At this point, I'm supposed to promise I'll share the secrets of my success as a professional stock market investor. But rule number one is stop listening to professionals. 20 years in this business has convinced me that any normal person using the customary 3% of his or her brain power can pick stocks as well, if not better, than the average Wall Street expert.
I know you don't expect the plastic surgeon to advise you to do your own facelift. You don't want the plumber to tell you to install your own hot water tank. But this isn't surgery or plumbing.
This is investing, where the smart money isn't so smart and the dumb money isn't so dumb. Dumb money is only dumb when it listens to the smart money. In fact, the amateur investor has many built-in advantages that can result in outperforming the experts. When you pick your own stocks, you should outperform the experts.
Otherwise, why bother? Once you've decided to invest individually, try going it alone. This means ignoring the hot tips, recommendations from brokerage houses, and the latest can't-miss suggestion from your favorite newsletter.
It also means you should ignore the stocks you hear Peter Lynch or some similar authority is buying. You've got better sources than Peter Lynch, and they're all around you. What makes your sources so good is that you can keep tabs on them. You can pick spectacular performers from your place of business or out of your neighborhood shopping mall long before Wall Street will find them. It's impossible to be a credit card carrying American consumer while having done a lot of fundamental analysis on dozens of companies.
This is where you'll find the 10 baggers. I've seen it happen over and over from my perch at Fidelity. In the language of Wall Street, a 10 bagger. is a stock in which you've made 10 times your money.
I suspect this technical term has been borrowed from baseball, which goes up to a four-bagger or a home run. In my business, a four-bagger is nice, but a 10-bagger is a whole lot better. You might assume it's the sophisticated gossip that experts hear around Quotron machines, which give us our best investment ideas. But I stumble onto the potential... big winners in extracurricular situations the same way you can.
For instance, I was impressed with the Taco Bell burrito on a trip to California. Somebody at the rival Holiday Inn told me about La Quinta Motorins. My family and friends drive Volvos. My kids had an Apple computer at home, and then the systems manager bought several for our office.
I love the coffee at Dunkin'Donuts. My wife recommended the revamped Pier 1 imports. In fact, Carolyn is one of my best sources.
She's the one who discovered Legs. Legs is the perfect example of the power of common knowledge. It turned out to be one of the most successful consumer products of the 70s.
In the early part of that decade, I was working as a securities analyst at Fidelity. I knew the textile business. I visited textile plants, calculated profit margins, and learn the esoterica of warps and woofs.
But none of this information was as valuable as Carolyn's. I didn't find legs in any of my research. She found it by going to the grocery store. Carolyn didn't need to be a textile analyst to realize that legs was a superior product.
All she had to do was buy a pair and try them on. Two or three years after the product was introduced, you could have walked into any one of thousands of supermarkets and realized This product was a bestseller. From there, it was easy enough to find out that Legs was made by Hanes, and Hanes was listed on the New York Stock Exchange.
Hanes turned out to be a six-bagger before it was taken over by Consolidated Foods, which is now called Sara Lee. Legs still makes a lot of money for Sara Lee, and has continued to grow consistently over the past decade. I'm convinced Hanes would have been a 50-bagger if it hadn't been bought out.
You didn't have to know about legs from the outset. You could have bought Hanes stock during the first, second, or third year after legs went nationwide, and you could have tripled your money. The nice thing about investing in familiar companies like legs or Dunkin'Donuts is that when you try on the stockings or sip the coffee, you're doing the kind of basic analysis Wall Street analysts are paid to do.
Visiting stores and testing products is one of the critical elements of an analyst's job. During a lifetime of car buying, you develop a sense of what's good and what's bad. If you don't know about cars, you do know about something else. Why wait for the Merrill Lynch restaurant expert to recommend Dunkin'Donuts when you've already noticed eight new franchises opening up in your area? The Merrill Lynch analyst isn't going to notice Dunkin'Donuts until the stock has gone from $2 to $10.
But you noticed it when the stock was at $2. For some reason, amateur investors usually don't consider eating donuts a sophisticated initial investigation into equities. People seem more comfortable investing in something they know nothing about. There seems to be an unwritten rule on Wall Street.
If you don't understand it, put your life savings into it. Shun the enterprise around the corner, which can be observed, and seek out the one making an incomprehensible product. Does this mean I think you should buy shares in every business with a hot product?
The answer is no. Finding the promising company is the first step. The next step is doing the research. The Fidelity Magellan Mutual Fund has risen over 24-fold per share during the last 12 years. This is partly due to some of the little-known, out-of-favor stocks I've discovered.
researched on my own. Any investor can benefit from the same tactics. It doesn't take much to outsmart the smart money, which as I've said, isn't always so smart. Before you think about buying stocks, you should answer some basic questions about the market. How much do you trust corporate America?
Do you need to invest in stocks? What do you expect to get from them? Are you a short-term or a long-term investor?
How will you react to sudden price drops? Do you believe stocks are riskier than bonds? It's best to define your objectives and clarify your attitudes before you begin investing.
You are a potential market victim if you're undecided and lack conviction. Personal preparation is as important as research when it comes to separating the successful stock picker from the chronic loser. In this section called Preparing to Invest, Peter Lynch will tell you what you're up against and how you can best ensure your own success. Chapter 1. The Making of a Stock Picker There's no such thing as a hereditary knack for picking stocks. Many would like to blame their losses on a genetic flaw.
They believe others are somehow born to invest. My own history refutes that idea. There was no ticker tape above my cradle, and I didn't teethe on the stock pages.
Most of my relatives distrusted the stock market. My mother was the youngest of seven children. My aunts and uncles reached adulthood during the Great Depression. They had first-hand knowledge of the crash of 1929. Distrust of stocks was the prevailing American attitude throughout the 1950s and into the 1960s.
During that time, the market tripled and then doubled again. This period was truly the greatest bull market in history, not the 1980s. My father died when I was 10 and my mother had to go to work.
I wanted to help out. so I got a part-time job as a caddy. I began to understand the more important aspects of caddying when I was in high school. My clients were the presidents and CEOs of major corporations, including Gillette, Polaroid, and more to the point, Fidelity. In helping D.
George Sullivan find his ball, I was helping myself to find a career. The golf course was the next best thing to being on the floor of a major exchange. After my clients sliced the drive, They enthusiastically described their latest investment. The happy stories I heard on the fairways made me rethink the family position that the stock market was a place to lose money. Many of my clients seemed to be making money in the stock market.
I continued to caddy throughout high school and into college. I was on the liberal arts side of Boston College, avoiding all the required math and accounting courses, the normal preparations for business. Instead, I studied metaphysics, logic, and philosophy. along with history, psychology, and political science. Investing in stocks is an art, not a science.
People trained to rigidly quantify everything are at a disadvantage. If stock picking could be quantified, you could rent time on the nearest Cray computer and make a fortune, but it doesn't work that way. I applied for a summer job at Fidelity during my senior year.
This was at Mr. Sullivan's suggestion, Fidelity's president for whom I had caddied. I was thrilled to be hired at Fidelity. Some interns like me were put to work researching companies and writing reports just like the regular analysts.
The whole business was suddenly demystified. Even a liberal arts major can analyze a stock. I went to Wharton after that interlude at Fidelity, more skeptical than ever about the value of academic stock market theory.
It seemed to me that most of what I was learning at Wharton could only help you fail in the investment business. I studied statistics. advanced calculus, and quantitative analysis. Quantitative analysis taught me that the things I saw happening in Fidelity couldn't really be happening.
It was also obvious that the Wharton professors, who believe in academic theories, weren't doing nearly as well as my new colleagues at Fidelity. So I cast my lot with the practitioners, and my distrust of theorizers continues to this day. After serving my ROTC-required two-year hitch in the Army, I rejoined Fidelity as a research analyst in 1969. I was promoted to Director of Research in 1974. And in May 1977, I took over the Fidelity Magellan Fund.
Fidelity Magellan had $20 million in assets and 40 stocks in the portfolio. My boss suggested I reduce the number to 25. I listened politely and raised the number to 60. Six months later, to 100. Soon after that, to 150 stocks. I didn't do it to be contrary. I did it because I couldn't resist buying a bargain. There were bargains everywhere in those days.
My portfolio continued to grow. Instead of settling for a couple of savings and loans, I bought them across the board after determining each was a promising investment. It wasn't enough for me to invest in one convenience store.
I just had to buy Circle K, National Convenience, Shop and Go, and Hoppin'Foods to mention a few. Pretty soon, I became known as the Will Rogers of equities, a man who never saw a stock he didn't like. Since I own $1,400 now, I guess they have a point.
Actually, Will Rogers may have offered the best bit of advice about stocks. He said, don't gamble. Take all your savings and buy some good stock. And hold it till it goes up. Then sell it.
If it don't go up, don't buy it. Chapter 2. The Wall Street Oxymorons. To the list of famous oxymorons. which includes military intelligence, learned professor, deafening silence, and jumbo shrimp, I'd add professional investing. It's important to view the profession with skepticism.
Since 70% of the shares in major companies are controlled by institutions, you're competing against oxymorons whenever you buy or sell stock. This is a lucky break for you. There are many cultural, legal, and social barriers limiting the professionals.
Of course, not all professionals are oxymoronic. There are innovative fund managers who invest as they please, but the majority of the professional investors are hemmed in by the rules. The virtues of every spectacular stock I've found were so obvious that 99 out of 100 professionals would have wanted to add it to their portfolios.
But for reasons I'm about to describe, they couldn't. There are simply too many obstacles between the professional investors and the 10 baggers. Take the Limited, for example.
This company went public in 1969. Only one analyst followed the company for five years. A second analyst, Maggie Gilliam, noticed it in 1974. The first institution bought shares in the limited in the summer of 1975 when there were 100 limited stores open for business across the country. By 1979, 10 years after going public and having sustained a brilliant record, only two institutions had bought the stock. 400 limited stores were doing a thriving business in 1981, and only 6 analysts were covering the company.
When the stock hit its high of 9 in 1983, long-term investors were up 18-fold from 1979. The price fell to $5 a share in 1984, but the company was still doing well. Investors got another chance to buy in. As I'll explain later, if a stock is down but the fundamentals are good, it's best to hold on and better to buy more. It wasn't until 1985, with the stock back up to $15 a share, that analysts put the Limited on their buy lists. Aggressive institutional buying helped send the shares up to over $52, far beyond what the fundamentals justified.
By then, there were more than 30 analysts on the trail. Many arrived just in time to see the Limited drop. Contrast the story of the Limited with a 56- broker-journalists normally covering IBM. You haven't spent much time in Wall Street if you think the average Wall Street professional is looking for reasons to buy exciting stocks.
The rare professional has the guts to buy into an unknown company. In fact, choosing between the chance to make a large profit on an unknown company and the insurance of losing a small amount on an established company, most fund managers jump at the established company. Success is one thing.
