One Up On Wall Street
Book Summary
Whether you invest in stock or thinking to become an investor, this is a must-read book for you.
Peter Lynch was the manager of the Magellan Fund at Fidelity Investments between 1977 and 1990. His average annual return was 29.2%, making it the best-performing mutual fund in the world.
PART I: PREPARING TO INVEST
Distrust in the Stock market was a prevailing attitude not only in America throughout the 1950s and 1960s but also in Peter Lynch's family and relatives. Almost everyone advised him to stay away from the stock market. Peter got his first job as a caddie in a golf course where he would hear presidents and CEOs talking about their triumphant investments which made him rethink his family position that the stock market is a place to lose money.
He continued to caddie throughout high school and into Boston College where he, along with history, psychology, and political science, studied metaphysics, epistemology, logic, religion and the philosophy of the ancient Greek.
“As I look back on it now, it's obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics.”“All the math you need in the stock market you get in the fourth grade.”Peter bought his first stock in 1963 which increased by 5-fold in less than 2 years which later helped him to pay for his graduate school at Wharton. During his senior year at Boston, he got a summer internship at Fidelity which was the best performing investment house at the time. He was put to researching and writing reports and visiting companies, the same as regular analysts.
Individual and amateur investors have an edge on most professional and institutional investors.
In most cases, professional institutional/fund managers are restrained by cultural, legal and social barriers. Many are held back by various written rules and regulations. Some bank trust departments simply won't’ allow the buying stock in any companies/unions, other won’t invest in non growth industries or in specific industry groups, such as electric utilities or oil or steel. Some funds are further restricted with a market capitalization rule: they don’t own a stock in any company below, say, a $100-million size (Size is measured by multiplying the number of outstanding shares by the stock stock price.)
"The stocks I try to buy are the very stocks that traditional fund managers try to overlook. In other words, I continue to think like an amateur."But, there are some handful of fund managers/investors, with a little or no restrictions, including John Templeton, Warren Buffett, Peter Lynch, to name a few who have had a long successful track record.
Under the current system, for many large institutional/professional investors, a stock isn’t truly attractive until it is widely known and a number of large institutions have recognized its suitability and an equal number of respected Wall Street analysts have put it on the recommended list. For e.g. many pension funds are allowed to buy form a pre-approved list of stocks only.
“Between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the normal mutual-fund manager, pension-fund manager, or corporate-portfolio manager would jump at the latter. Success is one thing, but it's more important not to look bad if you fail.”Understanding the difference between investing in debt and investing in stocks or companies is important.
Investing in bonds, money-markets, or CDs are all different forms of debt—for which one is paid interest. Historically debt instruments have recorded less than 5% gains. 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.
Investing in stocks is undeniably more profitable than investing in debt. Since 1927, common stocks have recorded gains of 9.8 percent a year on average. Investing in stock has unlimited upside as you are a partner in a prosperous and expanding business.
Stocks are more riskier than bonds. There are a multitude of companies that have disappeared from the list. Fortune of a company changes, there is no assurance that major companies won’t become minor. Buy the right stock at the wrong time and at the wrong price, you will suffer huge losses.
Investing in bonds is not completely without risk. For example, when interest rates rise, the price of the bond decreases. Hence, you either accept low interest or sell your bond at a substantial discount to face value.
Unfortunately, investing in stocks is still considered gambling by many. It is gambling if you don’t know what you are doing and if you don’t have the skill and dedication.
“To me, an investment is simply a gamble in which you’ve managed to tilt the odds in your favor.”Chapter 4: Passing The Mirror Test
Before you buy a share of any company, there are three personal issues that ought to be addressed: (1) Do I own a house?, (2) Do I need the money?, and (3) Do I have the personal qualities that will bring me success in stocks?
1. DO I OWN A HOUSE?
Before you do invest in stocks, you ought to consider buying a house. Buying a house is a much better investment for most people as they are likely to hold for many several. It’s is a good hedge against inflation. Also, it gives you a roof over your head and a sense of permanence where you can live for many years.
“No wonder people make money in the real estate market and lose money in the stock market. They spend months choosing their houses, and minutes choosing their stocks. In fact, they spend more time shopping for a good microwave oven than shopping for a good investment.”2. DO I NEED THE MONEY?
The money you want to invest in stocks should be truly surplus. For instance, if you’re going to have to pay for a child’s college education in two or three years, don’t put that money into stocks.
“Only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.”3. DO I HAVE THE PERSONAL QUALITIES IT TAKES TO SUCCEED?
The qualities required are 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.
"The good news I can tell you is that to be a great investor you don’t have to have a terrific IQ. If you’ve got 160 IQ, sell 30 points to somebody else because you won’t need it in investing. What you do need is the right temperament. You need to be able to detach yourself from the views of others or the opinions of others." —Warren Buffett
It is also crucial to be able to resist human nature and your ‘gut feeling’. Don’t try time things that are beyond your control, i.e. interest rate, stock prices in short term, monetary policy, etc.
