I recently re-read one of my favorite books on investing in stocks, One Up On Wall Street by Peter Lynch. This time I decided to jot down some reminders from it and a few things I missed last time. The following shouldn’t be taken as investment advice from me. These are notes I took while reading the book:
You might have more advantages than you think
-“Small investors” (general public) sometimes have advantages over institutional investors (professionals), but they usually don’t realize it. Everyone has experience with different products and services, both as employees and as consumers. That counts as research and often the small investor has done it before the professional has. Don’t ignore businesses you know and understand in favor of ones you know nothing about.
-Many professional fund managers are limited by laws, such as no more than 5% in any one stock. And by size—buying smaller companies doesn’t move the needle as much for them as it does for small investors. Some firms even limit themselves by their own in-house rules, such as preventing their fund managers from buying certain stocks. There’s also a lot of pressure on fund managers to produce good quarterly results, which can adversely affect long-term results.
Focus on the fundamentals
-Own shares in companies that have good fundamentals. What is the financial condition of the company? What are its competitive positions? What are the plans for expansion? Is it entering new markets? Are its earnings rising? Are those earnings likely to continue rising? Etc.
Look for “little known and out of favor” stocks
-Look for stocks that analysts and institutional investors are ignoring. It’s often safer for professional investors to lose money on well-known stocks than relatively unknown stocks. Safer for their reputation and job security.
Look for simple “dull” businesses
-Cleaning companies and funeral homes are examples, in contrast to high flying tech companies.
Look for repeat customers
-Companies that sell products that people have to keep buying vs one-time purchases. An example of a one-time purchase would be a new popular toy.
Look for a niche
-A niche business is one with either 1) an established brand that has earned customer trust and loyalty, 2) strong patents on popular or much needed products, or 3) large barriers to entry, such as owning the only rock pit in town. Business prospects can change though. Check up on the company once in awhile to see if things are still looking good.
Are they already doing it?
-Look for proven products and proof that they’ll work elsewhere.
Watch out for “diworseification”
-For many companies, especially those with a lot of cash, there’s a temptation to buy something for the sake of buying something. They’ll sometimes buy companies that are mediocre and pay too much for them. Usually a company will be better off acquiring a related business. One that has earnings and a strong balance sheet. Or simply buying back some of its own shares.
How many clients?
-Beware of companies that rely on only a few large customers. They might have very little bargaining power with those clients and will always be at risk of losing a big chunk of business if they should lose one or two clients.
How many stocks to buy
-You don’t need to make money on every stock you buy. Six successful stocks out of ten is enough to get a “satisfying result.” Because you can’t lose more money than the amount you put into a stock, and the upside is unlimited. The more the good picks go up in value, the less the bad picks hurt your overall results.
-Own as many stocks that meet your criteria and in which you have an “edge.” Whether that’s only one stock (a very stable growth stock, like Walmart in the 1980’s) or a dozen others.
You don’t need to get in on IPOs (initial public offerings). Often they’re over-priced. If it’s truly a great company, you can still make big gains if you wait awhile to see how the story unfolds before buying in. If you had waited three years after Microsoft’s IPO, you still could have made hundreds of times your initial investment by now.
Beware of “whisper” stocks
-Companies that provide a solution that is either “imaginative” or “impressively complicated.” They often have high expectations, but no earnings.
-If you can’t resist investing in tech companies, look for companies that either provide established tech or that benefit from established tech, instead of investing in companies that invent new tech. Automatic Data Processing is an example of a company that provided tech, but didn’t invent it.
-One of the reasons Lynch preferred brick & mortar businesses was because it’s easy to see when new hotels and restaurants are being built and you never know what’s being invented in someone’s lab. New technology also tends to spread fast and become ubiquitous. With brick & mortar businesses, you can see them coming and they might not spread beyond a certain region. The downside to brick & mortar businesses is that they’re more capital intensive, but if the company manages its expenses well and is growing at a good clip, it can still be a great investment (at least for awhile). Lynch mentioned La Quinta as an example—a hotel chain that was growing at 50% per year (at the time) and keeping expenses to a bare minimum.
Focus on companies over industries
-Don’t be fooled by hot industries. Even in hot industries there are a lot of mediocre and terrible businesses. Hot industries attract a lot of entrepreneurs and venture capitalists who create competing companies. A price war can develop to the point where there’s no profits for any of them. You’ll also likely find unrealistically high stock prices, which will one day be followed by a sudden crash.