It's more important not to look bad if you fail. There's an unwritten rule on Wall Street which states... You'll never lose your job losing your clients money in IBM.
Whenever fund managers do decide to buy something exciting, they may be held back by rules and regulations. Some bank trust departments won't allow stock purchases in companies with unions. Others won't invest in specific industry groups. It's the Securities and Exchange Commission making up the rules if it's not the mutual fund.
For instance, the SEC says a mutual fund like Fidelity Magellan cannot own more than 10% of the shares in any company. It also says we cannot invest more than 5% of the fund's assets in any one stock. These restrictions are well-intentioned. They protect against the fund putting all its eggs in one basket.
They also protect against the fund taking over a company. But the secondary result is that the larger funds are forced to limit themselves to the very large 500 companies out of the over 10,000 companies that are publicly traded. Fidelity Magellan has continued to compete successfully.
For this, I have to thank the fast-growing stocks, the turnaround opportunities, and the out-of-favor enterprises I've found. The stocks I try to buy are the very stocks traditional fund managers try to overlook. In other words, I continue to think like an amateur as frequently as possible. An individual investor doesn't have to operate like an institution.
You've got an edge already. The 10 baggers come from beyond the boundaries of what's accepted on Wall Street. Great opportunities can be found in your neighborhood or workplace.
Better yet, you can find them months or even years before the news reaches the professionals. Then again, maybe you shouldn't have anything to do with the stock market at all. This is an issue worth discussing because the stock market demands conviction as surely as it victimizes the unconvinced. Chapter 3. Is this gambling or what?
Many investors took refuge in bonds after the October 1987 crash. The issue of stocks versus bonds should be resolved up front, or it will come up at frantic moments, like when the stock market is dropping. Investing in bonds, money markets, or CDs are forms of investing in debt, for which one is paid interest. Traditionally, bonds were sold in large denominations, too large for the small investor. Bond funds were eventually invented.
This made it possible for regular people to invest in debt along with the tycoons. Later, the money market fund liberated former passbook savers from the captivity of the banks. It's one thing to prefer stocks to a stodgy savings account yielding 5% forever. It's quite another to prefer them to a money market where the yields rise immediately if the interest rates go up.
Stocks have paid off about 30 times better than treasury bills. in spite of crashes, depressions, wars, and recessions. There's a logical explanation for this.
In stocks, you've got the company's growth on your side. You're a partner in a prosperous business. In bonds, you're nothing more than the nearest source of spare change.
When you lend money to somebody, the best you can hope for is to get it back, plus interest. Unless you're a professional specializing in troubled companies and bankruptcies, The average person will never get a 10-bagger in a bond. Ah, yes, you say, but what about the risk? Aren't stocks riskier than bonds? Of course stocks are risky.
Nowhere is it written that stocks owe you anything. Even blue-chip stocks, hell, long-term can be risky. The point is, fortunes change.
There's no assurance major companies won't become minor. There's no such thing as a can't-miss blue-chip. Buy the right stocks at the wrong price at the wrong time and you'll suffer great losses. Frankly, there is no way to separate investing from gambling when dealing with stocks and bonds. There is no absolute division between safe and risky places to store money.
In the late 1920s, common stocks were finally considered prudent investments. This was exactly when the overvalued market made buying stocks more of a wager than an investment. Stocks have been embraced as investments or dismissed as gambles in circular fashion, usually at the wrong times.
Remember, stocks are most likely to be accepted as prudent at the moment they are not. Once the risk is accepted, we can begin to separate gambling from investing by the skill and dedication of the participant. To the stock picker who rushes in and out of equities, an investment in stocks is no more reliable than betting on the prettiest horse. To me, an investment is simply a gamble.
in which you've managed to tilt the odds in your favor. It doesn't matter whether it's Atlantic City or the stock market. You can learn which companies are likely to grow and prosper by asking a few questions.
Although you can never be certain what will happen, each new occurrence, such as a jump in earnings, will indicate your likelihood of success. People who succeed in the stock market accept periodic losses and unexpected occurrences. Calamitous drops don't scare them out of the game.
If they've done the proper homework before investing in a company and suddenly it deteriorates, they accept it and look for the next company. They realize the stock market is not a pure science. If 7 out of 10 of my stocks perform as expected, I'm delighted. If 6 out of 10 of my stocks perform as expected, I'm thankful. Remember, 6 out of 10 is all it takes to produce an enviable record on Wall Street.
The greatest advantage to investing in stocks is the incredible reward for being right. If one invests $1,000 in a stock and he or she is wrong, all he can lose is $1,000. But if you're right, you can make $10,000, $20,000, or $30,000 over a long period of time.
Clearly, the stock market can be a gamble worth taking, as long as you know how to play the game. Chapter 4. Passing the Mirror Test If you find a stock that's a good investment, it doesn't mean you ought to own it. There's no point going any further until you've looked into the mirror. You should ask yourself three questions before you buy a share of anything.
First, do I own a house? Second, do I need the money? And third, do I have the personal qualities that will bring me success in stocks?
Whether stocks make good or bad investments depends more on your personal qualities. on your responses to these questions than anything you'll ever read in the Wall Street Journal. You should consider buying a house before you invest any money in stocks.
A house is the one good investment almost everyone manages to make, and it is a moneymaker 99 times out of 100. Houses, like stocks, are most likely to be profitable when they're held for a long period of time. Unlike stocks, houses are likely to be owned by the same person for a number of years. You're a good investor in houses because you know how to poke around from the attic to the basement asking questions.
Before you make an offer on a house, you hire experts to search for termites, roof leaks, dry rot, rusty pipes, faulty wiring, and cracks in the foundation. It's no wonder people make money in the real estate market and lose money in the stock market. They spend months choosing their houses and only minutes choosing their stocks. This brings us to the second question.
Do I need the money? Review your budget before you buy stocks. For instance, if you're going to pay for a child's college education in a few years, don't put that money into stocks.
In this instance, even buying blue chip stocks is too risky to consider. These stocks are relatively predictable over 10 to 20 years. But as to whether they're going to be higher or lower in 2 to 3 years, well, you might as well flip a coin. Blue chips can fall and stay down for as long as 5 years.
If you've invested in blue chips and the market hits a banana peel, well, your kid is going to go to night school. Maybe you're an older person living on a fixed income. Stay out of the stock market. There are lots of complicated formulas to figure out what percentage of your assets should be put into stocks. The mind is simple.
It's the same for Wall Street as it is for the racetrack. Only invest what you can afford to lose without that loss having any effect on your daily life in the foreseeable future. Third question is the most important of the three.
The list of personal qualities necessary for success include patience, self-reliance, common sense, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit to mistakes, and the ability to ignore general panic. Finally, it's crucial to be able to resist your human nature and your gut feelings. It's the rare investor who doesn't secretly harbor the conviction that he or she has the knack for predicting stock prices.
It's uncanny how often we feel most strongly that stocks are going up when the opposite occurs. It's not that investors and their advisors are chronically stupid or unperceptive. It is that by the time the signal is received, the message may have changed. If positive financial news filters down so investors feel confident about the short-term prospect, the economy is about to be hammered. The trick is to discipline yourself to ignore your gut feelings.
Stand by your stocks as long as the fundamental story of the company hasn't changed. If you can't, your only hope for increasing your net worth may be to adopt J. Paul Getty's surefire formula for financial success. Rise early, work hard, strike oil.
Chapter 5. Is this a good market? Please don't ask. Each time after I've given a speech, Somebody asked me if we're in a good or bad market.
For every person who wants to know if Goodyear Tire is a solid or attractively priced company, four more want to know if the bull is alive and kicking. I always tell them the only thing I know about predicting markets is that each time I'm promoted, the market goes down. As soon as those words are launched from my lips, somebody else asks me when I'm due for another promotion.
Obviously, you don't have to predict. the stock market to make money in stocks. I've sat at my Quotron through some of the worst drops, and I couldn't have foreseen them if my life depended on it. In the middle of the summer of 1987, I didn't warn anybody, least of all myself, about the imminent 1,000-point decline.
I learned in graduate school that the market goes up 9% a year. Since then, it's never gone up 9% in a year. I've yet to find a reliable source to tell me how much it will go up or down.
Another theory is that we have recessions every five years. It hasn't happened. I've looked in the Constitution and nowhere is it written that every fifth year we must have recession. I'd love to know when we're going into recession. Unfortunately, when future man comes to Boston, I'm always on the road.
I'd be able to adjust my portfolio. Things are never clear until it's too late. We always seem to be preparing ourselves for the last thing that's happened.
This penultimate preparedness is our way of making up for the fact we didn't see the last thing coming along in the first place. People began to worry the market was going to crash the day after the market crashed on October 19, 1987. It had crashed. We survived it, and now we were petrified there'd be a replay.
Those who got out on the market to ensure they wouldn't be fooled the next time were fooled again as the market went up. I don't believe in predicting markets. I believe in buying great companies, especially undervalued or underappreciated companies. It doesn't matter where the Dow Jones Industrials average is.
The market ought to be irrelevant. If I could convince you of this one thing, I feel this tape has done its job. I'd love to be able to predict markets and anticipate recessions.
Since that's impossible, I'm satisfied to search out profitable companies. I've made money in lousy markets and lost money in great markets. Pick the right stocks and the market will take care of itself. I hope you'll remember the following points from this section on preparing to invest. Don't overestimate the skill and wisdom of professionals.
Look for opportunities that haven't yet been discovered and certified by Wall Street. 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. Long-term returns from stocks are relatively predictable and far superior. to long-term returns from bonds. Common stocks aren't for everyone.
The average person is exposed to interesting local companies and products years before the professional. Having an edge will help you make money in stocks. This section is about how to exploit an edge and develop the story on a company. The first step is to determine what kind of stock you're considering.
Six stock categories are discussed, including what you can expect to gain from each type. Developing the story requires some research. The importance of earnings to the eventual success or failure of a stock, how to monitor a company's progress, and how to evaluate the price-to-earnings ratio are elements of the story. Peter Lynch tells you how to develop the story and pick out the winners. Chapter 6, Stalking the Ten-Bagger.
The best place to look for a tin bagger is close to home. The shopping mall and wherever you work are good places to begin. Ten baggers like Dunkin'Donuts and The Limited were apparent at hundreds of locations across the country. The women shopping at the local New Limited outlet had a chance to see the opportunity, research the company, and buy the stock long before Wall Street got its first clue.
The average person comes across two or three likely prospects each year. All along the retail and wholesale chains, People who make things, sell things, clean things, or analyze things encounter stock picking opportunities. Do you receive a paycheck?
Automatic Data Processing is a company which processes 9 million paychecks a week for 180,000 small and medium-sized companies. This was one of the all-time great stock buying opportunities. The company went public in 1961 and has increased earnings every year.
