“In this concise summary of One Up On Wall Street, you will discover my essential takeaways organized chronologically, designed to save time and serve as a convenient reference for future use. When relevant, I include a personal note to express my opinion or key take-away from the text, adding a personalized touch to the summary. To dive deeper into the complete book, I have provided an affiliate link to Amazon, where you can effortlessly purchase it for global delivery.” – Jeroen Snoeks.
How “One Up On Wall Street” Broadened My Perspective
I like Peter Lynch’s concept of putting stocks into categories to have a better idea of what to expect from them. Overall, “One Up On Wall Street” does an excellent job of explaining the whole investment process. Without a doubt, it’s become one of my favorite investment books.
In the following sections, I’ve detailed my key takeaways from each chapter in the same order they appear in the book. This structure should make it easier for you to cross-reference any particular chapter if you decide to delve deeper into the subject matter.
Introduction to the Millennium Edition
If you can follow only one bit of data, follow the earnings – assuming the company in question has earnings. As you’ll see in this text, I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow, or next week is only a distraction.
Prologue: A Note from Ireland
To all the dozens of lessons we’re supposed to have learned from the Stock Market Crash of 1987, I can add three:
- Don’t let nuisances ruin a good portfolio.
- Don’t let nuisances ruin a good vacation.
- Never travel abroad when you’re light on cash.
Introduction: The Advantages of Dumb Money
It’s when you’ve decided to invest on your own, that you ought to try going it alone. That means ignoring the hot tips, the recommendations from brokerage houses, and the latest “can’t miss” suggestion from your favorite newsletter – in favor of your own research. It means ignoring the stocks that you hear Peter Lynch, or similar authority, is buying.
There are at least three good reasons to ignore what Peter Lynch is buying:
- He might be wrong! (A long list of losers from his own portfolio constantly reminds Peter that the so-called smart money is exceedingly dumb about 40 percent of the time.)
- Even if he’s right, you’ll never know when he’s changed his mind about a stock and sold.
- You’ve got better sources, and they’re all around you. What makes them better, is that you can keep tabs on them, just as Peter keeps tabs on his.
Part I – Preparing to Invest
1 – The Making of a Stockpicker
Logic is the subject that’s helped me the most in picking stocks, if only because it taught me to identify the peculiar illogic of Wall Street. Actually Wall Street thinks just as the Greeks did. The early Greeks used to sit around for days and debate how many teeth a horse has. They thought they could figure it out by just sitting there, instead of checking the horse. A lot of investors sit around and debate whether a stock is going up, as if the financial muse will give them the answer, instead of checking the company.
2 – The Wall Street Oxymorons
Under the current system, a stock isn’t truly attractive until a number of large institutions have recognized its suitability and an equal number of respected Wall Street analysts (the researches who track the various industries and companies) have put it on the recommended list. With so many people waiting for others to make the first move, it’s amazing that anything get bought.
Personal note: This statement just underscores my principles again—only follow my own research. When executed correctly, Wall Street will pick up on these companies eventually, and only then will the stock prices rise further than my anticipation.
3 – Is This Gambling, or What?
Since there is very little in the corporate bond business that isn’t callable, you are advised to buy Treasuries (if you hope to profit from a fall in interest rates).
Buy the right stocks at the wrong prices at the wrong time and you’ll suffer great loss.
Stocks are most like to be accepted as prudent at the moment they’re not.
By asking some basic questions about companies, you can learn which are likely to grow and prosper, which are unlikely to grow and prosper, and which are entirely mysterious. You can never be certain what will happen, but each new occurance – a jump in earnings, the sale of an unprofitable subsidiary, the expansion into new markets – is like turning up another card. As long as the cards suggest favorable odds of success, you stay in the hand.
Six out of ten is all it takes to produce an enviable record on Wall Street.
4 – Passing the Mirror Test
Before you buy a share of anything, there are three personal issues that ought to be addressed:
- Do I own a house?
- Do I need the money?
- Do I have the personal qualities that will bring me success in stocks?
Whether stocks make a good or bad investment depends more on your responses to these three questions than on anything you’ll read in “The Wall Street Journal”.
3. Do I Have the Personal Qualities That Will Bring Me Success in Stocks?
This is the most important question of all. It seems to me the list of qualities ought to include patience, self-reliance, common sense, a tolerance for pain, 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.
It’s also important to be able to make decisions without complete or perfect information.
And finally, it’s crucial to be able to resist your human nature and your “gut feelings'”, especially about where the market is going (because then often the opposite occurs).
The true contrarian is not the investor who takes the opposite side of a popular hot issue (i.e., shorting a stock that everyone else is buying). The true contrarian waits for things to cool down and buys stocks that nobody cares about, and especially those that make Wall Street yawn.
When it comes to predicting the market, the important skill here is not listening, it’s snoring. The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.
5 – Is This a Good Market? Please Don’t Ask
Remember, things are never clear until it’s too late.
