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

by Peter Lynch

My experience shows you don’t have to be trendy to succeed as an investor. In fact, most great investors I know (Warren Buffett, for starters) are technophobes. They don’t own what they don’t understand, and neither do I.

An amateur investor can pick tomorrow’s big winners by paying attention to new developments at the workplace, the mall, the auto showrooms, the restaurants, or anywhere a promising new enterprise makes its debut.

Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition, competitive position, plans for expansion, and so forth.

In the not-so-distant past, when a mature, healthy company routinely raised the dividend, it was a sign of prosperity. Cutting a dividend or failing to raise it was a sign of trouble.

If anybody’s responsible for the disappearing dividend, it’s the U.S. government, which taxes corporate profits, then taxes corporate dividends at the full rate, for so-called unearned income.

People who want to know how stocks fared on any given day ask, Where did the Dow close? I’m more interested in how many stocks went up versus how many went down. These so-called advance/decline numbers paint a more realistic picture. Never has this been truer than in the recent exclusive market, where a few stocks advance while the majority languish. Investors who buy “undervalued” small stocks or midsize stocks have been punished for their prudence. People are wondering: How can the S&P 500 be up 20 percent and my stocks are down? The answer is that a few big stocks in the S&P 500 are propping up the averages.

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

It’s when you’ve decided to invest on your own that you ought to try going it alone. That means ignoring the hot tips, the recommendations from brokerage houses, and the latest “can’t miss” suggestion from your favorite newsletter—in favor of your own research. It means ignoring the stocks that you hear Peter Lynch, or some similar authority, is buying.

Hanes turned out to be a sixbagger before it was taken over by Consolidated Foods, now Sara Lee. L’eggs still makes a lot of money for Sara Lee and has grown consistently over the past decade. I’m convinced Hanes would have been a 50-bagger if it hadn’t been bought out.

This book is divided into three sections. The first, Preparing to Invest (Chapters 1 through 5), deals with how to assess yourself as a stockpicker, how to size up the competition (portfolio managers, institutional investors, and other Wall Street experts), how to evaluate whether stocks are riskier than bonds, how to examine your financial needs, and how to develop a successful stockpicking routine. The second, Picking Winners (Chapters 6 through 15), deals with how to find the most promising opportunities, what to look for in a company and what to avoid, how to use brokers, annual reports, and other resources to best advantage, and what to make of the various numbers (p/e ratio, book value, cash flow) that are often mentioned in technical evaluations of stocks. The third, The Long-term View (Chapters 16 through 20), deals with how to design a portfolio, how to keep tabs on companies in which you’ve taken an interest, when to buy and when to sell, the follies of options and futures, and some general observations about the health of Wall Street, American enterprise, and the stock market—things I’ve noticed in twenty-odd years of investing.

Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage. If stockpicking could be quantified, you could rent time on the nearest Cray computer and make a fortune.

I also found it difficult to integrate the efficient-market hypothesis (that everything in the stock market is “known” and prices are always “rational”) with the random-walk hypothesis (that the ups and downs of the market are irrational and entirely unpredictable).

I didn’t do it to be contrary. I did it because when I saw a bargain I couldn’t resist buying it, and in those days there were bargains everywhere.

The true contrarian waits for things to cool down and buys stocks that nobody cares about, and especially those that make Wall Street yawn.

Stand by your stocks as long as the fundamental story of the company hasn’t changed.

No matter how we arrive at the latest financial conclusion, we always seem to be preparing ourselves for the last thing that’s happened, as opposed to what’s going to happen next. This “penultimate preparedness” is our way of making up for the fact that we didn’t see the last thing coming along in the first place.

What I hope you’ll remember most from this section are the following points: • Don’t overestimate the skill and wisdom of professionals. • Take advantage of what you already know. • Look for opportunities that haven’t yet been discovered and certified by Wall Street—companies that are “off the radar scope.” • Invest in a house before you invest in a stock. • Invest in companies, not in the stock market. • Ignore short-term fluctuations. • Large profits can be made in common stocks. • Large losses can be made in common stocks. • Predicting the economy is futile. • Predicting the short-term direction of the stock market is futile. • The long-term returns from stocks are both relatively predictable and also far superior to the long-term returns from bonds. • Keeping up with a company in which you own stock is like playing an endless stud-poker hand. • Common stocks aren’t for everyone, nor even for all phases of a person’s life. • The average person is exposed to interesting local companies and products years before the professionals. • Having an edge will help you make money in stocks. • In the stock market, one in the hand is worth ten in the bush.

THE SIX CATEGORIES 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.

Electric utilities are today’s most popular slow growers, but throughout the 1950s and into the 1960s the utilities were fast growers, expanding at over twice the rate of GNP.

