Beating the Street

by Peter Lynch

The company had equity of $1.68 billion and total debt (minus cash) of only $318 million. Clearly, this was no candidate for bankruptcy no matter what the price of copper (well, zero would be a problem). Many weaker competitors will be forced to close their mines and pack up their slag and go home before Phelps Dodge even has to refinance.

The autos, often misidentified as blue chips, are classic cyclicals. Buying an auto stock and putting it away for 25 years is like flying over the Alps—you may get something out of it, but not as much as the hiker who experiences all the ups and downs.

One useful indicator for when to buy auto stocks is used-car prices. When used-car dealers lower their prices, it means they’re having trouble selling cars, and a lousy market for them is even lousier for the new-car dealers. But when used-car prices are on the rise, it’s a sign of good times ahead for the automakers.

GM’s reputation for excellence far exceeded any desire to live up to it.

in the stock market it rarely pays to take yesterday’s news too seriously, or to hold an opinion too long.

For brief periods at Magellan, I had 10 percent of the fund invested in utilities. Usually this happened when interest rates were declining and the economy was in a sputter. In other words, I treated the utilities as interest-rate cyclicals, and tried to time my entrances and my exits accordingly.

Corporations, like people, change their names for one of two reasons: either they’ve gotten married, or they’ve been involved in some fiasco that they hope the public will forget.

The reason my record with troubled utilities is better than with troubled companies in general is that utilities are regulated by the government. A utility may declare bankruptcy and/or eliminate its dividend, but as long as people need electricity, a way must be found for the utility to continue to function. The regulatory system determines what prices the utility can charge for the electricity or gas, what profit it’s allowed to make, and whether the costs of its mistakes can be passed along to the customer. Since the state government has a vested interest in the survival of the enterprise, the odds are overwhelming that the troubled utility will be given the wherewithal to overcome its problems.

This suggests a simple way to make a nice living from troubled utilities: buy them when the dividend is omitted and hold on to them until the dividend is restored. This is a strategy with a terrific success ratio.

Privatization is a strange concept. You take something that’s owned by the public and then sell it back to the public, and from then on, it’s private. From a practical standpoint, what’s useful to know about this is that whenever the Americans or the British have privatized something by selling shares in it, it’s usually been a good deal for the buyers.

Whatever the queen is selling, buy it.

They were monopolies, just as water utilities everywhere tend to be—it’s always nice to own a monopoly.

Speak about Thames Water

In our conversation in my office, the water lords told me that water bills in England were so low (100 pounds a year) that even if these prices doubled the customers would not resent it. Even if they did resent it, there was nothing they could do about it except stop using water, which was unlikely. Water demand in England was growing at 1 percent a year.

Here’s another great what-if portfolio, Telephones of the Emerging Nations:

This was one of those rare periods when a homeowner could say: “My house is OK, but my mortgage is beautiful.”

Fannie Mae copied the Freddie Mac idea and began packaging mortgages in 1982. Let’s say you had a mortgage on your house that came from Bank X. Bank X would sell your mortgage to Fannie Mae. Fannie Mae would lump it together with other mortgages to create a “mortgage-backed security.” It could then sell the mortgage-backed security to anybody, even back to the banks that had originated the mortgages in the package.

2008 financial crisis

When a company can earn back the price of its stock in one year, you’ve found a good deal.

Backing up the truck” is a technical Wall Street term for buying as many shares as you can afford.

Here is another of my favorite what-if portfolios: if you had divided your money equally among these eight stocks and held them from the beginning of 1988 to the end of 1989, you would have outperformed 99 percent of the funds that these companies promote.

During periods when mutual funds are popular, investing in the companies that sell the funds is likely to be more rewarding than investing in their products. I’m reminded that in the Gold Rush the people who sold picks and shovels did better than the prospectors.

When interest rates are declining, the bond and equity funds tend to attract the most cash, and the companies that specialize in such funds (Eaton Vance and Colonial...

Dreyfus manages a lot of money-market assets, so when interest rates are going up and people are getting out of the stock market and out...