“As far as I’m concerned, the stock market doesn’t exist. It is there only as a reference to see if anybody is offering to do anything foolish.” – Warren Buffet
The way you know the market is overvalued is when you can’t find a single company that’s reasonably priced or that meets your other criteria for investment. The only buy signal I need is to find a company I like. It’s never too soon, nor too late to buy shares.
Part I – What I Hope You’ll Remember from this Section are the Following Points:
- Don’t overestimate the skill and wisdom from professionals.
- Take advantage of what you already know.
- Look for opportunities that haven’t yet been discovered and certified by Wall Street – companies that are “off-the-radar scope”.
- Invest in a house before you invest in a stock.
- Invest in companies, not in the stock market.
- Ignore short-term fluctuations.
- Large profits can be made in common stocks.
- Large losses can be made in common stocks.
- Predicting the economy is futile.
- Predicting the short-term direction of the stock market is futile.
- The long-term returns from stocks are both relatively predictable and also far superior to the long-term returns of bonds.
- Keeping up with a company in which you own stocks is like playing an endless stud-poker hand.
- Common stock aren’t for everyone, not even for all phases of a person’s life.
- The average person is exposed to interesting local companies and products years before the professionals.
- Having an edge will help you make money in stocks.
- In the stock market, one in the hand is worth ten in the bush.
Part II – Picking Winners
6 – Stalking the Tenbagger
In most endeavors the grassroot observer can spot a turnaround six to twelve months ahead of the regular financial analysts. This gives an incredible head start in anticipating an improvement in earnings – and earnings, as you’ll see, make stock prices go higher. It doesn’t have to be a turnaround in sales that gets your attention. It may be that companies you know about have incredible hidden assets that don’t show up on the balance sheet.
I could go on for the rest of the book about the edge that being in a business gives the average stock picker. On top of that, there’s the consumer’s edge that’s helpful in picking out the winners from the newer and smaller fast-growing companies, especially in the retail trades. Whichever edge applies, the exciting part is that you can develop your own stock detection system outside the normal channels of Wall Street, where you’ll always get the news late.
7 – I’ve Got It, I’ve Got It – What is It?
If you’re considering a stock on the strength of some specific product that a company makes, 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. How big is the company in which you’ve taken an interest? Specific products aside, big companies don’t have big stock moves. In certain markets they perform well, but you’ll get your biggest moves in smaller companies.
Once I’ve established the size of the company relative to others in a particular industry, next I place it into one of six general categories:
- Slow Growers (sluggards) Usually these large and aging companies are expected to grow slightly faster than the gross national product. Slow growers started out as fast growers and eventually pooped out, either because they had gone as far as they could, or else they got too tired to make the most of their chances. When an industry at large slows down (as they always seem to do), most of the companies within the industry lose momentum as well. Sooner or later every popular fast-growing industry becomes a slow growing industry, and numerous analysts and prognosticators are fooled. There’s always a tendency to think that things will never change, but inevitably they do. Another sure sign of a slow grower is that it pays a generous and regular dividend. Companies pay generous dividends when they can’t dream up new ways to use the money to expand the business, an effort that always enhances their prestige, rather than to pay a dividend, an effort that is mechanical and requires no imagination.
- Medium Growers (stalwarts) These multibillion-dollar hulks usually generate 10 to 12 percent annual growth in earnings. If you own a stalwart like Coca-Cola and the stock’s gone up 50 percent in a year or two, you have to wonder if maybe that’s enough and begin to think about selling.
- Fast Growers Peter Lynch’s favorite investments: small, aggressive new enterprises that grow at 20 to 25 percent a year. If you choose wisely, this is the land of the 10- to 40-baggers, and even the 200-baggers. With a small portfolio, one or two of these can make a career. A fast-growing company doesn’t necessarily have to belong to a fast-growing industry. All it needs is room to expand in a slow-growing industry. These upstart enterprises learned to succeed in one place, and then to duplicate the winning formula over and over, city by city. The expansion into new markets results in the phenomenal acceleration in earnings that drives the stock price to giddy heights. There’s plenty of risk in fast growers, especially in the younger companies that tend to be overzealous and underfinanced. I look for the ones that have good balance sheets and are making substantial profits. The trick is figuring out when they’ll stop growing, and how much to pay for that growth.
- Cyclicals A cyclical is a company whose sales and profits rise and fall in regular if not completely predictable fashion. In a growth industry business keeps expanding, but in a cyclical industry it expands and contracts, then expands and contracts again. Coming out of a recession and into a vigorous economy, the cyclical flourish, and their stock prices tend to rise much faster than the prices of the stalwarts and vice versa. Timing is eveything in cyclicals, and you have to be able to detect the early signs that business is falling off or picking up. If you work in some profession that’s connected to steel, aluminium, airlines, automobiles, etc., then you’ve got an edge, and nowhere is it more important than in this kind of investment.
Personal note: Cyclicals should not be part of my long-term portfolio. However, investing in the cyclicals with healthy balance sheets during a financial crisis can be very profitable. When the economy is flourishing again, these cyclicals often payout generous dividends – it is then that you have to monitor these holdings closely and sell the company on any weakness.