A hot product doesn’t always make a big difference
-Don’t buy shares in a company merely because it has a hot product. For a large company, profit from a hot product might not move the needle much. Find out how much it’s adding to the company’s bottom line.
Big companies tend to grow slow
-You probably won’t get big gains from owning big companies. You might still do well over the long-run, but (all things being equal) it will be a slower growth path compared to owning smaller companies. However, there may be extraordinary situations where a big company goes down a lot in price and then makes a huge rebound.
-Lynch favored fast growing companies with annual earnings growth in the 20-25% range. Fast growing companies with strong balance sheets are ideal, but you have to be wary of when the growth is going to slow and the potential drop in stock price as a result. Has the momentum of the long-term growth rate been maintained in recent years?
-Fast growing companies don’t need to be in fast growing industries. It could be a company taking away significant market share from other companies in a no-growth industry.
-Cyclical stocks, such as auto companies, airlines and steel companies, tend to be the best stocks to own when the economy is coming out of recession. When going into recession, cyclicals tend to get hit harder than average. It could be years before the earnings and stock price recover, and sometimes never.
-It’s easier to predict up turns in cyclicals than down turns.
-Companies that are close to bankruptcy can sometimes be potential “turnarounds.” Stay away from ones where the outcome seems “unmeasurable.”
-Is the potential turnaround company getting rid of unprofitable subsidiaries and divisions? Is it cutting costs? Is business going to pick up? Does the potential turnaround company have lots of cash and little to no debt? These things bode well.
-Low profit margin businesses tend to improve earnings more than higher margin business when rebounding from tough times. They get hit so hard to begin with that there is a lot of room for improvement relative their weakened position (small changes in margin can make a big difference for them). This is part of what can make turnarounds attractive.
-One thing that a company coming out of bankruptcy can have working in its favor is that it might not need to pay taxes for several years (known as tax loss carry-forward).
-Large pension obligations can be a problem for turnarounds. Pension plan assets need to exceed vested benefit liabilities.
-Watch out for dilution of shares—the company might survive, but the stock price might not recover.
-Sometimes there are opportunities in “asset plays,” where the assets of a company, such as land it owns, is worth more than what the stock is selling for. Sometimes it could be the shares it owns in other companies.
-During market declines, the stock price of dividend stocks tend not to go down as much as non-dividend payers, because investors want the yield. But not all dividend payers can continue to pay during tough times (cyclicals in particular). As far as dividend stocks go, it’s best to go with companies that have been regularly raising the dividend for at least the past 20-years.
-Dividends that represent a high percentage of company earnings are at higher risk of being cut when times are tough.
Balance sheet strength
-Look for Cash and Marketable Securities increasing and Long-Term Debt decreasing. Lynch said he ignored shot-term debt and assumed the other assets were enough to compensate for it.
-Bank debt is the worst kind of debt a company can have, because the lender can demand the money back at any time. Funded debt is better, because it involves the issuance of corporate bonds which can have 15 to 30 year maturity dates. As long as the interest payments are being made, the principal can’t be called in (and sometimes the interest payments can be deferred).
-Watch out for debt that is increasing at a higher rate relative to earnings.
-Watch out for inventory build-up relative to sales. It could be a sign of troubles beginning.
Book value is can be a deceptive number
-Because not every asset can be sold for the value listed on the balance sheet. Some assets could be almost worthless in a liquidation (textiles and looms, as examples). The company might have a positive book value on paper, but in reality it might be negative.
-Natural resources, like land, timber and oil tend to be undervalued on the balance sheet, because they’re listed at the purchase price, which could have been long ago.
-In a liquidation, finished products may not be worth as much as the material used to make them.
-Some assets, like drug patents, are amortized until they disappear from the balance sheet even though they might still have value.
-The brand power of a company is an asset not accounted for on the balance sheet. Except for acquired companies. The amount paid above book value for an acquired company is listed under Goodwill on the asset side of the balance sheet of the company that made the acquisition. Goodwill is the intangible qualities that the acquirer was willing to pay extra for. If the value of the subsidiary later declines, the parent company will receive an impairment charge to its Goodwill (reassessed annually). An impairment charge will also show up in the form of reduced earnings on the Income Statement. Conversely, if the value of the subsidiary has been going up after it was acquired, the increased value won’t be reflected in Goodwill.
Pay attention to who is buying
-It’s usually a good sign when executives and board members of a company (insiders) are buying a lot of shares. They have confidence that the stock is going to go higher and they’ll likely run the company in a way that makes the stock go higher.