Automatic data processing sounds like the sort of high-tech enterprise I advise against, but it's not a computer company. It uses computers to process paychecks. Users of technologies are beneficiaries of high-tech.
As competition drives down computer prices, firms like automatic data processing can buy cheaper equipment. This reduces their operating expenses and leads to greater profits. Who had an edge on automatic data processing?
The officers and employees of the 180,000 client firms could have known about its success. In fact, can't think of an equivalent opportunity in your life? Let's say you're retired. You live 10 miles from the nearest traffic light, grow your own food, and don't have a television set.
One day you have to go to the doctor because a country life has given you ulcers. This is the perfect introduction to SmithKline Beckman, the makers of Tagament. Hundreds of doctors, thousands of patients, and millions of friends and relatives of patients heard about the wonder drug Tagamet.
Pharmacists dispensing the pills and delivery boys delivering prescriptions also heard about the drug. Tagamet was a boon for the afflicted and a bonanza for the investor. These users and prescribers had a big lead on Wall Street.
No doubt some of the oxymorons on Wall Street suffered from ulcers themselves. But SmithKline must not have been on their buy lists. From 1974 to 1976, the testing period for the drug, the price climbed from around $4 to $7. The stock sold for $11 in 1977 when the government approved tagment.
From there, it shot up to $72 a share. Many people invest in the stock market in a manner similar to playing poker without looking at your cards. The edge is especially helpful when it comes to deciding when to buy shares in established companies. Let's say you own a Goodyear tire store. After three years of slow sales, you suddenly can't keep up with new orders.
This is a strong signal to you that Goodyear may be on the rise as a stock. You already know Goodyear's new high-performance tire is the best in the market. You should call your broker and ask for the latest background information on the tire company.
Don't wait for your broker to call you. When he calls, he'll want to tell you about a company like Wang Laboratories. What good is a Wang tip to you unless you work in a computer-related job?
What do you know that thousands of other people don't know a lot better? If the answer is nothing, then you don't have an edge in Wang. But if you sell, make, or distribute tires, you've got an edge in Goodyear. I could go on for the rest of this tape about the advantages of knowing the industry you're involved in.
On top of that, there's the consumer's edge. Whichever edge applies to you can help you to develop your own stock detection system outside the Wall Street channels. Remember, if you wait to hear it from Wall Street, you'll get the news late. Chapter 7. I've got it.
I've got it. What is it? However a stock has come to your attention, the discovery is not a buy signal.
Just because Dunkin'Donuts is always crowded doesn't mean you should buy the stock. Not yet. What you've got so far is a lead to a story that must be developed.
You should treat this lead as if it were an anonymous tip left mysteriously in your mailbox. Developing the story is not difficult. It only takes a couple of hours.
This homework phase is as important to your success in stocks As your previous vow to ignore short-term market gyrations, it is possible to make money in stocks occasionally without doing any of the research. But why take unnecessary chances? Remember, investing without research is like playing stud poker and never looking at the cards.
Procter & Gamble is a good example of why you need to develop the story. Procter & Gamble makes Pampers. Pampers, like Legs, was one of the most profitable new products of the 1970s.
Should you have rushed out to buy the stock on the strength of Pampers? No, not... if you had begun to develop the story. In five minutes, you would have noticed that Procter & Gamble is a huge company. Pampers sales amount to a small part of the company's total earnings.
Pampers made some difference to Procter & Gamble, but it was nothing like Legs did for a smaller company, Hanes. If you're considering a stock on the strength of a specific product, the first thing to find out is, what effect will the success of the product have on the company's bottom line. The size of a company has a great deal to do with what you can expect to get out of the stock.
Specific products aside, big companies don't have big stock moves. You'll get your biggest moves in smaller companies. The first thing I do is establish the size of the company in relation to others in the industry.
Then I place it into one of six general categories, slow grower, stalwart. fast grower, cyclical, asset play, or turnaround. These six categories cover all of the useful distinctions any investor has to make. Slow growers are usually large, mature companies.
They are expected to grow slightly faster than the gross national product. You won't find a lot of 2% to 4% growers in my portfolio, because if companies aren't going anywhere fast, neither will the price of their stocks. Stallworths are companies like Coca-Cola, Bristol-Myers, Procter & Gamble, and Colgate-Palmolive.
These multi-billion dollar hulks are not agile climbers, but they're faster than slow growers. When you traffic in stalwarts, you can expect a 10 to 12 percent annual growth in earnings. In the market we've had since 1980, the stalwarts have been good, but not spectacular performers. If you own a stalwart like Colgate-Palmolive, The stock's gone up 50% in a year or two. You have to figure that's enough and think about selling.
I always keep some stalwarts in my portfolio because they offer pretty good protection during recessions. Bristol-Myers went sideways during the 1981-82 period when the stock market fell apart. The fast growers are among my favorite investments.
These are small, aggressive, new enterprises that grow at 20% to 25% a year. This is the land... of the 10 to 100 baggers.
Fast growers are high-risk investments, particularly the stocks of the younger companies which tend to be overzealous and underfinanced. An underfinanced company with headaches usually winds up in chapter 11. Fast growers are big winners in the stock market. I look for the ones with good balance sheets making substantial profits. The trick is figuring out when they'll stop growing.
A cyclical is a company whose sales and profits rise and fall with changes in the economy. In a growth industry, business keeps expanding. In a cyclical industry, it repeatedly expands and contracts.
Autos, airlines, tire companies, steel companies, and chemical companies are cyclicals. They flourish when we're coming out of a recession and into a vigorous economy. Their stock prices tend to rise much faster. than the prices of the stalwarts. The cyclicals suffer when the economy is going the other way.
You can lose more than 50% of your investment very quickly if you buy cyclicals in the wrong part of the economic cycle. Cyclicals are often lumped together with the trusty stalwarts because most are large, well-known companies. Since Ford is a blue chip, one might assume it will behave like Bristol-Myers, another blue chip.
It doesn't. The common stock of Ford fluctuates wildly as the company loses billions of dollars in recessions and makes billions during periods of economic growth. Bristol-Myers earnings will not go down in a recession.
Ford's earnings could disappear. It's important to know that owning Ford is very different from owning Bristol-Myers. Turnaround candidates are battered companies.
They aren't slow growers. They are no growers. They aren't cyclicals.
They're rebound. In fact, these companies may already be bankrupt. Turnaround companies are potential fatalities, like Chrysler. Chrysler was a cyclical that went so far down, people thought it would never come back up.
Turnaround stocks can make up lost ground very quickly, as Chrysler has proven. An asset plays a company sitting on something valuable that you know about. But Wall Street is overlooked.
The asset may be simple, like a pile of cash. Sometimes it's real estate. Pebble Beach was a great asset play. At the end of 1976, this stock was selling for $14.5 per share.
There were 1.7 million shares outstanding, so the company was valued at only $25 million. Less than three years later, 20th Century Fox bought out Pebble Beach for $72 million, or $42.5 per share. After buying the company, 20th Century turned around and sold Pebble Beach's gravel pit.
one of the company's many assets, for over $30 million. In other words, the gravel pit alone was worth more than what investors paid for the whole company in 1976. Companies don't stay in the same category forever. Fast growers lead exciting lives and then burn out. Sooner or later, they exhaust themselves and become slow growers and stalwarts. Some companies fall into two categories at once.
Some, like Disney, have been in every major category. Putting stocks into categories is the first step to developing the story. You'll know what the story is supposed to be after you've correctly identified the category.
The next step is filling in the details so you can intelligently guess how the story will turn out. Chapter 8. The Perfect Stock. What a Deal.
Getting the story is a lot easier If you understand the company's business, I'd rather invest in pantyhose than in fiber optics. The simpler it is, the better I like it. You never find the perfect risk-free company, the kind of stock I dream about. But you can recognize favorable attributes, which will greatly increase your likelihood of success. The following discussion covers 13 of the most favorable attributes you should look for.
The first attribute is that the company name is dull, or even better, ridiculous. Automatic data processing is boring, but not quite as boring as Bob Evans Farms. But even Bob Evans Farms won't win the prize for the best name you could give a stock.
Pep Boys, Manny Mojack, is the most promising name I've ever heard. It's better than dull. It's ridiculous. Who wants to put money in a company that sounds like the Three Stooges?
No Wall Street analyst in his right mind would recommend a stock called Pep Boys, Manny Moe and Jack. Unless, of course, Wall Street already realizes how profitable it is. By the time Wall Street knows about it, the price is already up tenfold. The second attribute is the company does something dull.
I'd love to find a company with a boring name that also does something boring. Crown Cork and Seal makes cans and bottle caps. What's duller than that?
A company that does boring things is almost as good as a company with a boring name. Both together is terrific. Both together will keep the oxymorons away. Ultimately, the good news will compel them to buy in, and that always pushes the stock price higher and higher. The third attribute is that the company does something disagreeable.
What's better than boring? The answer is boring and disgusting. A company that does something that makes people shrug, wretch, or turn away in disgust is ideal.
Take SafetyClean, for example. SafetyClean provides gas stations with a machine that washes greasy auto parts. Gas stations gladly pay for the service. What analyst would want to write about this? What portfolio manager would want to have SafetyClean on his buy list?
Not many, which is precisely what's endearing about SafetyClean. The fourth attribute is that the company is a spin-off. Spinoffs of companies into separate freestanding entities often result in lucrative investments.
Large parent companies do not want to spin off divisions just to watch them fail. A spinoff failure brings embarrassing publicity, which reflects badly on the parent. Therefore, the spinoffs normally have strong balance sheets and are well prepared to succeed as independent entities. The greatest spinoffs of all were the Babybel companies. created from the AT&T breakup.
While the parent has been an uninspiring performer until recently, the average stock gain in the newly created companies was 114% from November 1983. to October 1988. When the dividends are added in, the return is more like 170%. This beats the total return of the market by more than twice. The fifth attribute is that institutions don't own it, and the analysts don't follow it. If you find a stock with little or no institutional ownership, you've found a potential winner. Find a company no analyst has visited, and you've found a double winner.
You can find these stocks in banks, savings and loans, and insurance companies. There are thousands of these opportunities, but Wall Street keeps up with less than 100. The sixth attribute is that there are negative rumors about the company, like it's involved with toxic waste and or the mafia. It's hard to think of a more perfect industry than waste management. Sewage and toxic waste dumps disturb people.
Waste Management Inc., the largest company in the waste management industry, is a better prospect than Safety Clean because it has two unthinkable things going for it. The toxic waste industry itself and the mafia. Anybody who fantasizes that the mafia runs all the Italian restaurants, the newsstands, the dry cleaners, and the construction sites, also thinks the mafia controls the garbage industry.
This fantastic assertion was a great advantage to the earliest buyers of waste management stock. The shares were grossly underpriced relative to the actual opportunity. The seventh attribute is that there's something depressing about it. My all-time favorite in this category is Service Corp International, or SRV. Now, if there's anything Wall Street would rather ignore besides toxic waste, it's mortality.