- Asset Plays An asset play is any company that’s sitting on something valuable that you know about, but that the Wall Street crowd has oerlooked. The asset play is where the local edge can be used to great advantage. asset opportunities are everywhere. Sure they require a working knowledge of the company that owns the assets, but once that’s understood, all you need is patience.
- Turnarounds Turnaround candidates have been battered, depressed, and often can barely drag themselves into Chapter 11. These aren’t slow growers; these are no growers. Turnaround stocks make up lost ground very quickly. The best thing about investing in turnarounds is that of all categories of stocks, their ups and downs are least related to the general market. There is the perfectly-good-company-inside-a-bankrupt-company kind of turnaround. There’s the restructuring-to-maximize-shareholder-values kind of turnaround. Restructuring is a company’s way of ridding itself of certain unprofitable subsidiaries it should never have acquired in the first place (diworseification).
Companies don’t stay in the same category forever. Fast growers can’t maintain double digit growth forever, and sooner or later they settle down in the comfortable single digits of sluggards and stalwarts.
It’s simply impossible to find a generic (buy or sell) formula that sensibly applies to all the six types of stocks.
8 – The Perfect Stock, What a Deal!
The simpler the business, the better I like it. The statement: “Any idiot could run this joint”, is a big plus, because sooner or later any idiot probably is going to be running it.
The most important thirteen attributes how to recognize the perfect company:
- It Sounds Dull – or, Even Better, Ridiculous The perfect company has to be engaged in a perfectly simple business, and the perfectly simple business ought to have a perfectly boring name (Automatic Data Processing).
- It Does Something Dull I get even more excited when a company with a boring name also does something boring (as not many analysts will follow this company).
- It Does Something Disagreeable Better than boring alone is a stock that’s boring and disgusting at the same time (as not many people want to associate themselves with this company).
- It’s a Spinoff Large parent companies do not want to spin off divisions and then see those spinoffs get into trouble, because that would bring embarrassing publicity that would reflect back on the parents. Therefore, the spinoffs normally have strong balance sheets and are well-prepared to succeed as independent entities. new management can cut costs and take creative measures that improve the near-term and long-term earnings.
Personal note: When a parent company distributes shares of the spinoff to its shareholders, you often see a lot of selling pressure when the spinoff gets its first listing (as not all the parent’s shareholders want to own shares in the spinoff for different kinds of reasons). These are the best moments to scoop up those shares for a true bargain.
A month or two after after the spin-off is completed, you can check to see if there is heavy insider buying among the new officers and directors. This will confirm that they, too, believe in the company’s prospects.
- The Institutions Don’t Own It, and the Analysts Don’t Follow It This includes once-popular stocks that the professionals have abandoned.
- The Rumors Abound: It’s Involved with Toxic Waste and/or The Maffia
- There’s Something Depressing About It
- It’s a No-Growth Industry In a no-growth industry, especially one that’s boring and upsets people, there’s no problem with competition (because nobody else is going to be interested).
- It’s Got a Niche Once you’ve got an exclusive franchise in anything, you can raise prices. In the case of rock pits you can raise prices to just below the point that the owner of the next rock pit might begin to think about competing with you. He’s figuring his prices via the same method. Brand names such as Coca-Cola and Marlboro are almost as good as niches as it costs fortunes and years to develop public confidence in a soft drink or cigarette brand.
- People have to Keep Buying It Why take chances on fickle purchases when there’s so much steady business around?
- It’s a User of Technology Instead of investing in a company that makes automatic scanners, why not invest in the supermarkets that install those scanners? If a scanner helps a supermarket company cut costs just three percent, that alone might double the company’s earnings.
- The Insiders are Buying When management owns stock, then rewarding the shareholders becomes first priority, whereas when management simply collects a paycheck, then increasing salaries becomes a first priority. Since bigger companies tend to pay bigger salaries to executives, there’s a natural tendency for corporate wage-earners to expand the business at any cost, often to the detriment of shareholders. This happens less often when management is heavily invested in its shares.
- The Company is Buying Back Shares Buying back shares is the simplest and best way a company can reward its investors. Alternatively the company can raise its dividend, develop new products, start new operations or make acquisitions.
Personal note: You can find a lot of helpful resources about analyzing insiders, institutions and analysts in the Assessment of Stock Ownership section on UndervaluedEquity.com.
9 – Stocks I’d Avoid
Just when analysts predict double-digit growth rates forever, the industry goes into a decline. If you had to live off the profits from investing in the hottest stocks in each successive hot industry, soon you’d be on welfare.
If you have a can’t-fail idea but no way of protecting it with a patent or a niche, as soon as you succeed, you’ll be warding off the imitators.
When people tout a stock as the next of something, it often marks the end of the prosperity not only for the imitator but also for the original to which it is being compared.
Instead of buying back shares or raising dividends, profitable companies often prefer to blow the money on foolish acquisitions. The dedicated diworseifier seeks out merchandise that is (1) overpriced, and (2) completely beyond his or her realm of understanding.
That’s not to say it’s always foolish to make acquisitions. It’s a very good strategy in situations where the basic business is terrible. “Synergy” is also a good strategy, where the two-plus-two-equals-five theory of putting together related businesses and making the whole thing work can succeed.
