamental situations. I think if you decide that a certain amount you’ve invested in the stock market will always be invested in the stock market, you’ll save yourself a lot of mistimed moves and general agony.

Some people automatically sell the “winners”—stocks that go up—and hold on to their “losers”—stocks that go down—which is about as sensible as pulling out the flowers and watering the weeds.

Both strategies fail because they’re tied to the current movement of the stock price as an indicator of the company’s fundamental value.

If you can’t convince yourself “When I’m down 25 percent, I’m a buyer” and banish forever the fatal thought “When I’m down 25 percent, I’m a seller,” then you’ll never make a decent profit in stocks.

The best time to buy stocks will always be the day you’ve convinced yourself you’ve found solid merchandise at a good price—the same as at the department store. However, there are two particular periods when great bargains are likely to be found.

The first is during the peculiar annual ritual of end-of-the-year tax selling. It’s no accident that the most severe drops have occurred between October and December. It’s the holiday period, after all, and brokers need spending money like the rest of us, so there’s extra incentive for them to call and ask what you might want to sell to get the tax loss. For some reason investors are delighted to get the tax loss, as if it’s a wonderful opportunity or a gift of some kind—I can’t think of another situation in which failure makes people so happy.

The second is during the collapses, drops, burps, hiccups, and freefalls that occur in the stock market every few years.

One of the biggest troubles with stock market advice is that good or bad it sticks in your brain. You can’t get it out of there, and someday, sometime, you may find yourself reacting to it.

It’s normally harder to stick with a winning stock after the price goes up than it is to believe in it after the price goes down. These days if I feel there’s a danger of being faked out, I try to review the reasons why I bought in the first place.

Over the years I’ve learned to think about when to sell the same way I think about when to buy. I pay no attention to external economic conditions, except in the few obvious instances when I’m sure that a specific business will be affected in a specific way.

WHEN TO SELL A SLOW GROWER

The company has lost market share for two consecutive years and is hiring another advertising agency. • No new products are being developed, spending on research and development is curtailed, and the company appears to be resting on its laurels. • Two recent acquisitions of unrelated businesses look like diworseifications, and the company announces it is looking for further acquisitions “at the leading edge of technology.” • The company has paid so much for its acquisitions that the balance sheet has deteriorated from no debt and millions in cash to no cash and millions in debt. There are no surplus funds to buy back stock, even if the price falls sharply. • Even at a lower stock price the dividend yield will not be high enough to attract much interest from investors.

WHEN TO SELL A STALWART

There’s no point expecting a quick tenbagger in a stalwart, and if the stock price gets above the earnings line, or if the p/e strays too far beyond the normal range, you might think about selling it and waiting to buy it back later at a lower price—or buying something else, as I do.

Other sell signs: • New products introduced in the last two years have had mixed results, and others still in the testing stage are a year away from the marketplace. • The stock has a p/e of 15, while similar-quality companies in the industry have p/e’s of 11–12. • No officers or directors have bought shares in the last year. • A major division that contributes 25 percent of earnings is vulnerable to an economic slump that’s taking place (in housing starts, oil drilling, etc.). • The company’s growth rate has been slowing down, and though it’s been maintaining profits by cutting costs, future cost-cutting opportunities are limited.

WHEN TO SELL A ...

Other than at the end of the cycle, the best time to sell a cyclical is when something has actually started to go wrong. Costs have started to rise. Existing plants are operating at full capacity, and the company begins to spend money to add to capacity. Whatever inspired you to buy XYZ between the last bust and latest boom ought to clue you in that the latest boom is over.

One obvious sell signal is that inventories are building up and the company can’t get rid of them, which means lower prices and lower profits down the road.

Competition businesses are also a bad sign for cyclicals. The outsider will have to win customers by cutting prices, which forces everyone else to cut prices and leads to lower earnings for all the producers.

Other signs: • Two key union contracts expire in the next twelve months, and labor leaders are asking for a full restoration of the wages and benefits they gave up in the last contract. • Final demand for the product is slowing down. • The company has doubled its capital spending budget to build a fancy new plant, as opposed to modernizing the old plants at low cost. • The company has tried to cut costs but still can’t compete with foreign producers.

WHEN TO SELL A FAST GROWER

The main thing to watch for is the end of the second phase of rapid growth, as explained earlier.

Other signs: • Same store sales are down 3 percent in the last quarter. • New store results are disappointing. • Two top executives and several key employees leave to join a rival firm. • The company recently returned from a “dog and pony” show, telling an extremely positive story to institutional investors in twelve cities in two weeks. • The stock is selling at a p/e of 30, while the most optimistic projections of earnings growth are 15–20 percent for the next two years.

WHEN TO SELL A TURNAROUND

The best time to sell a turnaround is after it’s turned around. All the troubles are over and everybody knows it. The company has become the old self it was before it fell apart: growth company or cyclical or whatever. The shareholders aren’t embarrassed to own it again. ...

Other signs: • Debt, which has declined for five straight quarters, just rose by $25 million in the latest quarterly report. • Inventories are rising at twice the rate of sales growth. • The p/e is inflated relative to earnings prospects. • The company’s strongest division sells 50 percent of its output to one leading customer, and that leading customer is suffering from a slowdown in its own sales.

WHEN TO SELL AN ASSET PLAY

Lately, the best idea is to wait for the raider. If there are really hidden assets there, Saul Steinberg, the Hafts, or the Reichmanns will figure it out. As long as the company isn’t going on a debt binge, thus redu...

Other sell signs: • Although the shares sell at a discount to real market value, management has announced it will issue 10 percent more shares to help finance a diversification program. • The division that was expected to be sold for $20 million only brings $12 million in the actual sale. • The reduction in the corporate tax rate considerably reduces the value of the company’s tax-loss carryforward. • Institutional ownership has risen from 25 percent five years ago to 60 percent today—with several Boston fund groups being major purchasers.

These are the Twelve Silliest Things People Say About Stock Prices,