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

by Peter Lynch

Hot stocks can go up fast, usually out of sight of any of the known landmarks of value, but since there’s nothing but hope and thin air to support them, they fall just as quickly.

In fact, when people tout a stock as the next of something, it often marks the end of prosperity not only for the imitator but also for the original to which it is being compared.

If a company must acquire something, I’d prefer it to be a related business, but acquisitions in general make me nervous.

There’s a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them. I’d rather see a vigorous buyback of shares, which is the purest synergy

What all these longshots had in common besides the fact that you lost money on them was that the great story had no substance. That’s the essence of a whisper stock.

You can get tenbaggers in companies that have already proven themselves. When in doubt, tune in later.

The company that sells 25 to 50 percent of its wares to a single customer is in a precarious situation. SCI Systems (not to be confused with the funeral-home

As often as a dull name in a good company keeps early buyers away, a flashy name in a mediocre company attracts investors and gives them a false sense of security.

On chart after chart the two lines will move in tandem, or if the stock price strays away from the earnings line, sooner or later it will come back to the earnings.

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,

An average p/e for a utility (7 to 9 these days) will be lower than the average p/e for a stalwart (10 to 14 these days), and that in turn will be lower than the average p/e of a fast grower (14–20).

to expand enough to justify a p/e of 64, but for a company the size of Avon, which already had over a billion in sales, it would have had to sell megabillions worth of cosmetics and lotions. In fact, somebody calculated that for Avon to justify a 64 p/e it would have to earn more than the steel industry, the oil industry, and the State of California combined.

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.

If they aren’t already doing it, then don’t invest in it.

I didn’t wait to see if this good idea from the neighborhood would actually succeed someplace else. Successful cloning is what turns a local taco joint into a Taco Bell or a local clothing store into The Limited, but there’s no point buying the stock until the company has proven that the cloning works.

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.

(That’s a rule with annuals and perhaps with publications in general—the cheaper the paper the more valuable the information.)

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.

This means that Ford has been buying back its own shares, another positive step.

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.

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. We use this measure all the time in analyzing stocks for the mutual funds.

Nevertheless, it’s always advisable to check the cash position (and the value of related businesses) as part of your research.

trouble. (In one of the footnotes of a typical annual report, the company gives a breakdown of its long-term debt, the interest that is being paid, and the dates that the debt is due.)

Years. Still today, there is a propensity among corporate managers to piss away profits on ill-fated ventures—but

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.

A ten percent return on cash corresponds nicely with the ten percent that one expects as a minimum reward for owning stocks long term.

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.

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

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.

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 i...

whether it has kept up the same momentum in recent years. • If you plan to hold the stock forever, see how the company has fared during previous recessions and market drops. (McDonald’s did well in the 1977 break, and in the 1984 break it went sideways. In the big Sneeze of 1987, it got blown away with the rest. Overall it’s been a good defensive stock. Bristol-Myers got clobbered in the 1973–74 break, primarily because it was so overpriced. It did well in ...

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. (For instance, everyone knows there are cycles in the auto industry. Eventually there are going to be three or four up years to follow three or four down years. There always are. Cars get older and they have to be replaced. People can put off replacing cars for a year or two longer than expected, but sooner or later they are back in the dealerships. The worse the slump in the auto industry, the better the recovery. Sometimes I root for an extra year of bad sales, because I know it will bring a longer and more sustainable upside. Lately we’ve had five years of good car sales, so I know we are in the middle, and perhaps somewhere close to the end, of a prosperous cycle. But it’s much easier to predict an upturn in a cyclical industry than it is to predict a downturn.)

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 electronic surveillance system (the one-time purchase) far overshadowed whatever they got from selling those lit...

$6 in twelve months. • That few institutions own the stock and only a handful of analysts have ever heard of it. With fast gro...

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,...

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...

investors, because the company printed and sold millions of new shares to raise capital. This dilution resulted in the company’s havi...

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. 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 ...

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 Loc...

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...

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. Time also has sold off divisions and dramatically cut costs. It is one of my favorite recent turnarounds. Actually it’s an asset play as well. The cable-TV part of the business is potentially worth $60 a share, so if the stock sells for $100, you’re buying the rest of the company for $40. • Is business coming back? (Thi...

(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. The turnaround in Apple Computer was harder to predict. However, if you’d been close to the company, you might have notic...

ASSET PLAYS • What’s the value of the assets? Are there any hidden assets? • How much debt is there ...

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