“Whisper stocks”, who suppose to be on the brink of solving the latest problem, usually have a great story but no substance.
If the loss of one customer would be catastrophic to a supplier, I’d be wary of investing in the supplier.
Beware of the stock with an exciting name as people seem to fall in love with the name and don’t look at the fundamentals.
10 – Earnings, Earnings, Earnings
Why will a company be more valuable tomorrow than it is today? Focus on earnings and assets, especially earnings.
The P/E ratio can be thought of as the number of years it will take the company to earn back the amount of your initial investment – assuming, of course, that the company’s earnings stay constant. You’ll find that the P/E levels tend to be lowest for the slow growers and highest for the fast growers, with the cyclicals vacillating in between. Thus, buying any stock with a low P/E doesn’t make sense as you will then be comparing apples with pears.
The stock market as a whole has it’s own collective P/E ratio, which is a good indicator of whether the market at large is overvalued or undervalued.
If you can’t predict future earnings, at least you can find out how a company plans to increase it’s earnings. Then you can check periodically to see if the plans are working out.
There are five basic ways companies can increase earnings:
- Reduce costs;
- Raise prices;
- Expand into new markets;
- Sell more of its product in the old market;
- Revitalize, close, or otherwise dispose of a losing operation.
11 – The Two-Minute Drill
Once you’ve identified whether you’re dealing with a slow grower, a stalwart, a fast grower, a turnaround, an asset play, or a cyclical – and you’ve familiarized yourself with the P/E ratio to gauge the stock’s relative pricing – your next step is to delve into understanding the company’s operations and its role in your path to prosperity. This is known as the “story”.
Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. Once you’re able to tell the story of a stock so that even a child could understand it, then you have a proper grasp of the situation.
Here are some of the topics that might be addressed in the monologue:
- Slow Grower: you’re in it for the dividend (why else own this kind of stock?). “This company has increased earnings every year for the last ten, it offers an attractive yield; it’s never reduced or suspended a dividend, and in fact it’s raised the dividend during good times and bad and the new operations may add a substantial kicker to the growth rate.”
- Cyclical: you focus on business conditions, inventories and prices. “There has been a three year business slump in the industry, but this year things have turned around. I know that because sales are up across the board for the first time in recent memory. I notice that new products are selling well, and in the last eighteen months the company has closed five inefficient plants, cut twenty percent of labor costs, and earnings are about to turn sharply higher.”
- Asset play: what are the assets and how much are they worth? “The stock sells for $8, but the X division alone is worth $4 a share and the real estate is worth $7, so I’m getting the rest of the company for minus $3. Insiders are buying, and the company has steady earnings, and there’s no debt to speak of.”
- Turnaround: is the improvement-plan working so far? “The company made great progress in curing its diworseification. It’s gone from eleven basic businesses to two. By selling some of these divisions for top dollar the company can no focus on what is does best. The company has been buying back lots of its shares. The X subsidiary has grown its market-share and are introducing new promising products. Earnings are up sharply.”
- Stalwart: you focus on the P/E ratio, whether the stock already has had a dramatic run-up in price in recent months, and what, if anything, is happening to accelerate the growth rate. “The company is selling at the low end of it’s P/E range. The stock hasn’t gone anywhere for two years. The company has improved itself in many ways (selling unprofitable business, introducing promising products, selling more products, etc.).”
- Fast Grower: where and how can it continue to grow fast? “The company is located in city X and is very profitable there. The company successfully duplicated its successful formula in cities Y and Z. Last year it increased the base of their operation with 20 percent. Earnings have increased every quarter. The company plans rapid future expansion. The debt is not excessive. The company operates in a low-growth industry, and very competitive, but found something of a niche. It has a long way before it has saturated the market.”
Asking about the competition is one of my favorite techniques for finding promising new stocks. When an executive of one company admits he’s impressed by another company, you can bet that company is doing something right.
I learned that hotel and motel customers routinely pay one one-thousandth of the value of a room for each night’s lodging. (Thus, a $400,000 room will probably cost you $400 a night, while a $20,000 room will cost you around $20 a night.)
“That the stock had doubled in the previous year wasn’t bothersome – the P/E ratio relative to growth rate still made it a bargain.”
“Successful cloning is what turns a local taco joint into a Taco Bell or a local clothing store into The Limited, but there’s no point buying the stock until the company has proven that cloning works.”
12 – Getting the Facts
If you have specific questions, the investor relations office is a good place to get answers – preferably by phone.
The accepted form of the question is subtle and indirect: “What are the Wall Street estimates of your company’s earnings for the upcoming year?”
Always lead off with a question that shows you have done some research on your own, such as: “I see in the last annual report that you reduced debt by $500 million. What are the plans for further debt reductions?”
Two general questions: “What are the positives this year?” and “What are the negatives?”
“When is the last time a fund manager or analyst visited here?” If the answer is “two years ago, I think”, then I’m ecstatic.
“Rich earnings and a cheap headquarters is a great combination.”
