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

by Peter Lynch

Once a patent is approved, all the rival companies with their billions in research dollars can’t invade the territory. They have to invent a different drug, prove it is different, and then go through three years of clinical trials before the government will let them sell it.

Chemical companies have niches in pesticides and herbicides. It’s not any easier to get a poison approved than it is to get a cure approved. Once you have a patent and the federal go-ahead on a pesticide or a herbicide, you’ve got a money machine. Monsanto has several today.

Brand names such as Robitussin or Tylenol, Coca-Cola or Marlboro, are almost as good as niches. It costs a fortune to develop public confidence in a soft drink or a cough medicine. The whole process takes years.

There’s no better tip-off to the probable success of a stock than that people in the company are putting their own money into it. In general, corporate insiders are net sellers, and they normally sell 2.3 shares to every one share that they buy. After the 1,000-point drop from August to October, 1987, it was reassuring to discover that there were four shares bought to every one share sold by insiders across the board. At least they hadn’t lost their faith.

Although it’s a nice gesture for the CEO or the corporate president with the million-dollar salary to buy a few thousand shares of the company stock, it’s more significant when employees at the lower echelons add to their positions. If you see someone with a $45,000 annual salary buying $10,000 worth of stock, you can be sure it’s a meaningful vote of confidence. That’s why I’d rather find seven vice presidents buying 1,000 shares apiece than the president buying 5,000.

The announcement of massive share buybacks by company after company broke on October 20, 1987 the fall of many stocks, and stabilized the market at the height of its panic.

This sensible practice was almost unheard of until quite recently. Back in the 1960s, International Dairy Queen was one of the pioneers in share buybacks, but there were few others who followed suit.

The common alternatives to buying back shares are (1) raising the dividend, (2) developing new products, (3) starting new operations, and (4) making acquisitions. Gillette tried to do all four, with emphasis on the final three. Gillette has a spectacularly profitable razor business, which it gradually reduced in relative size as it acquired less profitable operations.

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 of all.

On October 4, 1980, Genentech came public at $35 and on the same afternoon traded as high as $89 before backing off to $711/4.

IPOs of brand-new enterprises are very risky because there’s so little to go on. Although I’ve bought some that have done well over time (Federal Express was my first and it’s gone up twenty-five-fold), I’d say three out of four have been long-term disappointments.

I’ve done better with IPOs of companies that have been spun out of other companies, or in related situations where the new entity actually has a track record.

Look at the chart of Dow Chemical. When earnings are up the stock is up. That’s what happened during the period from 1971 to 1975 and again from 1985 through 1988. In between, from 1975 through 1985, earnings were erratic and so was the stock price.

Look at Avon, a stock that jumped from $3 in 1958 to $140 in 1972 as earnings continued to rise. Optimism abounded, and the stock price became inflated relative to earnings. Then, in 1973, the fantasy ended. The stock price collapsed because earnings collapsed, and you could have seen it coming. Forbes magazine warned us all in a cover article ten months before the collapse began.

And how about Masco Corporation, which developed the single-handle ball faucet, and as a result enjoyed thirty consecutive years of up earnings through war and peace, inflation and recession, with the earnings rising 800-fold and the stock rising 1,300-fold between 1958 ...

Look at Shoney’s, a restaurant chain that has had 116 consecutive quarters (twenty-nine years) of higher revenues—a record few companies could match. Sure enough, the stock price has steadily moved up. In those few spots where the price got ahead of the earnings, it promptly fell back to reality, as you can see in the chart.

(In a few cases the p/e ratio listed in the newspaper may be abnormally high, often because a company has written off some long-term losses against the current short-term earnings, thus “punishing” those earnings.

I know I’ve already advised you to ignore the market, but when you find that a few stocks are selling at inflated prices relative to earnings, it’s likely that most stocks are selling at inflated prices relative to earnings. That’s what happened before the big drop in 1973–74,

Interest rates have a large effect on the prevailing p/e ratios, since investors pay more for stocks when interest rates are low and bonds are less attractive. But interest rates aside, the incredible optimism that develops in bull markets can drive p/e ratios to ridiculous levels,

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.

Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path.

If it’s a slow-growing company you’re thinking about, then presumably you’re in it for the dividend, (Why else own this kind of stock?) Therefore, the important elements of the script would be: “This company has increased earnings every year for the last ten, it offers an attractive yield; it’s never reduced or suspended a dividend, and in fact it’s raised the dividend during good times and bad, including the last three recessions. It’s a telephone utility, and the new cellular operations may add a substantial kicker to the growth rate.”

If it’s a cyclical company you’re thinking about, then your script revolves around business conditions, inventories, and prices. “There has been a three-year business slump in the auto industry, but this year things have turned around. I know that because car sales are up across the board for the first time in recent memory. I notice that GM’s new models are selling well, and in the last eighteen months the company has closed five inefficient plants, cut twenty percent off labor costs, and earnings are about to turn sharply higher.”

If it’s an asset play, then what are the assets, how much are they worth? “The stock sells for $8, but the videocassette division alone is worth $4 a share and the real estate is worth $7. That’s a bargain in itself, and I’m getting the rest of the company for a minus $3. Insiders are bu...