IBM and Digital may be the slow growers of tomorrow.

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

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?

Stalwarts are stocks that I generally buy for a 30 to 50 percent gain, then sell and repeat the process with similar issues that haven’t yet appreciated.

I always keep some stalwarts in my portfolio because they offer pretty good protection during recessions and hard times.

A fast-growing company doesn’t necessarily have to belong to a fast-growing industry. As a matter of fact, I’d rather it didn’t, as you’ll see in Chapter 8. All it needs is the room to expand within a slow-growing industry.

Beer is a slow-growing industry, but Anheuser-Busch has been a fast grower by taking over market share, and enticing drinkers of rival brands to switch to theirs.

The hotel business grows at only 2 percent a year, but Marriott was a...

The same thing happened to Taco Bell in the fast-food business, Wal-Mart in the general store business, and The Gap in the retail clothing business. These upstart enterprises learned to succeed in one place, and then to duplicate the winning formula over and over, mall by mall, city by city. The expansion into new markets results i...

Also, Wall Street does not look kindly on fast growers that run out of stamina and turn into slow growers, and when that happens, the stocks are beaten down accordingly.

But for as long as they can keep it up, fast growers are the big winners in the stock market. 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.

The autos and the airlines, the tire companies, steel companies, and chemical companies are all cyclicals. Even defense companies behave like cyclicals, since their profits’ rise and fall depends on the policies of various administrations.

I made a lot of money for my shareholders by buying Chrysler. I started buying at $6 (unadjusted for later splits) in early 1982 and watched it go up fivefold in less than two years and fifteenfold in five years. At one point I had 5% of my fund invested in Chrysler. While other stocks that I owned have risen higher, no single stock ever had the impact of Chrysler because none ever represented such a large percentage of the fund while it rose. And I didn’t even buy Chrysler at the bottom!

There’s the bail-us-out-or-else kind of turnaround such as Chrysler or Lockheed, where the whole thing depended on a government loan guarantee.

There’s the who-would-have-thunk-it kind of turnaround, such as Con Edison.

There’s the little-problem-we-didn’t-anticipate kind of turnaround, such as Three Mile Island.

I try to stay away from the tragedies where the outcome is unmeasurable, such as the Bhopal disaster at the Union Carbide plant in India.

There’s the perfectly-good-company-inside-a-bankrupt-company kind of turnaround, such as Toys “R” Us.

There’s the restructuring-to-maximize-shareholder-values kind of turnaround, such as Penn Central.

Many of the publicly traded railroads such as Burlington Northern, Union Pacific, and Santa Fe Southern Pacific are land rich, dating back to the nineteenth century when the government gave away half the country as a sop to the railroad tycoons. These companies have the oil and gas rights, the mineral rights, and the timber rights as well.

Actually Penn Central might have been the ultimate asset play. The company had everything: tax-loss carryforward, cash, extensive land holdings in Florida, other land elsewhere, coal in West Virginia, and air rights in Manhattan. Anybody who had anything to do with Penn Central could have figured out that this was a stock worth buying. It went up eightfold.

I would have understood that cable is as much of a fixture as water or electricity—the video utility.

Fast growers can lead exciting lives, and then they burn out, just as humans can. They can’t maintain double-digit growth forever, and sooner or later they exhaust themselves and settle down into the comfortable single digits of sluggards and stalwarts.

A fast grower such as Holiday Inn inevitably slows down, and the stock is depressed until some smart investors realize that it owns so much real estate that it’s a great asset play. Look what’s happened to retailers such as Federated and Allied Stores—because of the department stores they built in prime locations, and because of the shopping centers they own, they’ve been taken over for their assets.

McDonald’s is a classic fast grower, but because of the thousands of outlets it either owns or is repurchasing from the franchisees, it could be a great future asset play in real estate.

Basing a strategy on general maxims, such as “Sell when you double your money,” “Sell after two years,” or “Cut your losses by selling when the price falls ten percent,” is absolute folly. It’s simply impossible to find a generic formula that sensibly applies to all the different kinds of stocks.

and being the lowest-cost producer gives it a big advantage in the industry.

Dart & Kraft, which merged years ago, eventually separated so that Kraft could become a pure food company again. Dart (which owns Tupperware) was spun off as Premark International and has been a great investment on its own. So has Kraft, which was bought out by Philip Morris in 1988.

blasé,

A month or two after the spinoff is completed, you can check to see if there is heavy insider buying among the new officers and directors. This will confirm that they, too, believe in the company’s prospects.

In a no-growth industry, especially one that’s boring and upsets people, there’s no problem with competition. You don’t have to protect your flanks from potential rivals because nobody else is going to be interested. This gives you the leeway to continue to grow, to gain market share,