Personal note: Use Google Street View to virtually explore the company’s headquarters, providing you with firsthand insight into the location and offering a sense of how much emphasis management places on it.
Consolidated Balance Sheet – Some Calculations
- Cash and Cash Items + Marketable Securities => compare both periods. If you see an increase in cash, you have noticed a sign of prosperity.
- Long-term debt => compare both periods. If you see an decrease in long-term debt, you have noticed a sign of prosperity.
- Substracting the long-term debt from the cash and marketable securities calculates the “net cash” position. Net cash is of course very favorable. Therefore, Lynch also calculates the net cash per share (to substract it from the share price to see what he really pays for the stock).
Peter Lynch ignores short-term debt as he assumes that the company’s other assets are valuable enough to cover the short-term debt.
13 – Some Famous Numbers
Percent of Sales
When I’m interested in a company because of a particular product, the first thing I want know is what percentage of sales it represent.
The Price / Earnings Ratio
The P/E ratio of any company that is fairly priced will equal it’s growth rate (of earnings). Thus, a P/E ratio of 15 means that you expect earnings to grow 15 percent annually. If the P/E ratio is less than the growth rate, you may have found yourself a bargain. In general, a P/E ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative.
Personal note: When you apply this principle to calculate the PEG ratio, you’ll find that bargain stocks typically have a value of around 0.5, while overvalued stocks tend to be valued around 2.0.
A slightly more complicated formula enables us to compare growth rate to earnings, while also taking dividends into account.
(Long-term Growth Rate + Dividend Yield) / P/E ratio
Less than 1.0 is poor, but what you are looking for is 2.0 or better. A company with a 15 percent growth rate, a 3 percent dividend yield, and a P/E ratio of 6 would have a fabulous 3.
The Cash Position
“Substracting the long-term debt from the cash and marketable securities calculates the “net cash” position. Net cash is of course very favorable. Therefore, Lynch also calculates the net cash per share (to substract it from the share price to see what he really pays for the stock).”
The Debt Factor
How much does the company owe, and how much does it own?
A normal corporate balance sheet has 75 percent equity and 25 percent debt. A weak balance sheet might have 80 percent debt and 20 percent equity.
Among turnarounds and troubled companies, I pay special attention to the debt factor. More than anything else, it’s debt that determines which companies will survive and which will go bankrupt in a crisis. Young companies with heavy debts are always at risk.
It’s the kind of debt, as much as the actual amount, that separates the winners from the losers in a crisis. There’s bank debt (the worst kind as it is due on demand) and funded debt (can never be called in as long as interest is paid on time)
“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” – John. D. Rockefeller
One strong argument in favor for companies that pay dividends is that companies that don’t pay dividends have as sorry history of blowing the money on a string of stupid diworseifications. Another argument in favor for dividend-paying stocks is that the presence of the dividend can keep the stock price from falling as far as it would if there were no dividend.
However, the smaller companies that don’t pay dividends are likely to grow much faster because of it. The’re plowing the money into expansion. I’ll take an aggressive grower over a stodgy old dividend-payer any day.
If you do plan to buy a stock for its dividend, find out if the company is going to be able to pay it during recessions and in bad times (likely companies which little debt). Cyclicals are not always reliable dividend-payers.
The stated book value often understates or overstates reality by a large margin.
Regarding to inventory value: the closer you get to a finished product, the less predictable the resale value.
Overvalued assets on the left side of the balance sheet are especially treacherous when there is a lot of debt on the right. When you buy a stock for its book value, you have to have a detailed understanding of what those values really are. You have to focus on understated true worth – the asset plays.
Companies that own natural resources often carry those assets on their book at a fraction of the true value.
Personal note: Although I always deduct the value for Goodwill and Intangibles in my stock analyses, I recognize the importance of gaining a deeper understanding of how these assets have been accounted for on the balance sheets. It is crucial to ascertain whether there are robust brand names, exclusive sales channels, patents, or other intangible assets that truly represent tangible value in the company’s operations.
Cash flow is the amount of money a company is taken in as a result of doing business. All companies take in cash, but some have to spend more than others to get it.
A $20 stock with $2 per share in annual cash flow has a 10-to-1 ratio, which is standard. If you find a $20 stock with a sustainable $10-per-share cash flow, mortgage your house and buy all the shares you can find. Make sure to focus on free cash flow – what’s left over after the normal capital spending is taken out.
I always check the note on inventories in the company’s “management’s discussion of earning” to see if inventories are piling up. With a manufacturer or a retailer, an inventory buildup is usually a bad sign. When inventories grow faster than sales, it’s a red flag.
Personal note: Within natural resource companies, a buildup in inventories could be a sign of a bargain, or in the words of Lynch a potential “asset play”. This becomes particularly intriguing when resource prices are in a depressed cycle, and the company doesn’t need to sell its reserves at the current depressed rates to sustain its operations.
There are two basic accounting methods to compute the value of inventories:
- LIFO: Last In, First Out
- FIFO: First In, First Out
If Company X bought some gold fifty years ago for $50 an ounce, and yesterday they bought some for $500 an ounce, and today they sell for $550 an ounce, what is the profit? Under LIFO it’s $50 ($550 minus $500) and under FIFO it’s $500 ($550 minus $50).