If it’s a turnaround, then has the company gone about improving its fortunes, and is the plan working so far? “General Mills has made great progress in curing its diworseification. It’s gone from eleven basic businesses to two. By selling off Eddie Bauer, Talbot’s, Kenner, and Parker Brothers and getting top dollar for these excellent companies, General Mills has returned to doing what it does best: restaurants and packaged foods. The company has been buying back millions of its shares. The seafood subsidiary, Gortons, has grown from 7 percent of the s...

If it’s a stalwart, then the key issues are the p/e ratio, whether the stock already has had a dramatic run-up in price in recent months, and what, if anything, is happening to accelerate the growth rate. You might say to yourself: “Coca-Cola is selling at the low end of its p/e range. The stock hasn’t gone anywhere for two years. The company has improved itself in several ways. It sold half its interest in Columbia Pictures to the public. Diet drinks have sped up the growth rate dramatically. Last year the Japanese drank 36 percent more Cokes than they did the year before, and the Spanish upped their consumption by 26 percent. That’s phenomenal progress. Foreign sales are excellent in general. Through a separate stock offering, Coca-Cola Enterprises, the company has b...

If it is a fast grower, then where and how can it continue to grow fast? “La Quinta is a motel chain that started out in Texas. It was very profitable there. The company successfully duplicated its successful formula in Arkansas and Louisiana. Last year it added 20 percent more motel units than the year before. Earnings have increased every quarter. The company plans rapid future expansion. The debt is not excessive. Motels are a low-growth industry, and very...

What bothered me was that one of the important insiders had sold his shares at half the price I was staring at in the newspaper. (I found out later that this insider, a member of the founding family of La Quinta, was simply diversifying his portfolio.)

I continue to eat sandwiches from Bildner’s, and every time I take a bite of one it reminds me of what I did wrong. 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.

That’s what I forgot to ask Bildner’s: Does the idea work elsewhere? I should have worried about a shortage of skilled store managers, its limited financial resources, and its ability to survive those initial mistakes.

It’s the old oracle rule at work: the more mysterious the source, the more persuasive the advice. Investors continually put their ears to the walls when it’s the handwriting that tells everything. Perhaps if they stamped the annual and quarterly reports “classified” or mailed them out in plain brown wrappers, more recipients would browse through them.

After Apple computer fell apart and the stock dropped from $60 to $15, I wondered if the company would ever recover from its difficulties, and whether I should consider it as a turnaround. Apple’s new Lisa, its entry into the lucrative business market, had been a total failure. But when my wife told me that she and the children needed a second Apple for the house, and when the Fidelity systems manager told me that Fidelity was buying 60 new Macintoshes for the office, then I just learned that (a) Apple still was popular in the home market, and (b) it was making new inroads in the business market. I bought a million shares and I haven’t regretted it.

The more homogeneous the country gets, the more likely that what’s popular in one shopping center will also be popular in all the other shopping centers.

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.

When cash exceeds debt it’s very favorable. No matter what happens, Ford isn’t about to go out of business.

Value Line is easier to read than a balance sheet, so if you’ve never looked at any of this, start there. It tells you about cash and debt, summarizes the long-term record so you can see what happened during the last recession, whether earnings are on the upswing, whether dividends have always been paid, etc. Finally, it rates companies for financial strength on a simple scale of 1 to 5, giving you a rough idea of a company’s ability to withstand adversity. (There’s also a rating system for the “timeliness” of stocks, but I don’t pay attention to that.)

PERCENT OF SALES

THE PRICE/EARNINGS RATIO

THE CASH POSITION

Young companies with heavy debts are always at risk.

It’s the kind of debt, as much as the actual amount, that separates the winners from the losers in a crisis. There’s bank debt and there’s funded debt.

I pay particular attention to the debt structure, as well as to the amount of the debt, when I’m evaluating a turnaround

One strong argument in favor of companies that pay dividends is that companies that don’t pay dividends have a sorry history of blowing the money on a string of stupid diworseifications.

Another argument in favor of dividend-paying stocks is that the presence of the dividend can keep the stock price from falling as far as it would if there were no dividend.

In the wipeout of 1987, the high-dividend payers fared better than the nondividend payers and suffered less than half the decline of the general market. This is one reason I like to keep some stalwarts and even slow growers in my portfolio.

If investors are sure that the high yield will hold up, they’ll buy the stock just for that. This will put a floor under the stock price. Blue chips with long records of paying and raising dividends are the stocks people flock to in any sort of crisis.

Then again, the smaller companies that don’t pay dividends are likely to grow much faster because of it. They’re plowing the money into expansion. The reason that companies issue stock in the first place is so they can finance their expansion without having to burden themselves with debt from the bank. I’ll take an aggressive grower over a stodgy old dividend-payer any day.

Stocks such as Kellogg and Ralston Purina haven’t reduced dividends—much less eliminated them—through the last three wars and eight recessions, so this is the kind you want to own if you believe in dividends.

Heavily indebted companies like Southmark can never offer the same assurance as a Bristol-Myers, which has very little debt.