SRV does burials. also pioneered the pre-need funeral policy. This is a popular layaway plan. It enables you to pay off your casket and funeral service now while you can afford it. SRV gets the money for its pre-need sales, and the cash continues to compound.
This company was shunned by most professional investors. SRV executives had to beg the professionals to listen to their story. Here was the perfect opportunity. Everything was working.
You could see it happening. The earnings kept increasing. There was rapid growth, almost no debt, and Wall Street turned the other way. The eighth attribute is that it's a company in a no-growth industry.
Many people prefer to invest in a high-growth industry where there's a lot of sound and fury. Not me. I prefer to invest in no-growth industries like funerals. For every product in a hot industry, There are a thousand recent graduates trying to figure out how to make it cheaper and better in Taiwan or Korea. This doesn't happen with bottle caps, oil drum retrieval, or funerals.
In a no-growth industry, especially one that's boring and upsets people, there's no problem with competition. That gives you the leeway to continue to grow and gain market share. SRV already owns 5% of the nation's funeral homes. And there's nothing to stop it from owning 15%.
The ninth attribute is that it's got a niche. I'd much rather own a local rock pit than 20th Century Fox. A movie company competes with other movie companies, while the rock pit has a niche.
Owning a rock pit is very safe and very boring. But if you've got the only gravel pit in town, you've got a virtual monopoly. A rock pit is valuable because nobody can compete with it. The nearest rival owner may be two towns away.
He's not going to haul his rocks into your territory because the trucking bills eat up his profit. I always look for niches. Drug and chemical companies have niches. Once a patent is approved, all the rival companies with the billions in research dollars can't invade the territory. They must invent a different drug, prove it is different, and then do three years of clinical trials before the government lets them sell it.
The tenth attribute is that people have to keep buying the product. I'd rather invest in a company making drugs, soft drinks, razor blades, or cigarettes than a company that makes toys. Somebody can make a wonderful doll that every child must have, but every child only gets one. Eight months later, that doll is removed from the shelves to make room for the newest doll the children must have, manufactured by a different company. Why take chances on fickle purchases?
when there's so much steady business around. The 11th attribute is that a company is a user of technology. Why invest in a computer company that struggles to survive in an endless price war when you can invest in a company benefiting from the price war? Again, look at automatic data processing. As computers get cheaper, ADP can do its job cheaper.
This results in increase in profits. The twelfth attribute is that the company insiders are buyers of the stock. There's no better tip-off to the probable success of a stock. than that the people in the company are putting their own money into it. If you see someone with a $45,000 salary buying $10,000 worth of stock, you can be sure it's a meaningful vote of confidence.
There's only one reason insiders buy. They think the stock price is undervalued and will eventually go up. The thirteenth attribute is the company is buying back shares. Buying back shares is the simplest and best way a company can reward its investors. If a company has faith in its own future, then why shouldn't it invest in itself?
Massive share buybacks occurred after the October 1987 market drop. This stabilized the market at the height of its panic. These buybacks reward investors over the long term.
When a stock is bought by its company, it is taken out of circulation. The number of outstanding shares is reduced. This can have a magical effect on the earnings per share, which in turn has a magical effect on the stock price. If a company buys back half its shares and its overall earnings are constant, the earnings per share have doubled. Chapter 9. Stocks I'd Avoid If I could avoid a single stock, it would be the hottest stock in the hottest industry.
Hot stocks can go up fast. Usually they go way beyond any of the known indicators of value. Since there's nothing but thin air supporting them, They fall quickly. If you aren't clever at selling hot stocks, you'll watch your profits turn into losers.
When the price falls, it falls fast. Remember what happened to disk drives? The experts said this industry would grow at 50% a year, and they were right, it did.
But with 30 rival companies scrambling for the action, there are no profits. There's never been a hotter stock than Xerox in the 1960s. Copying was a fabulous industry.
and Xerox had control of the entire process. In 1972, the analysts assumed Xerox would keep growing indefinitely, but the Japanese got into it, IBM got into it, and Eastman Kodak got into it. Soon, there were over 20 firms making nice copy machines, and product prices collapsed.
Xerox got frightened and bought several unrelated businesses it didn't know how to run. The stock lost 84% of its value. Contrast the poor stock performance of Xerox to that of Philip Morris.
Philip Morris sells cigarettes, a negative growth industry in the U.S. Over the past 15 years, Xerox dropped from $160 to $60 a share, while Philip Morris rose from $14 to over $140. Philip Morris increases its earnings by expanding its market share abroad, by raising prices, and by cutting costs.
Philip Morris has found its niche. Negative growth industries do not attract flocks of competitors. Another stock I'd avoid is a stock in a company that's been touted as the next IBM, the next McDonald's, or the next Disney.
The next of something almost never is, whether on Broadway, the bestseller list, the National Basketball Association, or Wall Street. In fact, when people tout a stock as the next of something, It often marks the end of the prosperity for both the imitator and the original. When other computer companies were called the next IBM, you should have guessed IBM would have some terrible times.
It has. Today, most computer companies are trying not to become the next IBM. Sometimes profitable companies prefer to blow their money on foolish acquisitions instead of buying back shares.
I call this process diversification. The dedicated diversifier seeks out merchandise that is overpriced and beyond his realm of understanding. This ensures maximum losses. Consider the story of Melville and Genesco, two shoe manufacturers, one successfully diversified and one diversified.
Thirty years ago, Melville was making men's shoes for its own family of shoe stores. Sales grew as the company began to lease shoe departments and other stores, most notably in the Kmart chain. After years of experience in discount shoe retailing, the company launched into a series of acquisitions.
They always established the success of one before proceeding with another. Melville bought CVS, a discount drugstore operation in 1969, Marshalls, a discount apparel chain in 1976, and KB Toys in 1981. During the same period, Melville reduced its number of shoe manufacturing plants from 22 to 1. Slowly but efficiently, a shoe manufacturer had transformed itself. into a diversified retailer. Genesco, on the other hand, went off in a frenzy. Starting in 1956, it acquired Bonwit Teller, Henri Bendel, Tiffany, and Crest Variety Stores.
Then it got into security consulting, men's and women's jewelry, knitting materials, textile, and blue jeans. Genesco spread out into many forms of retailing and wholesaling. while still trying to manufacture shoes. The company made 150 acquisitions from 1956 to 1973. These purchases greatly increased the company's sales. Genesco had bigger on paper, but its fundamentals were deteriorating.
The difference in the strategies of these two companies ultimately showed up in their earnings and stock performances. Both stocks suffered from the 1973-1974 bear market. But Melville's earnings were growing steadily and its stock rebounded.
It was a 30-bagger by 1987. Genesco's financial position continued to deteriorate after 1974. The stock has never come back. I get calls all the time from people who recommend solid companies for Magellan. Then they lower their voices as if to confide something personal and they say, there's this great stock I want to tell you about.
It's too small for your fund, but you ought to look at it for your own account. It's a fascinating idea, and it could be a big winner. These are long shots, also known as whisper stocks. Often the whisper companies are on the brink of solving the latest national problems, the oil shortage, drug addiction, or AIDS. The solution is either very imaginative or impressively complicated.
Whisper stocks have a hypnotic effect. The stories usually have emotional appeal. The stocks may go up before they come down, but they are lousy, long-term propositions. I've lost money and each one of them I've bought. They have great story, but no substance.
That's the essence of a whisper stock. Another stock out of the void is in a company selling 25% to 50% of its wares to a single customer. If the loss of one customer would be catastrophic to a supplier, Be wary of investing in the supplier.
Just drive companies like Tandon, who are always on the brink of disaster, because they were too dependent on a few clients. Chapter 10. Earnings, earnings, earnings. Let's say you notice Sensomatic, the company that invented the tag and buzzer system for foiling shoplifters. The Sensomatic stock rose from $2 to $42 as the business expanded between 1979 and 1983. Your broker tells you it's a small company and a fast grower. You've reviewed your portfolio and found two stalwarts and three cyclicals.
What possible assurance do you have that Sensomatic will go up in price? And if you're buying, how much should you pay? What you're really asking is, what is it that makes a company valuable? Why will it be more valuable?
tomorrow than it is today. There are many theories, but to me, it always comes down to earnings and assets, especially earnings. Analyzing a company's stock on the basis of earnings and assets is no different than analyzing a laundromat, a drugstore, or an apartment building. Although it's easy to forget sometimes, a share of stock is not a lottery ticket.
It's part ownership of a business. When you buy stock in a fast-growing company, You're really betting on its chances to earn more money in the future. That's why investors seek out promising fast growers.
They bid the stocks up even when the companies are earning very little. People may wonder what the Japanese are doing, but the earnings will decide the fate of a stock. People may bet on the hourly wiggles in the market, but it's the earnings that waggle the wiggles over the long term.
Any serious discussion of earnings involves the price-to-earnings ratio, also known as the P.E. ratio. This ratio is a numerical shorthand for the relationship between the stock price and the earnings of the company.
The P.E. ratio for the stock is listed in the daily stock tables of most major newspapers. Like the earnings line, the P.E. ratio is often a useful tool to help you determine whether the stock is fairly priced in relation to the company's money-making potential. The P.E.
ratio, we thought of, is the number of years it will take the company to earn back the amount of your initial investment, assuming the company's earnings stay constant. If you buy shares in a company selling at two times earnings or at a PE of two, your initial investment is earned back in two years. If you buy shares in a company selling at 40 times earnings or a PE of 40, it takes 40 years to accomplish the same thing.
With all the low PE opportunities around, why would anyone buy a stock with a high PE? The only reason is because they're looking for a fast grower. They're investing in the company's potential.
You'll also find that the P levels tend to be low for slow growers and high for fast growers. The cyclicals vacillate in between. If you remember only one point about P ratios, you should remember to avoid stocks with excessively high PEs. An extremely high P is a handicap to a stock most of the time.
Company P ratios do not exist in a vacuum. Stock market has its own collective P-E ratio, which is a good indicator whether the market at large is over or undervalued. I know I've already advised you to ignore the market, but when you find a few stocks are selling at inflated prices, it's likely that most stocks are selling at inflated prices.
That's what happened before the big drop in 1973 and 74 and also in 1987. How can you predict future earnings? The best you can do with current earnings is make an educated guess as to whether a stock is fairly priced. If you do this much, you'll never overpay for Bristol-Myers, Coca-Cola, or McDonald's. However, what you'd really like to know is what's going to happen to earnings in the next month, year, or decade.
Battalions of analysts and statisticians are launched against the questions of future growth and earnings. I'm not about to suggest that you can begin to predict earnings. or growth in earnings successfully on your own.