Before I invest in a turnaround, I always check to make sure the company doesn’t have an overwhelming pension obligation that it can’t meet. I specifically look to see if pension fund assets exceed the vested liabilities. If this isn’t the case, it would naturally raise a red flag.
The only growth that really counts, is earnings growth (by lowering costs, raising prices, etc.).
All else being equal, a 20-percent grower selling at 20 times earning (P/E 20) is a much better buy than a 10-percent grower selling at 10 time earnings (P/E 10) as shown in the table below:
|Company A (20% Earnings Growth)||Company B (10% Earnings Growth)|
|Base Year||$1.00 a share||$1.00 a share|
The Bottom Line
Only compare companies within the same industry. The company with the highest profit margin is by definition the lowest-cost operator, and the low-cost operator has a better change of surviving if business conditions deteriorate.
On the upswing, as business improves, the companies with the lowest profit margins are the biggest beneficiaries.
What you want, is a relatively high profit-margin in a long-term stock that you plan to hold through good times and bad, and a relatively low profit-margin in a successful turnaround.
14 – Rechecking the Story
There are three phases to a growth company’s life and each of these phases may last several years:
- Start-up Phase: during which it works out the kinks in the basic business. The riskiest phase, because the success of the company is not yet established.
- Rapid Expansion Phase: during which it moves into new markets. The safest phase, and also where the most money is made, because the company is growing simply by duplicating its successful formula.
- Mature Phase (Saturation Phase): when it begins to prepare for the fact that there’s now easy way to continue to expand. The most problematic phase, because the company runs into its limitations. Other ways must be found to increase earnings.
Personal note: Naturally, I diligently review quarterly reports and stay informed about the latest developments related to the companies in my investment portfolio. Nevertheless, now that I’m publishing My Portfolio on UndervaluedEquity.com, I recognize the importance of incorporating these moments into my routine to revisit and validate the investment analysis presented in my publications.
15 – The Final Checklist
Stocks in General
- The P/E ratio. is it high or low for this particular company and for similar companies in the same industry.
- The percentage of institutional ownership. The lower the better.
- Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs.
- The record of earnings growth to date and whether the earnings are sporadic or consistent. (The only category where earnings may not be important is in the asset play.)
- Whether the company has a strong balance sheet or a weak balance sheet (debt-to-equity ratio) and how it’s rated for financial strength.
- The cash position. With $16 in net cash, it’s unlike that that the share price drops below $16.
Part II – Here Are Some Pointers From This Section:
- Understand the nature of the companies you own and the specific reasons for holding the stock.
- By putting your stocks into categories you’ll have a better idea of what to expect from them¹.
- Big companies have small moves, small companies have 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 that their concept can be replicated.
- Be suspicious of companies with growth rates of 50 to 100 percent a year².
- Avoid hot stocks (especially) in hot industries.
- Distrust diversifications, which usually turns out to be diworseifications.
- Long shots almost never pay off.
- It’s better to miss the first move in a stock and wait to see if the company’s plans are working out.
- People get incredibly valuable fundamental information from their jobs that may not reach the professionals for months or even years.
- Separate all stock tips from the stock tipper, even if the tipper is very smart, very rich, and his or her last tip went up.
- Some stock tips, especially from an expert in the field, may turn out to be quite valuable. However, people in the paper industry normally give out tips on drug stocks, and people in the health care field never run out of tips on the coming takeovers in the paper industry.
- 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 percent) in nongrowth industries are ideal investments.
- Look for companies with niches.
- When purchasing depressed stocks in troubled companies, seek out the ones with superior financial positions and avoid the ones with loads of bank debt.
- Companies that have no debt can’t go bankrupt.
- Managerial ability may be important, but it’s quite difficult to assess. Base your purchases on the company’s prospects, not on the president’s resume or speaking ability.
- A lot of money can be made when a troubled company turns around.
- Carefully consider the price-earnings ratio. If the stock is grossly overpriced, even if everything else goes right, you won’t make any money.
- Find a story line to follow as a way of monitoring a company’s progress.
- Look for companies with little or no institutional ownership.
- All else being equal, favor companies in which management has a significant personal investment over companies run by people that benefit only form their salaries.
- Insider buying is a positive sign, especially when several individuals are buying (significant amounts) at once.
- Devote at least an hour a week to investment research. Adding up your dividends and figuring out your gains and losses doesn’t count.
- Be patient. Watched stock never boils.³
- Buying stocks based on the stated book value alone is dangerous and illusory. It’s real value that counts.
- When in doubt, tune in later.
- Invest as least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.
Personal notes: What wisdom from Peter Lynch in these bullet points! For personal emphasis, I’ve added some text in italics (between brackets) and included the following notes:
¹ Perhaps even separate the stock categories in different trading accounts.
² Even a 30 percent growth rate is probably not sustainable over the long term.