I learned long ago that if you make 10 inquiries at 10 different companies, you are going to discover at least 1 unexpected development. Unexpected developments are what make stocks go up and down,

Since the 1960s, when fast food became an accessory to the automobile and people learned to eat their lunches, then breakfasts, and finally dinners on the road, restaurant chains have become great growth companies, with new ones forever taking over where the old ones left off.

A restaurant chain, like a retailer, has 15–20 years of fast growth ahead of it as it expands. This is supposed to be a cutthroat business, but the fledgling restaurant company is protected from competition in a way that an electronics company or a shoe company is not. If there’s a new fish-and-chips chain in California and a better one in New York, what’s the impact of the New York chain on the California chain? Zero.

What continues to separate the triumphs from the flops among the restaurant chains is capable management, adequate financing, and a methodical approach to expansion. Slow but steady may not win the Indianapolis 500, but it wins this kind of race.

There are several ways a restaurant chain can increase its earnings. It can add more restaurants, as Chili’s is doing, or it can improve its existing operations, as Wendy’s has done. Some restaurants make money with high turnover at the tables and low-priced meals (Cracker Barrel, Shoney’s, and McDonald’s fit this category), while others have low turnover and higher-priced meals (Outback Steakhouse and Chart House are recent examples). Some make their biggest profits on food sales, and some have gift shops (Cracker Barrel). Some have high profit margins because their food is made from inexpensive ingredients (Spaghetti Warehouse), others because their operating costs are low.

You follow a restaurant story the same way you follow a retailer. The key elements are growth rate, debt, and same-store sales. You’d like to see the same-store sales increasing every quarter. The growth rate should not be too fast—above 100 new outlets a year, the company is in a potential danger zone. Debt should be low to nonexistent, if possible.

Any time you can find a 25 percent grower selling for 20 times earnings, it’s a buy. If the price dropped any further, I’d back up the truck.

A healthy portfolio requires a regular checkup—perhaps every six months or so.

As a stockpicker, you can’t assume anything. You’ve got to follow the stories. You are trying to get answers to two basic questions: (1) is the stock still attractively priced relative to earnings, and (2) what is happening in the company to make the earnings go up?

No matter how hard you try to imagine the next event that will make trouble for a company, it’s usually something you haven’t thought of.

British shareholders are not as familiar with small growth companies as we are, and therefore abandon them more readily in a market crisis.

Your investor’s edge is not something you get from Wall Street experts. It’s something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.

Over the past three decades, the stock market has come to be dominated by a herd of professional investors. Contrary to popular belief, this makes it easier for the amateur investor. You can beat the market by ignoring the

Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.

Long shots almost always miss the mark.

Always look at the balance sheet to see if a company is solvent before you risk your money on it.

In every industry and every region of the country, the observant amateur can find great growth companies long before the professionals have discovered them.

Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether.

Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.

If you have the stomach for stocks, but neither the time nor the inclination to do the homework, invest in equity mutual funds. Here, it’s a good idea to diversify. You should own a few different kinds of funds, with managers who pursue different styles of investing: growth, value, small companies, large companies, etc. Investing in six of the same kind of fund is not diversification.

Among the major stock markets of the world, the U.S. market ranks eighth in total return over the past decade. You can take advantage of the faster-growing economies by investing some portion of your assets in an overseas fund with a good record.

In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.

My routine is always the same. I search for companies that are undervalued, and I usually find them in sectors or industries that are out of favor.

Whenever a popular stock suffers a big drop in price, especially a stock that is widely held by pension funds and mutual funds, Wall Street has to make up a reason for the decline that gets the fund managers off the hook for owning it. Recently we’ve heard that the drug company stocks declined because Wall Street was nervous about the Clinton health plan, and Coca-Cola declined because investors were worried about the effect of a stronger dollar on Coca-Cola’s earnings, and Home Depot declined because of sluggishness in the housing market. The real reason these stocks declined is that they had gotten terrifically overpriced relative to current earnings.

In my experience, the price of a stock, the “p” in the p/e equation, cannot run too far ahead of the earnings, the “e” in the equation, without something having to give.