So you can't predict future earnings, but you can find out how a company plans to increase earnings. Then you can check periodically to see if the plans are working out. There are five basic ways a company can increase its earnings. They are reduce cost, raise prices, expand into new markets, sell more of its product in the old markets, and revitalize, close, or dispose of losing operations.
These are the factors to investigate as you develop the story. If you have an edge, this is where it's going to be the most helpful. This is the end of Side 1B.
On Side 2A, Peter Lynch continues his discussion on how to develop the story on a company and increase your chances to pick out winning stocks. Chapter 11, The Two-Minute Drill. At this point, you should know whether you're dealing with a slow grower, a stalwart, a fast grower, a turnaround, an asset play, or a cyclical.
The price-earnings ratio has given you a rough idea of whether the stock is currently undervalued or overvalued relative to its immediate prospects. The next step is to learn what the company is doing to bring about added prosperity. increase growth, or whatever happy event is expected to occur. This is known as the story.
Something dynamic must happen to keep the earnings moving along. The more certain you are about what that something is, the better you'll be able to follow the script. Analyst reports and short essays in the publication value line provide the professional version of the story. But you can develop your own detailed script. if you've got an edge on the company.
Before buying a stock, everyone should be able to give a short monologue summarizing why they're interested in the company. The following sample monologues are examples of ones that have worked well for me in the past few years. If it's a slow-growing company, you're probably in it for the dividend.
The important elements of the script include, this company has increased its earnings every year for the last 10. It offers an attractive yield. It's never reduced or suspended a dividend. In fact, It's raised the dividend during good times and bad. It's a telephone utility, so the new cellular operations may add a kicker to the growth rate. If it's a cyclical company, your script revolves around business conditions, inventories, and prices.
There has been a three-year slump in the auto industry, but this year, things have turned around. Car sales are up for the first time in recent memory. GM's new models are selling well. In the last 18 months, GM has closed five inefficient plants, cut 20% off labor costs, and earnings are about to turn sharply higher.
If it's an asset play, what are the assets? How much are they worth? The stock sells for eight, but the video cassette division alone is worth $4 a share, and the real estate is worth another seven.
That's a bargain. I'm getting the rest of the company for minus three. Insiders are buying. The company has steady earnings.
and there's no debt to speak of. If it's a turnaround, has the company taken action to improve its fortunes? Is the plan working? General Mills has made great progress in curing its diversification. It's gone from 11 businesses to two.
The company has sold Eddie Bauer, Talbots, Kenner, and Parker Brothers for top dollar and has returned to what it knows best, restaurants and packaged foods. If it's a stalwart, the key issues are the P-E ratio, whether the stock has already had a recent run-up in price, and what, if anything, is happening to accelerate the growth rate. Coca-Cola is selling at the low end of its P-E range.
The stock hasn't gone anywhere for two years, but the company has improved itself. Coca-Cola sold half its interest in Columbia Pictures to the public. Diet drinks have sped up the growth rate. Foreign sales are increasing.
In the past few years, the company has bought out many of its independent bottlers. Coca-Cola has better control over distribution and domestic sales now. If it's a fast grower, where and how can it continue to grow fast? La Quinta is a motel chain that began in Texas and was very profitable.
The company duplicated its successful formula in Arkansas and Louisiana. Last year, it added 20% more motel units than the year before. Earnings have increased every quarter. The company plans rapid future expansion, and its debt is not excessive.
Motels are a low-growth, competitive industry, but La Quinta has found a niche. There's a long way to go before it has saturated the market. I often devote several hours to developing a script. Let me give you two examples.
The first is a situation I checked out properly. That was La Quinta Motor Inns, which was a 15-bagger for me. In the second example, there was something I forgot to ask. That was Bildner's, a 15-bagger in reverse. The motel industry was due for a cyclical turnaround.
I'd already invested in United Inns, the largest franchisee of Holiday Inns. During a telephone interview with the vice president of United Inns, I asked which company was Holiday Inn's most successful competitor. Asking about the competition is one of my favorite techniques for finding promising new stocks.
Muckamucks speak negatively about the competition most of the time, but when an executive of one company admits he's impressed by another company, you can bet the competitor is doing something right. Lakinta Motor Inns, vice president of United Inns and Thuzed, they're doing a great job. They're killing us. in Houston, and in Dallas.
That was the first time I had ever heard of La Quinta. I wanted to know what the story was. The concept was simple. La Quinta offered rooms of holiday-in quality at lower prices.
La Quinta had eliminated the wedding area, the conference rooms, the large reception area, the kitchen area, and the restaurant. Excess space contributing nothing to profits. while adding to the costs.
La Quinta's idea was to install a Denny's or similar 24-hour place next door to each motel. Somebody else would worry about the food. Most hotels and motels lose money on their restaurants.
Where was the niche? La Quinta had a specific target, the small businessman who didn't care for the budget motel, but didn't want to spend a lot of money either. If he had the choice, he'd rather pay less for the equivalent luxury of a Holiday Inn. La Quinta was there to provide the equivalent luxury, and at locations that are often more convenient to traveling businessmen. Because La Quinta's guests were business travelers, a high percentage of them booked rooms in advance.
This gave La Quinta the advantage of a more predictable clientele. Nobody had captured this part of the market, the middle ground underneath the Hilton hotels and the Holiday Inns, but above the Budget Inns. Lakinta was a great story.
They've been operating for several years by the time I heard about them. The original Lakinta have been duplicated in many different locations. The company was growing at an astounding 50% a year and the stock was selling at a very attractive 10 times earnings multiple.
This made it an incredible bargain. To top it off, I was delighted to discover that only three brokerage firms covered Lakinta. Also, less than 20% of the stock was held by institutions, another major positive. I followed up by spending three nights in three different LaQuintas.
I was satisfied LaQuinta was Holiday Inn's equal. I bought as much LaQuinta as possible for the Magellan Fund. I made 11-fold on it over a five-year period before it suffered a turndown.
I made two major mistakes. with Jay Bildner and Sons. Bildner's is a specialty food store located across the street from my Boston office.
It sells gourmet sandwiches and prepared hot foods. Bildner's is a cross between a convenience store and a three-star restaurant. I had firsthand information that they had the best bread and the best sandwiches in Boston.
That was my edge. Bildner's was going public to raise money so it could expand into other locations. The company had carved out a niche, the millions of white-collar types who won't eat microwave sandwiches and who also refuse to cook. I researched the operation by wandering into the store across the street.
It was clean, efficient, full of satisfied customers, and a fabulous moneymaker. From the prospectus of the stock offering, I learned that Builders wasn't going to burden itself with excessive bank debt. This was a plus. Without further investigation, I bought Bildner's at the initial offering price of $13 in September 1986. Soon after the sale of stock, Bildner's opened two outlets and a couple of Boston department stores.
They flopped. Then it opened three new outlets in mid-Manhattan. They were killed by the delis.
It continued to expand into more distant cities. By quickly spending more than the proceeds from the public offering, Buildner's had financially overextended itself. One or two mistakes at a time might not have been so bad, but Buildner's suffered multiple simultaneous failures. I'm sure the company learned from these mistakes, but there was no second chance once the money ran out.
The stock bottomed at one-eighth of a dollar. The management retreated to its original stores, including the one across from my office. I gradually unloaded my shares at losses ranging from 50 to 95 percent.
The lesson here is if the prototype is in Texas, hold off buying until the company shows it can make money in Illinois. Does the idea work in some other place? That's the question I forgot to ask builders. Chapter 12, getting the facts. Fund managers have an advantage when it comes to getting the facts in a company.
Companies will talk to us. several times a week if we'd like. On the other hand, I can't imagine any useful information that the amateur investor can't get.
All the pertinent facts are waiting to be picked up. Companies are required to tell nearly all in their prospectuses, quarterlies, and annual reports. Stockbrokers can be your information gatherers.
They can provide the S&P reports, investment newsletters, annuals, quarterlies, and prospectuses. the Value Line Survey, and their firm's research. Let them get the data on the P.E.
ratios, growth rates, insider buying, and institutional ownership. They'll be happy to do it once they realize you're serious. Professionals call companies all the time. Amateurs rarely think of it.
The Investor Relations Office is a good place for you to get answers to specific questions. Prepare your questions before you call the company. Earnings are a good topic, but it's not proper etiquette to ask the company how much you're going to make, any more than it's proper for strangers to ask you for your annual salary.
The accepted form of question is subtle. What are the Wall Street estimates on your company's earnings for the upcoming year is a better question. As you already know, future earnings are hard to predict.
The companies themselves aren't sure how much they will earn. What you really want from investor relations is the company's reaction to whatever script you've been trying to develop. If you don't have a script, you can learn something by asking two general questions. What are the positives this year, and what are the negatives? In most cases, you'll hear something that confirms what you suspected, especially if you understand the business.
But every so often, you'll learn something unexpected. Things are either better or worse than they appear. The unexpected can be very profitable if you're buying or selling stocks.
When you call investor relations, you can have confidence the facts you get are correct. The adjectives, though, will vary widely. Different kinds of companies use different words to describe the same scene.
It's important to remember, when looking at the same sky, people in mature industries see clouds, where people in immature industries see pie. Don't waste your time deciphering the corporate vocabulary. It's simpler to ignore all the adjectives. Wandering through stores and tasting things is one of my research strategies. Although it's not a substitute for asking the right questions, it's reassuring to personally check out the product.
Before I bought La Quinta, I spent a few nights in the motorhands. I could have gotten the information from Investor Relations, but it wouldn't have been the same thing as bouncing on their beds. It's no surprise that so many annual reports end up in the garbage can. The text on the glossy pages is understandable, but normally useless.
The numbers in the back can sometimes seem incomprehensible and intimidating. But there's a way to get something out of an annual report. It only takes a few minutes. Consider the 1987 Ford Motor annual report. Turn directly to the consolidated balance sheet.
on the cheaper paper. The general rule with antireports is the cheaper the paper, the more valuable the information. The balance sheet lists the assets and the liabilities of the company. I look at the current assets column and take the cash figure and add that number to the marketable securities.
The total is the company's overall cash position. Comparing the 1987 cash to 1986 cash, Also listed, I see Ford is socking away a lot of money. This is a sign of prosperity. Then I look at the other half of the balance sheet to the entry that says long-term debt.
I see that the 1987 long-term debt has been greatly reduced from 1986. Debt reduction is another sign of prosperity. A balance sheet is improving when cash is increasing relative to debt. Subtracting the long-term debt from the total cash, I arrive at Ford's net cash position. The cash and cash assets greatly exceed the debt. When cash exceeds debt, it's very favorable.
No matter what happens, Ford isn't going out of business. To keep it simple, ask your broker whether Ford is buying back shares, whether cash exceeds long-term debt, and how much cash there is per share. You can also get the numbers from the S&P reports or from ValueLine. ValueLine is easier to read than a balance sheet and a good place for an amateur to start. It tells you about the cash and debt, summarizes the long-term record, so you can see what happened during the last recession.