³ Peter Lynch’s quote, “Be patient. Watched stock never boils,” is a twist on the common saying, “A watched pot never boils.” In the context of investing, Lynch is emphasizing the importance of patience and not constantly obsessing over the daily or short-term fluctuations of a stock’s price. As a Dutch speaker, I recognized that this quote might require some clarification for non-native English readers (as I had to look it up myself too 😉).
Part III – The Long-Term View
16 – Designing a Portfolio
To be able to say that picking your own stocks is worth the effort, you ought to be getting a 12-15 percent return, compounded over time. That’s after all the costs and commissions have been substracted, and all dividends and other bonusses have been added.
The point is not to rely on any fixed number of stocks to own, but rather to investigate how good they are, on a case-by-case basis.
There’s no use diversifying into unknown companies just for the sake of diversity. That said, it isn’t safe to own just one stock, because in spite of your best efforts, the one you choose might be the victim of unforeseen circumstances. In small portfolio’s I’d be comfortable owning between three and ten stocks.
The more stocks you own, the more flexibility you have to rotate funds between them. My idea is to stay in the market forever, and to rotate stocks depending on the fundamental situation. I don’t go into cash – except to have enough of it around to cover anticipated redemptions. For instance, if a stalwart has gone up 40 percent – which is all I expected to get out of it, I sell the stock and replace it with another stalwart I find attractive that hasn’t gone up. If you didn’t want to sell all of it, you could sell some of it.
The fast growers I keep as long as the earnings are growing and the expansion is continuing, and no impediments have come up.
A price drop in a good stock is only a tragedy if you sell at that price and never buy more. To me, a price drop is an opportunity to load up on bargains from among your worst performers and your laggards that show promise.
17 – The Best Time to Buy and Sell
(Institutional) investors clean up their portfolio’s by selling their losing stocks between October and December to make use of the tax loss. All this compound selling drives stock prices down to sometimes crazy levels, and especially in the lower-priced issues, because once the $6-per-share threshold is reached, stocks do not count as collateral for people who buy on credit in margin accounts.
More about tax-loss-selling can be found in the following article: January Effect – How Do Tax Loss Selling and Window Dressing Effect Your Stock Prices.
Personal note: At the beginning of October, I usually scan the market for stocks that are hitting their 52-week lows to investigate if there are potential bargains to be found among them.
Another period in which you can find bargains is during collapses, drops, burps, hiccups, and freefalls that occur in the stock market every few years.
One of the biggest troubles with stock market advice is that good or bad it sticks in your brain.
If you know why you bought a stock in the first place, you’ll automatically have a better idea of when to say good-bye to it. Let’s review some of the sell signs, category by category:
When to Sell a Slow Grower
- When there’s been a 30-50 percent appreciation or when the fundamentals have detoriated.
- The company has lost market share for two consecutive years and is hiring another advertising agency.
- No new products are being developed, spending on research and development is curtailed, and the company appears to be resting on its laurels.
- Two recent acquisitions of unrelated businesses look like diworseification, and the company announces it is looking for further acquisitions “at the leading edge of technology”.
- The company has paid so much for its acquisitions that the balance sheet has deteriorated from no debt and millions in cash to no cash and millions in debt. There are no surplus funds to buy back stock, even if the price falls sharply.
- Even at a lower stock price the dividend yield will not be high enough to attract much interest from investors.
When to Sell a Stalwart
- If the stock price gets above the earnings line.
- New products introduced in the last two years have had mixed results, and others still in the testing stage are a year away from the marketplace.
- The stock has a P/E of 15, while similar-quality companies in the industry have P/E’s of 11-12.
- No officers or directors have bought shares in the last year.
- A major division that contributes 25 percent of earnings is vulnerable to an economic slump that’s taking place.
- The company’s growth rate has been slowing down, and though it’s been maintaining profits by cutting costs, future cost-cutting opportunities are limited.
When to Sell a Cyclical
- Towards the end of the cycle, but who knows when that is?
- When something has actually started to go wrong. For instance, costs have started to rise, or existing plants are operating at full capacity.
- Inventories are building up and the company can’t get rid of them (which means lower prices and lower profits down the road).
- Falling commodity prices. Pay attention to when the future price is lower than the current, or spot, price.
- New competitors enter the market.
- Two key union contracts expire in the next twelve months, and labor leaders are asking for a full restoration of the wages and benefits they gave up in the last contract.
- Final demand for the product is slowing down.
- The company has doubled its capital spending budget to build a fancy new plant, as opposed to modernizing the old plants at low cost.
- The company has tried to cut costs but still can’t compete with foreign producers.
When to Sell a Fast Grower
- If the company stops expanding.
- If forty Wall Street analysts are giving the stock their highest recommendation, 60 percent of the shares are held by institutions and three national magazines have fawned over the CEO.
- The P/E ratio reached absurd and illogical levels.
- Same store sales are down 3 percent in the last quarter.
- New store results are disappointing.
- Two top executives and several key employees leave to join a rival firm.
- The company recently returned from a “dog and pony” show, telling an extremely positive story to institutional investors in twelve cities in two weeks.
- The stock is selling for a P/E ratio of 30, while the most optimistic projections of earnings growth are 15-20 percent for the next two years.
