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

by Peter Lynch

If my favorite Internet company sells for $30 a share, and yours sells for $10, then people who focus on price would say that mine is the superior company. This is a dangerous delusion. What Mr. Market pays for a stock today or next week doesn’t tell you which company has the best chance to succeed two to three years down the information superhighway. 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.

Anyone who plays regularly in a monthly stud poker game soon realizes that the same “lucky stiffs” always come out ahead. These are the players who undertake to maximize their return on investment by carefully calculating and recalculating their chances as the hand unfolds. Consistent winners raise their bet as their position strengthens, and they exit the game when the odds are against them, while consistent losers hang on to the bitter end of every expensive pot, hoping for miracles and enjoying the thrill of defeat. In stud poker and on Wall Street, miracles happen just often enough to keep the losers losing.

In case after case the proper picking of markets would have resulted in your losing half your assets because you’d picked the wrong stocks. If you rely on the market to drag your stock along, then you might as well take the bus to Atlantic City and bet on red or black. If you wake up in the morning and think to yourself, “I’m going to buy stocks because I think the market is going up this year,” then you ought to pull the phone out of the wall and stay as far away as possible from the nearest broker. You’re relying on the market to bail you out, and chances are, it won’t.

I could go on for the rest of the book about the edge that being in a business gives the average stockpicker. On top of that, there’s the consumer’s edge that’s helpful in picking out the winners from the newer and smaller fast-growing companies, especially in the retail trades. Whichever edge applies, the exciting part is that you can develop your own stock detection system outside the normal channels of Wall Street, where you’ll always get the news late.

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?

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. There are almost as many ways to classify stocks as there are stockbrokers—but I’ve found that these six categories cover all of the useful distinctions that any investor has to make.

Another sure sign of a slow grower is that it pays a generous and regular dividend. As I’ll discuss more fully in Chapter 13, companies pay generous dividends when they can’t dream up new ways to use the money to expand the business.

You won’t find a lot of two to four percent growers in my portfolio, because if companies aren’t going anywhere fast, neither will the price of their stocks. If growth in earnings is what enriches a company, then what’s the sense of wasting time on sluggards?

When somebody says, “Any idiot could run this joint,” that’s a plus as far as I’m concerned, because sooner or later any idiot probably is going to be running it.

High growth and hot industries attract a very smart crowd that wants to get into the business. Entrepreneurs and venture capitalists stay awake nights trying to figure out how to get into the act as quickly as possible. If you have a can’t-fail idea but no way of protecting it with a patent or a niche, as soon as you succeed, you’ll be warding off the imitators. In business, imitation is the sincerest form of battery.

Philip Morris has found its niche. Negative-growth industries do not attract flocks of competitors.

Whisper stocks have a hypnotic effect, and usually the stories have emotional appeal. This is where the sizzle is so delectable that you forget to notice there’s no steak. If you or I regularly invested in these stocks, we both would need part-time jobs to offset the losses.

If you can’t predict future earnings, at least you can find out how a company plans to increase its earnings. Then you can check periodically to see if the plans are working out. 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.

I’ve seen it happen in many an office: when they bring the rubber trees indoors, it’s time to fear for the earnings.

I could never prove this scientifically, but if you can’t imagine how a company representative could ever get that rich, chances are you’re right.

Pic ’N’ Save’s strategy was to take discontinued products out of the regular distribution channels and offer them at fire-sale prices. I could have gotten that information from investor relations, but it wasn’t the same as seeing the brand-name cologne for 79 cents a bottle, and the customers oohing and aahing over it.

In the top column marked Current Assets, I notice that the company has $5.672 billion in cash and cash items, plus $4.424 billion in marketable securities. Adding these two items together, I get the company’s current overall-cash position, which I round off to $10.1 billion. Comparing the 1987 cash to the 1986 cash in the right-hand column, I see that Ford is socking away more and more cash. This is a sure sign of prosperity. Then I go to the other half of the balance sheet, down to the entry that says “long-term debt.” Here I see that the 1987 long-term debt is $1.75 billion, considerably reduced from last year’s long-term debt. Debt reduction is another sign of prosperity. When cash increases relative to debt, it’s an improving balance sheet. When it’s the other way around, it’s a deteriorating balance sheet. Subtracting the long-term debt from the cash, I arrive at $8.35 billion, Ford’s “net cash” position. The cash and cash assets alone exceed the debt by $8.35 billion. When cash exceeds debt it’s very favorable. No matter what happens, Ford isn’t about to go out of business.