It also rates companies for financial strength on a scale of 1 to 5. This rating gives you an idea. of a company's ability to withstand adversity. To summarize the material on the two-minute drill and getting the facts, the difference between gambling and investing is knowing what you own, checking the financial condition, and constantly monitoring the story.
Chapter 13. Some Famous Numbers When a specific product arouses my interest in a company, the first thing I want to know is, What the product means to the company. What percent of sales does it represent? Legs sent Haynes stock soaring because Haynes was a relatively small company. Pampers was a more profitable product than Legs, but it didn't mean as much to the huge Procter & Gamble. We've already talked about the price-to-earnings ratio, but I want to add another bit of information.
The P.E. ratio of any fairly priced company will equal its growth rate. In general, a P 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 to analyze stocks for the mutual funds. You want to know if a company is sitting on billions in cash. Let's look at Ford.
In the last chapter, we established that Ford had loads of cash in relation to its long-term debt. Cash doesn't always make a difference. More often than not, There isn't enough of it to worry about.
Nevertheless, it's always advisable to check the cash position as part of your research. How much does a company owe? How much does it own? Debt versus equity. It's the kind of thing a loan officer wants to know about you when deciding whether you're a good credit risk.
A normal corporate balance sheet has two sides. The left side lists the assets. The right side... shows how the assets are financed. The right side can be divided into debt and equity.
One quick way to determine the financial strength of a company is to compare the equity with its total debt. I pay special attention to the debt factor in turnarounds and troubled companies. More than anything else, it's debt that determines which companies will survive and which will go bankrupt. Young companies with heavy debts are always at risk. It's also 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. Bank debt is the worst kind from the investor's point of view because it's due on demand. It doesn't have to come from a bank. It can take the form of commercial paper, which is loaned from one company to another for a short period of time.
The important thing to remember is that it's due very soon. Sometimes it's due on call. This means the lender can ask for his money back at the first sign of trouble. If the borrower can't pay back the money, it's off to Chapter 11. Funded debt, the best kind from the shareholder's point of view, can never be called in as long as the borrower continues to pay the interest.
The principal may not be due for 15 to 30 years. Funded debt usually takes the form of regular corporate bonds with long maturities. Unlike banks, bondholders cannot demand immediate repayment of principal. Funded debt gives companies time to wiggle out of trouble. One of the important numbers to consider is the cash dividend.
Stocks paying dividends are often favored over stocks that don't pay dividends by investors who want the extra income. But the real issue is how the dividend or the lack of a dividend, affects the value of a company and its stock price over time. One strong argument in favor of companies that pay dividends is that companies that don't pay dividends have a history of blowing the money on diversifications. Another point in favor of dividend-paying stocks is that the presence of the dividend can keep the stock price from falling as far as it might if there was no dividend. A company with a long record of regularly raising the dividend is your best bet.
Stocks like Kellogg and Rawson Prina have not eliminated or reduced dividends during the last three wars and eight recessions. This is the kind of stock you want to own if you believe in dividends. Heavily indebted companies can never offer the same assurance as a company with little debt.
An easy number to find is book value. You can find it everywhere. People often invest on the theory.
that if the book value is $20 a share and the stock sells for $10 a share, they're getting something for half price. But the flaw in this is that the stated book value may not reflect the actual value of the company. It often understates or overstates reality. For example, Penn Central had a book value of more than $60 a share when it went bankrupt.
Overvalued assets on the left side of a balance sheet are especially treacherous when there's a lot of debt on the right. Let's say a company shows 400 million assets and $300 million in debt. This results in a positive book value of $100 million.
You know the debt part is a real number, but if the $400 million assets will bring only $200 million in a bankruptcy sale, then the actual book value is a negative $100 million rather than a positive $100 million. The company is less than worthless. When you buy a stock for its book value, you must have a detailed understanding of what those values really are.
At Penn Central, tunnels through mountains that hadn't been used for years were counted as assets. As often as book value overstates true worth, it can also understate true worth. This is where you find the greatest asset place.
There are many kinds of hidden assets. Sometimes companies own natural resources like land, oil, or precious metals. They may carry these assets on their books at a fraction of the true value.
If a company has a large inventory of gold, they may carry it on the books at the original purchase price. As gold has risen sharply in the last 40 years, that's a hidden asset. Earlier I mentioned Pebble Beach, a great hidden asset play in real estate. Real estate plays like that are everywhere.
Sometimes you'll find an oil company that's kept the inventory in the ground for 40 years at original cost. The oil alone is worth more. than the current price of all the shares of the stock.
Another important number to consider is the cash flow of a company. 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. Let's say Pig Iron Inc. sells out its entire inventory and makes $100 million.
That's good. Then again, Pig Iron Inc. has to spend $80 million. to keep the furnaces up to date.
That's bad. If Pig Iron doesn't spend $80 million on furnace improvements, it loses business to more efficient competitors. Philip Morris doesn't have this problem.
The cash that comes in doesn't have to struggle against the cash that goes out. It's simply easier for Philip Morris to earn money than it is for Pig Iron Inc. A lot of people use the cash flow numbers to evaluate stocks. If cash flow is mentioned as a reason to buy a stock, be sure it's free cash flow.
Free cash flow is what's left over after the normal capital spending is deducted. Pig Iron Inc. will have a lot less free cash flow than Philip Morris. Any reports include a detail note on inventories and a footnote section to the balance sheet.
Check to see if inventories are piling up. An inventory buildup is usually a bad sign. When inventories grow faster than sales, it's a red flag. There are two basic accounting methods used to compute the value of inventories, and one or the other is used in the annual report. They are LIFO and FIFO.
As much as this sounds like a pair of poodles, LIFO stands for last in, first out, and FIFO stands for first in, first out. If a company bought gold 30 years ago for $40 an ounce, and yesterday they bought gold for $400 an ounce, and today they sell some gold for $450 an ounce, what is the profit? Under LIFO, it's $50, or $450 minus $400.
And under FIFO, it's $410, or $450 minus $40. Under FIFO, the profit is $410, or over eight times the $50 profit using LIFO accounting. Whichever method is used, it's possible to compare this year's LIFO or FIFO value to last year's LIFO or FIFO value. This way you can determine whether there's been an increase or decrease in the size of the inventory.
One of the most popular misconceptions in Wall Street is that the word growth is synonymous with the word expansion. This leads people to overlook some great growth companies like Philip Morris. You wouldn't see it from the industry because U.S. cigarette consumption is growing at a negative annual rate.
of about minus 2%. Foreign smokers, however, have taken up where the U.S. smokers left off. But even the foreign sales don't account for Philip Morris's success. The key is that Philip Morris increases its earnings by lowering costs and raising prices.
That's the only growth rate that really counts, earnings. Chapter 14, Rechecking the Story. Rechecking the company's story every few months is a worthwhile habit. This may involve reading the latest value line or quarterly report.
It can be researching the sales and earnings. Has the story changed? When fast grows especially, you'll have to ask, what will keep them growing? There are three phases to a growth company's life. The startup phase, when it works out the kinks in the business.
The rapid expansion phase, when it moves into new markets. And the mature phase, also known as the saturation phase. This third phase is when the company begins to prepare for the fact there's no easy way to continue expanding. The first phase is the riskiest for the investor.
because the success of the enterprise isn't established. The second phase is the safest, and it's when the shareholder normally makes most of his money. The company grows by duplicating its successful formula. The third phase is the most problematic.
This is when the company runs into its limitations. New methods must be developed to increase earnings. You want to determine whether the company seems to be moving from one phase into another.
As you recheck the story, if you look at Automatic Data Processing, the paycheck processing company, you can see that they're beginning to approach saturation of the market. Automatic Data Processing is late in Phase 2. When Sensomatic was expanding its shoplifting detection system, the stock went from 2 to 40. Eventually, it reached the limit. Very few new stores to approach.
The company was unable. to think of new ways to maintain its momentum. The stock fell from $42.50 in 1983 to a low of $5.05 in 1984. As you saw this time approaching, you needed to find out what the new plan was and whether it could succeed.
When there's a Wendy's next to every McDonald's, the only way Wendy's will be able to grow will be by winning over McDonald's customers. Where can Anheuser-Busch grow if it has captured 40% of the beer drinking market? Sooner or later, Anheuser-Busch is going to slow down.
At that time, the stock price and the P multiple will shrink accordingly. Chapter 15, The Final Checklist All this research takes a couple hours at most for each stock. The more you know, the better, but you don't have to call the company.
You also don't have to study the end report with the concentration of a Dead Sea Scroll Scholar. Some of the important numbers apply to specific stock categories and can be ignored when you're looking at the others. The following is a checklist of things you want to know about stocks. Check the price-earnings ratio for every stock you consider.
Is it high or low for this company and for similar companies in the same industry? Look into the percentage of institutional ownership. The lower, the better. Find out whether insiders are buying and or the company is buying back its own shares. Both are positive signs.
What is the record of earnings growth to date? Are the earnings sporadic or consistent? Is the company's balance sheet weak or strong?
What is the debt-to-equity ratio? How is it rated for financial strength? What is the company's cash position?
For slow growers, you should check to see if the dividends have always been paid and whether they are routinely raised. The stalwarts aren't likely to go out of business. So the key issue is price. The P-E ratio will tell you whether you're paying too much. What is the stalwart's long-term growth rate?
If you're planning to hold a stock forever, you'll want to know how the company has fared during recessions and market declines. For cyclicals, keep tabs on inventories. Remember, if you know your cyclical, you have an advantage in trying to time the cycles.
With fast growers, Investigate whether the product that's supposed to enrich the company is a major part of the company's business. Has the company duplicated its successes in more than one city or town, proving that expansion works? Check to see if the company still has room to grow.
Find out whether the stock's P-E ratio is at or near the growth rate. How much of the stock is owned by institutions? With turnarounds, it's very important to know the company can survive a raid by its creditors.
How much cash does the company have? How much debt? What is the debt structure? How is the company supposed to be turning around?
Has it rid itself of unprofitable divisions? With asset plays, you want to know the value of the assets. Are there any hidden assets? I hope you remember the following pointers from this section on picking winners.
Understand the nature of the companies you own and the specific reasons for holding the stock. You'll have a better idea of what to expect from your stocks after you put them into categories. The stock of big companies makes small moves.
Those of small companies make big moves. Consider the size of a company if you expect it to profit from a specific product. Look for small companies that are already profitable and have proven their concept can be successfully cloned. Avoid hot stocks and hot industries.
Distrust diversifications. They usually turn out to be diversifications. Take advantage of the valuable fundamental information from your job. It may not reach the professionals for months or years.
Invest in simple companies that appear dull, mundane, out of favor, and haven't caught the fancy of Wall Street. Moderately fast growers, 20% to 25% in non-growth industries. are ideal investments.
