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

by Peter Lynch

When you’re a long-term investor, time is on your side.

As a very successful investor once said: “The bearish argument always sounds more intelligent.”

“That’s not to say there’s no such thing as an overvalued market, but there’s no point worrying about it.”

It is personal preparation, as much as knowledge and research, that distinguishes the successful stockpicker from the chronic loser. Ultimately it is not the stock market nor even the companies themselves that determine an investor’s fate. It is the investor.

Only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.

The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.

You’re looking for a situation where the value of the assets per share exceeds the price per share of the stock. In such delightful instances you can truly buy a great deal of something for nothing. I’ve done it myself numerous times.

Developing the story is really not difficult: at most it will take a couple of hours. In the next few chapters I’m going to tell you how I do it, and where you can find the most useful sources of information.

Investing without research is like playing stud poker and never looking at the cards.

If you’re considering a stock on the strength of some specific product that a company makes, the first thing to find out is: What effect will the success of the product have on the company’s bottom line?

The size of a company has a great deal to do with what you can expect to get out of the stock.

Once I’ve established the size of the company relative to others in a particular industry, next I place it into one of six general categories: slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds.

With individual companies it’s a little trickier, since growth can be measured in various ways: growth in sales, growth in profits, growth in earnings, etc. But when you hear about a “growth company,” you can assume that it’s expanding.

There are more sales, more production, and more profits in each successive year.

Another sure sign of a slow grower is that it pays a generous and regular dividend.

A fast-growing company doesn’t necessarily have to belong to a fast-growing industry.

I look for the ones that have good balance sheets and are making substantial profits. The trick is figuring out when they’ll stop growing, and how much to pay for the growth.

An asset play is any company that’s sitting on something valuable that you know about, but that the Wall Street crowd has overlooked.

The asset play is where the local edge can be used to greatest advantage.

Asset opportunities are everywhere. Sure they require a working knowledge of the company that owns the assets, but once that’s understood, all you need is patience.

Putting stocks in categories is the first step in developing the story. Now at least you know what kind of story it’s supposed to be. The next step is filling in the details that will help you guess how the story is going to turn out.

I always look for niches. The perfect company would have to have one. Warren Buffett started out by acquiring a textile mill in New Bedford, Massachusetts, which he quickly realized was not a niche business. He did poorly in textiles but went on to make billions for his shareholders by investing in niches. He was one of the first to see the value in newspapers and TV stations that dominated major markets, beginning with the Washington Post.

Every time an officer or a director buys or sells shares, he or she has to declare it on Form 4 and send the form to the Securities and Exchange Commission advising them of the fact.

If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train—and succumbing to the social pressure, often buys.

Although it’s easy to forget sometimes, a share of stock is not a lottery ticket. It’s part ownership of a business.

Like the earnings line, the p/e ratio is often a useful measure of whether any stock is overpriced, fairly priced, or underpriced relative to a company’s money-making potential.

The p/e ratio can be thought of as the number of years it will take the company to earn back the amount of your initial investment—assuming, of course, that the company’s earnings stay constant.

There are five basic ways a company can increase earnings*: reduce costs; raise prices; expand into new markets; sell more of its product in the old markets; or revitalize, close, or otherwise dispose of a losing operation. These are the factors to investigate as you develop the story. If you have an edge, this is where it’s going to be most helpful.

It’s never too late not to invest in an unproven enterprise.

When looking at the same sky, people in mature industries see clouds where people in immature industries see pie.

is buying back shares, whether cash exceeds long-term debt, and how much cash there is per share!

The p/e ratio of any company that’s fairly priced will equal its growth rate. I’m talking about growth rate of earnings here. How do you find that out? Ask your broker what’s the growth rate, as compared to the p/e ratio.

In general, a p/e ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative.

If your broker can’t give you a company’s growth rate, you can figure it out for yourself by taking the annual earnings from Value Line or an S&P report and calculating the percent increase in earnings from one year to the next. That way, you’ll end up with another measure of whether a stock is or is not too pricey. As to the all-important future growth rate, your guess is as good as mine.

A normal corporate balance sheet has two sides. On the left side are the assets (inventories, receivables, plant and equipment, etc.). The right side shows how the assets are financed. 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.

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” —John D. Rockefeller, 1901

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.

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. You wouldn’t see it from the industry—cigarette consumption in the U.S. is growing at about a minus two percent a year. True, foreign smokers have taken up where the U.S. smokers left off.

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.

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.

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.

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 of Wall Street.

Moderately fast growers (20 to 25 percent) in nongrowth industries are ideal investments. • Look for companies with niches. • When purchasing depressed stocks in troubled companies, seek out the ones with the superior financial positions and avoid the ones with loads of bank debt. • Companies that have no debt can’t go bankrupt. • Managerial ability may be important, but it’s quite difficult to assess. Base your purchases on the company’s prospects, not on the president’s resume or speaking ability. • A lot of money can be made when a troubled company turns around. • Carefully consider the price-earnings ratio. If the stock is grossly overpriced, even if everything else goe...

Study the dividend record of a company over the years and also how its earnings have fared in past recessions. • Look for companies with little or no institutional ownership. • All else being equal, favor companies in which management has a significant personal investment over companies run by people that benefit only from their salaries. • Insider buying is a positive sign, especially when several individuals are buying at once. • Devote at least an hour a week to investment research. Adding up your dividends and figuring out your gains and losses doesn’t count. • Be patient. Watched stock never boils. • Buying stocks based on stated book value alone is dangerous and illuso...