I discover that there are 511 million shares outstanding. I can also see that the number has been reduced in each of the past two years. This means that Ford has been buying back its own shares, another positive step. Dividing the $8.35 billion in cash and cash assets by the 511 million shares outstanding, I conclude that there’s $16.30 in net cash to go along with every share of Ford.

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. If the p/e of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year (also known as a “12-percent grower”) and a p/e ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown.

A slightly more complicated formula enables us to compare growth rates to earnings, while also taking the dividends into account. Find the long-term growth rate (say, Company X’s is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the p/e ratio (Company X’s is 10). 12 plus 3 divided by 10 is 1.5. Less than a 1 is poor, and 1.5 is okay, but what you’re really looking for is a 2 or better. A company with a 15 percent growth rate, a 3 percent dividend, and a p/e of 6 would have a fabulous 3.

So with Ford selling for $38, you were getting the $16.30 in net cash and another $16.60 in the value of the finance companies, so the automobile business was costing you a grand total of $5.10 per share. And this same automobile business was expected to earn $7 a share. Was Ford a risky pick? At $5.10 per share it was an absolute steal, in spite of the fact that the stock was up almost tenfold already since 1982.

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

There’s also hidden value in owning a drug that nobody else can make for seventeen years, and if the owner can improve the drug slightly, then he gets to keep the patent for another seventeen years. On the books, these wonderful drug patents may be worth zippo. When Monsanto bought Searle, it picked up NutraSweet. NutraSweet comes off patent in four years and will continue to be valuable even then, but Monsanto is writing the whole thing off against earnings. In four years NutraSweet will show up as a zero on Monsanto’s balance sheet. Just as in the case of Coca-Cola Enterprises, when Monsanto writes something off against earnings, the real earnings are understated. If the company actually makes $10 per share in profits, but has to devote $2 of that to “pay” to write things off such as NutraSweet, when it stops writing off NutraSweet the earnings will rise by $2 a share. In addition, Monsanto is expensing all its research and development in the same fashion, and someday when the expenses stop and the new products come onto the market, the earnings will explode. If you understand this, you have a big edge.

For the past several years, if you were interested in DuPont, you got it cheaper by buying Seagram, which happens to own about 25 percent of DuPont’s outstanding shares. Seagram became a DuPont play.

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.

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.

For example, in 1980 Lockheed earned $8.04 per share from its defense business, but it lost $6.54 per share in its commercial aviation division because of its L-1011 TriStar passenger jet. The L-1011 was a great airplane, but it suffered from competition with McDonnell Douglas’s DC10 in a relatively small market. And in the long-distance market, it was getting killed by the 747. These losses were persistent, and in December, 1981, the company announced that it would phase out the L-1011. This resulted in a large write-off in 1981 ($26 per share), but it was a one-time loss. In 1982, when Lockheed earned $10.78 per share from defense, there were no more losses to deal with. Earnings had gone from $1.50 to $10.78 per share in two years! You could have bought Lockheed for $15 at the time of the L-1011 announcement. Within four years it hit $60, for a fourbagger.

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. Others automatically sell their losers and hold on to their winners, which doesn’t work out much better. Both strategies fail because they’re tied to the current movement of the stock price as an indicator of the company’s fundamental value.

More recently we’ve been warned (in no particular order) that a rise in oil prices is a terrible thing and a fall in oil prices is a terrible thing; that a strong dollar is a bad omen and a weak dollar is a bad omen; that a drop in the money supply is cause for alarm and an increase in the money supply is cause for alarm. A preoccupation with money supply figures has been supplanted with intense fears over budget and trade deficits, and thousands more must have been drummed out of their stocks because of each.

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.

The point is, there’s no arbitrary limit to how high a stock can go, and if the story is still good, the earnings continue to improve, and the fundamentals haven’t changed, “can’t go much higher” is a terrible reason to snub a stock. Shame on all those experts who advise clients to sell automatically after they double their money. You’ll never get a tenbagger doing that.

Sometimes it’s always darkest before the dawn, but then again, other times it’s always darkest before pitch black.

Whenever I’m tempted to fall for this one, I remind myself that unless I’m confident enough in the company to buy more shares, I ought to be selling immediately.