-Look for a CEO who owns a lot of shares already. CEOs who are high wage earners, but own very few shares may have an incentive to expand the business through risky ventures. A CEO who owns a lot of shares will likely be more careful.
-Don’t pay much attention to insider selling, unless a lot of them are selling and they’re selling a majority of their shares. In general, corporate insiders are net sellers anyway—selling twice as many shares as they buy (to raise cash for personal use).
You can’t time the market
-Ignore any “gut feeling” you may have about when prices are going to move in either direction or by how much. It’s unpredictable. Often, the stock market makes its biggest upward moves in short periods of time—you don’t want to be out of the market when that happens.
-In bad markets, good companies can still go up a lot in price.
-Market indexes don’t reflect the price action of all stocks. Often it’s a small number of big companies that move the needle.
-While Lynch was managing his fund, the market went down between 10% and 35% eight times (but he never finished a year with negative returns).
When to buy
-Avoid excessively high P/E ratios (Price-to-Earnings). Generally, the higher the P/E, the more years it will take to make high returns on your investment. In some cases, the growth rate of the company may never catch up to the multiple you’re paying (do the math first—can the company really achieve that kind of earnings growth?). As a rule, it’s best to stick with low P/E ratios.
-Fair price for a stock is when the P/E is equal to the company’s annual earnings growth rate. Although, it’s better to have a 20% grower selling at a P/E of 20, than a 10% grower selling at a P/E of 10 (all else being equal), because of the increased compounding effect of fast-growers. Lynch mentioned that 30% growers aren’t sustainable.
-Another way to judge prices is to add the annual dividend rate to the annual growth rate and divide that number by the P/E ratio. Less than 1 is “poor,” 1.5 is “okay,” and 2 or better is ideal.
-Another thing Lynch did was divide Net Cash (Cash and Marketable Securities minus Long-Term Debt) by total number of shares outstanding. Subtract that figure (cash per share) from the stock price and calculate the P/E using that number. Lynch said Net Cash on a company’s balance sheet was like a type of bonus or rebate, because it was essentially in addition to the future earnings. Though it does depend on what the company does with that cash. Lynch believed that stock prices were unlikely to drop below parity with Net Cash Per Share.
-Lynch liked to measure Free Cash Flow Per Share against the stock price, looking for high percentage returns.
-Lynch also liked to use a chart with company earnings and stock price on it to compare the trajectories of the two, looking for divergence.
Predicting future earnings
-You can’t actually know what future earnings will be (though you can sometimes know what they won’t be). You can know what the company’s plan is to grow earnings and you can check once and awhile to see if they’re succeeding (expansion, cost cutting, acquisitions, etc.).
-A company with a lot of products and wide distribution of those products, such as Proctor & Gamble, will likely have much more predicable earnings than a company that relies heavily on commodity prices (copper, aluminum, etc.)
When to sell
-Lynch said his best investments usually took three to ten years and sometimes more to “play out.” He said most of the money he made was in the third or fourth year that he owned the stock.
-Lynch was not quick to sell his “clunkers” (stocks in his portfolio that had gone down considerably in price). He hung onto them if the company’s finances were still in “decent shape”and there was evidence of “better times ahead.”
-Knowing what category of stock you own should affect your holding period. For example, Lynch said he tended to sell “stalwarts” after a 30-50% gain and buy other stalwarts that hadn’t gone up yet. He described stalwarts as companies that were growing in the 10-12% range.
-Don’t make the mistake of selling fast growers merely because the stock price doubled. If it’s still growing at a good clip and the P/E isn’t super high—hang on for the ride. Don’t miss out on the “ten-baggers” and “100-baggers.”
-If a stock has been trading sideways for a long-time, and earnings are still increasing and the balance sheet is still strong, chances are the stock price will eventually make a big move higher.
Stocks vs bonds
-Over the long-run, stocks (as a group) always outperform bonds, by far. When you own stocks, you’re benefiting from the growth of the companies associated to the stocks. It’s the difference between owning profitable, growing businesses vs merely lending money to a business or government for a fixed rate of return. Not all public companies are profitable and growing, but there are enough of them that are.
-Stocks are risky if you buy the wrong ones or pay the wrong price even for the right ones. Even blue chip companies, which are considered the safest, don’t all last forever (watch out for headwinds that might affect the company’s growth). The main risk with owning bonds is that inflation might run at a higher rate than the return you’re getting from your bonds.
The book is a good read—more fun to read than this article and more info than I wrote here.