When to Sell a Turnaround
- After it’s turned around.
- Debt, which has declined for five straight quarters, just rose by $25 million in the latest quarterly report.
- Inventories are rising at twice the rate of sales growth.
- The P/E is inflated relative to earnings prospects.
- The company’s strongest division sells 50 percent of its output to one leading customer, and that leading customer is suffering from a slowdown in its own sales.
When to Sell an Asset Play
- You don’t sell until (for example) Icahn shows up and starts buying the stock too. After that, there could be a takeover, a bidding war, or a leveraged buyout to double, triple or quadruple the stock price.
- Although the shares sell at a discount to real market value, management has announced it will issue 10 percent more shares to help finance a diversification program.
- The division that was expected to be sold for $20 million only brings $12 million in the actual sale.
- The reduction in the corporate tax rate considerably reduces the value of the company’s tax-loss carryforward.
- Institutional ownership has risen from 25 percent five years ago to 60 percent today – with several Boston fund groups being major purchasers.
18 – The Twelve Silliest (and Most Dangerous) Things People Say About Stock Prices
- If It’s Gone Down This Much Already, It Can’t Go Much Lower.
- You Can Always Tell When A Stock’s Hit Bottom.
- If It’s Gone This High Already, How Can It Possibly Go Higher?
- It’s Only $3 A Share: What Can I Lose?
- Eventually They Always Come Back.
- It’s Always Darkest Before The Dawn.
- When It Rebounds To $10, I’ll Sell. 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.
- What Me Worry? Conservative Stocks Don’t Fluctuate Much.
- It’s Taken Too Long For Anything To Ever Happen. Here’s something else that’s certain to occur: 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. I call this the postdivestiture flourish.
- Look At All The Money I’ve Lost: I Didn’t Buy It! Regarding somebody else’s gains as your own personal losses is not a productive attitude for investing in the stock market.
- I Missed That One, I’ll Catch The Next One. In most cases it’s better to buy the original good company at a higher price than it is to jump on the “next one” at a bargain price.
- The Stock’s Gone Up, So I Must Be Right, Or … The Stock’s Gone Down, So I Must Be Wrong. A stock’s going up or down after you buy it only tells you that there was somebody who was willing to pay more – or less – for the identical merchandise.
19 – Options, Futures, and Shorts
I’ve never bought a future nor an option in my entire investing career, and I can’t imagine buying one now. Warren Buffet thinks that stock future and options ought to be out-lawed, and I agree with him.
Personal note: While I acknowledge that Lynch and Buffett are far wiser investors than myself, I must confess that I am occasionally drawn to investing in cheap LEAPS options (Long-Term Equity Anticipation Securities). After reading about Lynch’s stock categories, I’ve come to the realization that I tend to purchase them mainly in “turnaround” and “cyclical” situations.
Among all the folk tales of successful short sellers are the horror stories of shorters who watched helplessly as their favorite lousy stocks soared higher and higher, against all reason and logic, forcing them in the poorhouse.
20 – 50,000 Frenchmen Can Be Wrong
The market, like individual stocks, can move in the opposite direction of the fundamentals over the short term.
Although I buy and sell every day, my biggest winners continue to be stocks I’ve held for three and even four years.
Part III – If You Take Anything With You At All From This Last Section, I Hope You’ll Remember The Following:
- Sometime in the next month, year, or three years, the market will decline sharply.
- Market declines are great opportunities to buy stocks in companies you like. Corrections push outstanding companies to bargain prices.
- Trying to predict the direction of the market over one year, or even two years, is impossible.
- To come out ahead you don’t have to be right all the time, or even a majority of the time.
- The biggest winners are surprises to me, and takeovers are even more surprising. It takes years, not months, to produce big results.
- Different categories of stocks have different risks and rewards.
- You can make serious money by compounding a series of 20-30 percent gains in stalwarts.
- 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 id 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.
- Stalwarts with heavy institutional ownership and lots of Wall Street coverage 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.
- Selling an outstanding fast grower because its stock seems slightly overpriced is a losing technique.
- Companies don’t grow for no reason, nor do fast growers stay that way forever.
- You don’t lose anything by not owning a successful stock, even if it’s a tenbagger.
- A stock does not know that you own it.
- 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 $50, $10 or $2 – everything you invested.
- Be careful pruning and rotation based on fundamentals, you can improve your results. When stocks are out of line with reality and better alternatives exist, sell them and switch into something else.
- When favorable cards turn up, add to your bet, and vice versa.
- You won’t improve results by pulling out the flowers and watering the weeds.
- If you don;’t think you can beat the market, then buy a mutual fund and save yourself a lot of extra work and money.
- There is always something to worry about.
- Keep an open mind to new ideas.
- You don’t have to “kiss all the girls.” I’ve missed my share of tenbaggers and it hasn’t kept me from beating the market.
Reading the original book instead of a summary offers a comprehensive understanding, emotional connection, appreciation of the author’s writing style, direct support for the author, and the chance to discover hidden gems. Enhance your reading experience by purchasing the book through my affiliate link: Get the Book on Amazon.