Look for companies with niches. When purchasing depressed stocks in troubled companies, seek out the ones with superior financial conditions. Avoid the ones with loads of bank debt. Carefully consider the price-to-earnings ratio.
If the stock is grossly overpriced, even if everything else goes right, you won't make any money. Develop a storyline to follow as a way to monitor a company's progress. Look for companies that consistently buy back their own shares. Study the dividend record of a company over the years.
Look for companies with little or no institutional ownership. Insider buying is a positive sign. Be patient. A watch stock never boils. Buying stocks based on state-of-the-book value alone is dangerous.
Only real value counts. Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator. In this section called The Long-Term View, Peter Lynch talks about how to design a portfolio to maximize gain and minimize risk. He discusses when to buy and sell stocks and what to do when the market collapses.
Some of the common misconceptions about why stocks rise and fall are examined. Peter Lynch explains the pitfalls of gambling on options, futures, and the shorting of stocks. He takes a look at the stock market today and talks about how some things have changed.
Chapter 16, Designing a Portfolio. I've heard people say that they'd be satisfied with a 25 or 30 percent annual return from the stock market. Satisfied at that rate, they'd soon own half the country. Even the tycoons of the 20s couldn't guarantee themselves 30% forever.
That's when Wall Street was rigged in their favor. 9% to 10% return a year is the market average, and it's considered the generic long-term return for stocks. You can get 10% over time by investing in a no-load mutual fund that buys all 500 stocks in the S&P 500 index.
This fund duplicates the average automatically. You can get a 9% to 10% return without doing any homework. or spending any extra money.
When you pick your own stocks, you ought to be getting a 12% to 15% return, compounded over time. This is 12% to 15% after all costs and commissions have been subtracted and all the dividends have been added. It costs a small investor a lot of money to trade in and out.
If you turn over your portfolio once a year, you might lose as much as 4% to commissions. If you're going to get 12% to 15% after expenses, You have to make 16% to 19% from picking stocks. The more you trade, the harder it will be to outperform the funds.
How do you design a portfolio to get that 12% to 15% return? In my view, it's best to own as many stocks as there are situations in which you've got an edge and in which you've found an exciting prospect that passes the research tests. Maybe that will be a single stock, or maybe it's a dozen stocks.
There's no point diversifying into unknown companies just for the sake of diversity. But that said, it isn't safe to own just one stock. The single stock you choose might be the victim of unforeseen circumstances in spite of your best efforts.
Small portfolios should contain three to ten stocks. There are a couple reasons for this. The first reason is that if you're looking for ten baggers, the more stocks you own, the more likely one of yours will become a ten bagger.
The second reason is that the more stocks you own, the more flexibility you have to rotate funds between them. This is an important part of my strategy. Spreading your money among several stock categories is another way to minimize the risk. Beyond that, you might want to consider the following information. Slow growers are normally low risk, low gain.
These stocks are usually priced accordingly. Stallwarts are low risk, moderate gain. If you own Coca-Cola, everything goes right next year, you could make 30 to 50 percent.
If everything goes wrong, you could lose 20%. Asset plays are low risk, high gain, if you're sure of the value of the assets. Cyclicals may be low risk and high gain, or high risk and low gain, depending how well you can anticipate the cycles. If you're right, you can see 10 baggers here. If you're wrong, you can lose 80% to 90% of your investment.
Additional 10 baggers... can come from fast growers and from turnarounds. Both categories are high risk, high gain.
If a fast grower falters or the troubled turnaround has a relapse, the downside can be losing all your money. Later on, I'll explain when to sell a stock. But here, I want to discuss selling as it relates to portfolio management. I'm constantly rechecking my stocks.
I add and subtract from my investments as things change. But I don't cash in because cashing in will be getting out of the market. My idea is to stay in the market and rotate stocks depending on the fundamental situations. By successfully rotating in and out of several stalwarts for modest gains, you can get the same result as you could with one big winner.
I keep the fast growers as long as the earnings are growing. The expansion continues and no impediments have arisen. Same thing for cyclicals and turnarounds. You want to get out of the situations where you see the fundamentals worsen and the price increase. You want to get into situations where the fundamentals are better and the price is down.
If you can't convince yourself, when I'm down 25%, I'm a buyer, and banish forever the fatal thought, when I'm down 25%, I'm a seller, then you'll never make a decent profit in stocks. I've always detested stop orders. These are automatic bailouts at predetermined prices, usually 10% below the purchase price of a stock.
True, when you put in a stop order, you've limited your losses to about 10%. But in today's volatile market, a stock most always hits the stop. It's uncanny how stocks seem to shoot straight up after your stop is hit, and you're out of the stock.
There's no way to rely on stops as protection. on the downside, just as there's no way to rely on artificial objectives as goals on the upside. If I had believed in sell when it's a double, I wouldn't have benefited from a single very, very big winner. Stick around to see what happens as long as the original story continues to make sense. You'll be amazed at the results over time.
Chapter 17, the best time to buy and sell. I don't want to sound like a market timer and tell you there's a best time to buy stocks. The best time to buy stocks will always be the day you're convinced you found solid merchandise at a good price. However, there are two specific periods when great bargains can be found.
The first is during the ritual end-of-the-year tax selling. It's no accident that the most severe drops have occurred between October and December. It's the holiday period and brokers need spending money just like the rest of us. There's extra incentive for them to call and ask what you might want to sell to get a tax loss. Institutional investors also like to jettison the losers at the end of the year.
They want to clean up their portfolios for their upcoming evaluations. All this compound selling drives stock prices down. This selling begets more selling and drives perfectly good issues to low levels. The second time to buy stocks is during the collapses, drops, burps, hiccups, and free falls that occur in the stock market every few years. If you can summon the courage to buy during these scary episodes, you'll find opportunities that you wouldn't have thought you'd ever see.
Over the years, I've learned to think about when to sell the same way I think about when to buy. No single formula really applies. I pay no attention. to external economic conditions, except in the instances when a specific business will obviously be affected. But more often than not, I sell when I find a company's story has begun to collapse.
I'll sell a slow grower after there's been a 30% to 50% appreciation or when the fundamentals have deteriorated. Additional sell signs for slow growers include the company has lost market share for two consecutive years, or the company has curtailed spending on research and development, or the company has paid so much for its acquisitions that the balance sheet has been hurt. When I sell a stalwart, I frequently replace it with another stalwart.
The stock price gets above the earnings line, or the price-earnings multiple strays too far above the normal range. You might think about selling, waiting to buy it back at a lower price. Additional sell signs for stalwarts include the company's recently introduced products have had mixed results, or the company's stock has a P.E. of 15, while similar companies in the industry have P.E.s of 11 or 12 or the company's growth rate has been slowing down.
I try to sell a cyclical stock towards the end of the cycle but who knows when that is. Other than at the end of the cycle the best time to sell is when something has actually started to go wrong. An obvious sell signal is when inventories are building up and the company can't get rid of them.
Additional sell signs for cyclicals include when union contracts are about to expire and labor leaders want a restoration of the wages they gave up in the last contract, or the final demand for the product is slowing down, or the company has doubled its capital spending budget to rebuild a new plant instead of modernizing an old plant at a lower cost. Fast growers are tricky. You don't want to lose the potential 10-bagger. The main thing to watch for is the end of the second phase of rapid growth.
If 40 Wall Street analysts are giving the stock their highest recommendation. 60% of the shares are held by institutions, and three national magazines have fawned over the CEO. It's definitely time to think about selling. Additional sell signs for fast growth include the company's top two executives and several key employees leave the joint arrival firm, or the stock is selling at a P multiple of over 30, while the most optimistic earnings growth projections are 15% to 20% a year for the next two years.
Our sales have dropped 3% in the last quarter. The best time to sell a turnaround is after it's turned around. All the troubles are over, and everybody knows it. The company has become the company it was before it fell apart. Growth, cyclical, or whatever.
If the turnaround has been successful, you have to reclassify the stock. Additional sell signs for turnarounds include the company's debt suddenly rises sharply, or the company's inventories are rising at twice the sales growth rate, or the P-E ratio is inflated in relation to earnings prospects. Rather than sell an asset play, I like to wait for the rater.
You'll want to hold on as long as the company is not on a debt binge and reducing the value of the assets. Additional asset play sell signals include the company's management announcing it will issue 10% more shares to be sold at a discount, to the real market value to finance a diversification program, or the company has sold the division, which was expected to sell for $20 million, but only went for $12 million, or institutional ownership in the company has risen from 25% to 60% in the past few years. Chapter 18, The 12 Silliest and Most Dangerous Things People Say About Stock Prices Since graduate school, I've heard a continuous stream of theories about stocks.
Each one is more misguided than the last. The following statements are the 12 silliest things people say about stock prices. I present them here, hoping you'll dismiss them from your mind.
Silly statement number one. If it's gone down this much already, it can't go much lower. I bet the owners of Polaroid shares were repeating this very phrase. after the stock had fallen a third of the way down from its high of $143.5.
Polaroid had been a solid company with a blue-chip reputation. When earnings and sales collapsed, a lot of people didn't pay attention to how overpriced the stock was. Instead, they continued to reassure themselves that if it's gone down this much already, it can't go much lower. The fact is, Polaroid did go much lower.
This great stock fell from $143 to $14.5 in less than a year. Only then did it can't go much lower turn out to be true. The truth is there's simply no rule that tells you how low a stock can go.
Silly statement number two. You can always tell when a stock has hit bottom. Bottom fishing is a popular investor pastime, but it's usually the fisherman who gets hooked. Trying to catch the bottom of a falling stock is like trying to catch a falling knife.
It's normally a good idea. to wait until the knife hits the ground, sticks, vibrates for a while, and settles before you try to grab it. Grabbing a rapidly falling stock results in painful surprises. You almost always grab it in the wrong place.
Silly statement number three. It's gone this high already. How can it possibly go higher? Right you are. Unless, of course, you're talking about a stock like Philip Morris.
Philip Morris is one of the greatest stocks of all time. If you bought Philip Morris in the 1950s for the equivalent of 75 cents a share, you might have been tempted to sell it for 250 a share in 1961, the theory being that this stock couldn't go much higher. Eleven years later, with the stock selling for seven times the 1961 price and 23 times the 1950s price, you might again have concluded it couldn't go any higher.
But if you sold it then, you would have missed the next 7 bagger on top of the last 23 bagger. There's no arbitrary limit on how high a stock can go if the story stays good and the earnings continue to improve and the fundamentals don't change. Silly statement number four. It's only $3 a share.
What can I lose? How many times have you heard people say this? Maybe you've said it to yourself. You come across some stock that sells for $3 a share and you're thinking, it's a lot safer than buying a $50 stock. I'd worked in this business for almost 20 years before it finally dawned on me that whether a stock costs $50 a share or $1 a share, if it goes to zero, you lose everything.
The point is that a lousy cheap stock is just as risky as a lousy expensive stock. Silly statement number five. Eventually, they always come back. People said RCA would come back.
65 years passed and it never did. When you consider the thousands of bankrupt companies, the solvent companies that never regain their form of prosperity, and companies that get bought out at prices far below their all-time highs, you begin to see the weakness in this argument. Silly statement number six.
It's always darkest before the dawn. It's very human to believe that when things have gotten a little bad, they can't get any worse. For example, people invested on the basis of freight car deliveries were amazed when business dropped from a peak of over 95,000 units delivered in 1979 to a low less than 45,000 units in 1981. This was the lowest level in 17 years, and nobody imagined it could get worse. However, from 45,000 units, it dropped to 17,500 in 1982, and then to 5,700 in 1983. This was a whopping 90% decline in a once vibrant industry. Sometimes it's always darkest before the dawn, but then again, in the stock market, other times, it's always darkest before...
pitch black. Silly statement number seven. When it rebounds to $10, I'll sell.
Very often, downtrodden stocks never return to the level at which you decided you'd sell. In fact, the minute you say it gets back to $10, I'll sell, you've probably doomed the stock to several years of teetering around just below $9.75 before it keels over to $4 on its way down to $1. This painful process may take a decade, all the while you're tolerating an investment you don't even like, because some inner voice tells you to get $10 for it. 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.
Silly statement number eight. What, me worry? Conservative stocks don't fluctuate much. Two generations of conservative investors grew up with the idea you couldn't go wrong with utility stocks.
Then suddenly, there were nuclear problems and rate-based difficulties. Stocks like Consolidated Edison lost 80% of their value. Then just as suddenly, Con Ed gained back more than it had lost. There simply isn't a stock you can own that you can afford to ignore. Silly statement number nine.
It's taking too long for anything to ever happen. If you give up on a stock because you're tired of waiting for something wonderful to happen, then something wonderful will begin to happen the day after you get rid of it. Most of the money I make is in the third or fourth year that I own something, although sometimes it takes longer. If all is right with the company and whatever attracted me to it hasn't changed, I'm confident that sooner or later my patients will be rewarded.
Silly statement number 10. Look at all the money I've lost. I didn't buy it. Regarding someone else's gain as your personal loss is not a productive attitude for investing in the stock market. The worst part about this kind of thinking is that it leads people to try and play catch-up. They buy stocks they shouldn't buy under the delusion they are protecting themselves from losing more than they've already lost.
This usually results in real losses. Silly statement number 11. I missed that one. I'll catch the next one.
The trouble is, the next one rarely works. If you miss Toys R Us, a great company that continued to go up and bought Greenman Brothers, a mediocre company that went down, you compounded your error. You've taken a mistake that cost you nothing because you didn't lose anything by not buying Toys R Us and turned it into a mistake that cost you a lot.
In most cases, it's better to buy the good company at a high price than it is to jump in on the next one at a bargain price. Silly statement number 12. Stock's gone up. So I must be right. Or the stock's going down, so I must be wrong.
If I had to choose one great fallacy of investing, it's believing that when a stock's price goes up, it means you've made a good investment. All it means when a stock goes up or down after you've bought it is there was somebody who was willing to pay more or less for the same merchandise. I've bought stocks at $10 that went to $14.
that now if they double, you couldn't buy a Hershey bar with them. I bought stocks at $10 that went to $6 that are now $40. It's what happens to the fundamentals that really counts over the long term.
Chapter 19, Options, Futures, and Shorts. I've never bought a future nor an option in my entire investing career. I can't imagine buying either one now. It's hard enough to make money in regular stocks without getting distracted by these side bets.
There's no point describing how futures and options really work. In the first place, it requires a long, tedious explanation, and you'd still be confused. Second, if you know more about them, you might get interested.
And third, I don't understand futures and options myself. Actually, I do know a few things about options. I know that the large potential return is attractive.
to many small investors are dissatisfied with getting rich slowly. Instead, they opt for getting poor quickly. That's because an option is a contract that's only good for a month or two.
Unlike most stocks, it often expires worthless. Then the options player must buy another option, only to lose 100% of his or her money again. A string of these, and you're in deep trouble.
When you buy a share of even a risky stock, you are contributing something to the growth of the country. That's what stocks are for. In the multi-billion dollar futures and options market, none of the money is put to any constructive use.
It doesn't finance anything more than the cars, planes, and houses bought by the brokers and the handful of winners. You've probably heard the term shorting a stock. This enables you to profit from a stock that's going down.
Shorting is the same thing as borrowing something from the neighbors, selling the item, and pocketing the money. Sooner or later, you go out and buy the identical item and return it to the neighbors. What the shorter hopes to do is sell the borrowed item at a very high price, buy the replacement at a very low price, and keep the difference.
There are some serious drawbacks to going short. During the time you borrow the shares, the rightful owner gets a dividend. and other benefits. Also, You can't actually spend the proceeds you get from shorting a stock until you paid the shares back and closed out the transaction.
You're required to maintain a sufficient balance in your brokerage account to cover the value of the shorted stock. None of us is immune to the panic we feel when a normal stock drops in price, but our panic is restrained by our understanding the stock cannot go lower than zero. If you shorted something that's going up, you begin to realize There's nothing to stop it from going to infinity, because there's no ceiling on a stock price.
Stocks that are supposed to go down but don't remind me of the cartoon characters who walk off cliffs into thin air. As long as they don't recognize their predicament, they just hang out there forever. Before I continue with the last part of this program, let me remind you of the following points dealing with a long-term view.
Market declines are great opportunities to buy stocks in companies you like. Different categories of stocks carry with them different risks and rewards. Stock prices often move in opposite directions from the fundamentals, but long term, the direction and sustainability of profits will prevail. Just because a company is doing poorly doesn't mean it can't do worse. Just because the price goes up, doesn't mean you're right.
Just because the price goes down doesn't mean you're wrong. Stallwarts with heavy institutional ownership that have outperformed the market and are overpriced are due for a rest or a decline. Buying a company with mediocre prospects just because the stock is cheap is a losing technique.
Companies don't grow without a reason. Fast growers don't grow quickly forever. You don't lose anything by not owning a successful stock, even if it's a 10-bagger. Don't become so attached to a winner that complacency sets in and you stop monitoring the story.
If a stock goes to zero, you lose just as much money whether you bought it for $50 or for $2 a share. You lose everything you invested. You can improve your results by careful pruning and rotation based on fundamentals. When stocks are out of line with reality and better alternatives exist, sell and switch into something else. If you don't think you can beat the market, buy a mutual fund and save yourself a lot of extra work and money.
You can miss lots of tin baggers and still beat the market. I have. Chapter 20. 50,000 Frenchmen can be wrong.
Thinking back over the years, I remember several news events and their effects on the prices of stocks, beginning with President Kennedy's election. I was 16 in 1960, and I had already heard that a Democratic presidency was always bad for stocks. I was surprised that day after the election, the market rose slightly.
During the Cuban Missile Crisis, the one and only time America faced the immediate prospect of nuclear war, I feared for myself, my family, and my country. Yet the stock market fell less than 3%. Seven months later, when President Kennedy forced the steel industry to roll back prices, I feared for nothing.
But the market had one of its largest declines in history, 7%. I was mystified that the potential of a nuclear holocaust was less terrifying to Wall Street than the president's meddling in the steel business. The great events of the 1970s And the market reactions to them were as follows.
Nixon imposes price controls. Market up 3%. Nixon resigns. Market down 1%. Ford's whip inflation now buttons were introduced.
Market up 4.6%. IBM wins a big antitrust case. Market up 3.3%. The decade of the 70s was the poorest for stocks since the 1930s.
And yet... The major one-day changes were all upward on the days just mentioned. The event of most lasting consequence was OPEC's oil embargo of October 19, 1973. This helped to take the market down 16% in three months and 39% in 12 months.
It's interesting to note that the market did not respond to the significance of the embargo at the time. It actually rose four points on that day and climbed an additional 14 points before starting its dramatic fall. This demonstrates that the market, like individual stocks, can move in the opposite direction of the fundamentals over the short term. The 1980s have had more days of exceptional gains and losses than were seen in all the other decades combined. In the big picture, most of them are meaningless.
I'd rank the 508-point drop in October 1987 far below the meeting of the economic ministers on September 22nd. 1985 for its importance to long-term investors. At this conference, the major industrial nations agreed to coordinate economic policy and allow the value of the dollar to decline. After that decision was announced, the general market rose 38% over six months, had an even greater impact on specific companies which benefited from the lower dollar.
In my opinion, the breakup of AT&T ranks near the top of the most important developments in the stock market. It affected 2.96 million shareholders and over a million employees. The wobble of October 1987 doesn't even rank in my top three.
Lately, I've been hearing that the small investor has no chance in this dangerous environment. I've been hearing that the era of professional management has brought new sophistication and intelligence to the stock market. There are 50,000 stock pickers dominating the show, and like the expression, 50,000 Frenchmen can't be wrong, they can't possibly be wrong. From where I sit, I'd say the 50,000 stock pickers are usually right, but only for the last 20% of a typical move. It's that last 20% that Wall Street studies for, clamors for, and then lines up for, all the while with a sharp eye on the exits.
The idea is to make a quick gain and then stampede out the door. Small investors don't have to fight this mob. They can calmly walk in the entrance when there's a crowd at the exit, and they can walk out the exit when there's a crowd at the entrance.
I've been hearing that the 1987-88 market is a rerun of the 1929-30 market, and we're about to enter another Great Depression. So far... The 1987-88 market has behaved very much like the 1929-30 market.
But so what? If we have another depression, it won't be because the stock market crashed any more than the earlier depression happened because the stock market crashed. In those days, only 1% of Americans owned stocks.
The earlier depression was caused by an economic downturn in a country in which 66% of the workforce was in manufacturing, 22% was in farming, and the service sector was only 12%. There was no Social Security, unemployment compensation, pension plans, welfare and Medicare, guaranteed student loans, or government-insured bank accounts. Today, manufacturing represents only 27% of the workforce.
Agriculture accounts for a mere 3%, and the service sector has grown steadily through recession and boom. It now accounts for 70% of the U.S. workforce. Unlike the 30s, a large percentage of people now own or have equity built up in their own homes. The average household now has two wage earners instead of one, providing an economic cushion that didn't exist 60 years ago. If we have a depression, it won't be like the last one.
Every day I hear that major companies are going out of business. Some of them are. But what about the thousands of smaller companies that are going into business and providing millions of new jobs?
As I make my usual rounds, I'm amazed to discover that many companies are going strong. Some are actually earning money. If we've lost all sense of enterprise and our will to work, then who are those people who seem to be stuck in the rush hour? Frequent follies nonwithstanding.