"It's important to be able to make decisions without complete or perfect information. Things are almost never clear on Wall Street, or when they are, then it's too late to profit from them. The scientific mind that needs to know all the data will be thwarted here.""Some have fancied themselves 'long-term investors,' but only until the next big drop (or tiny gain), at which point they quickly become short-term investors and sell out for huge losses or the occasional minuscule profit. It's easy to panic in this volatile business."Invest in companies, not in stock market
Never should you ask, "is this a good market to invest?" Thousands of professionals including technical analysts, gold experts, macro economists and forecasters try to predict market, recession, boom and bust, inflation, interest rate, central bank’s policy, etc., but they haven’t been able to with any useful consistency.
“Obviously you don’t have to be able to predict the stock market to make money in stocks, or else I wouldn't have made any money.”The market ought to be irrelevant. If I could convince you of this one thing, I'd feel this book had done its job. And if you don't believe me, believe Warren Buffett. "As far as I'm concerned," Buffet has written, "the stock market doesn't exist. It is there only as a reference to see if anybody is offering to do anything foolish.""That's not to say that there isn't such a thing as an overvalued market, but there's no point worrying about it. The way you'll know when 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.""I don't believe in predicting markets. I believe in buying great companies—especially companies that are undervalued and/or underappreciated.... Pick the right stocks and the market will take care of itself.”PART II: PICKING WINNER
The best place to start looking for the tenbagger is close to your home. You just need to keep your eyes and mind open. You come across many different companies at shopping malls, workplace, medical tests office, etc. You didn’t have to work at Kodak to know that the new generation of inexpensive, easy to use, high quality cameras will turn the photo industry around. Maybe you work at school and come across a company that is automating the attendance system at school and thus will save hundreds of teachers’ hours. That company is worth researching.
It is important that you invest in companies you are able to understand well and that will give you an edge. A doctor is well positioned to understand companies in the health industry including pharmaceuticals. The person with the edge is always in a position to outguess the person without an edge. If you are in the business or industry, you have a double edge as you will know the customer liking as well when not to buy a particular company.
“Invest in things you know about.”
What you have got in the last chapter is simply a lead to a story that has to be developed. Just because Dunkin’ Donut is crowded doesn’t mean you own it.
"Investing without research is like playing stud poker and never looking at the cards."“All you have to do is put as much effort into picking your stocks as you do in buying your groceries.” What’s the Bottom Line?
If you think a company’s product is going to grow significantly, then the question is: what percentage of revenue or net income that product accounts for? For companies like Procter and Gamble, Pampers may be a fast growing product but it's impact on the company’s bottom may be too small.
Big Companies, Small Moves
The bigger the company, the harder it is to keep the percentage of growth constant or increasing.
“You’ll get your biggest moves in smaller companies. You don’t buy stock in a giant such as Coca-Cola expecting to quadruple your money in two years.” THE SIX CATEGORIES
Once you have established the size of the company relative to others in a particular industry, you can place it in one of the six general categories: slow growers, stalwarts, fast growers, cyclical, asset plays, and turnaround.
Three of the above six categories have to do with growth stocks. You can separate the growth stock into slow growers (sluggish), medium growers (stalwarts), and then the fast growers—the superstocks that deserve the most attention. Growth companies tend to expand in more sales, more production, and more profits in each successive year.
1. THE SLOW GROWERS
Large and aging companies are the slower grower but slightly faster than gross national product. They started out as fast growers and eventually pooped out. When the industry slows down, most of the companies within the industry slow down as well. Sooner or later every popular fast-growing industry becomes slow growing.
"Sure sign of 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."“If companies aren’t going anywhere fast, neither will the price of their stocks. If growth in earnings is what enriches a company, then what’s the sense of wasting time on sluggards.”2. THE STALWARTS
These are multi-billion companies that are expected to grow faster than slow growers; the stalwarts have been good performers, but not the star performers. 10 to 12 percent annual growth in earnings is expected from the Stalwarts. Depending on what you buy and what price, you can make a sizable profit in stalwarts. Companies in this category offer good protection during recessions and hard times. For example, people will continue to eat cornflakes during recession and thus Kellogg will grow steadily.
3. THE FAST GROWERS
These are small, aggressive new enterprises that grow at 20 to 25 percent a year. Big winners in the stock market as long as they can keep up the growth. With a small portfolio, one or two of these can make a career. A fast growing company doesn’t necessarily have to be in the fast-growing industry.
Risk in fast growers is overzealous and underfinanced young companies.
4. THE CYCLICALS
In a cyclical industry, companies’ sales and profits are expanding and contracting regularly. The autos and the airlines, the tire companies, steel companies, and chemical companies are all cyclicals. When the economy is expanding, the cyclicals companies are flourishing and their stock prices tend to rise much faster than the process of stalwarts. When the economy contracts, their sales and profits go down faster and thus the stock price. When bought at the wrong part of the economic cycle, it may be years before you’ll see another upswing.
"Timing is everything in cyclicals, and you have to be able to detect the early signs that business is falling off or picking up." Turnaround candidates have been battered, depressed and go so far down in a down cycle that people think it would never come back again. A poorly managed cyclical is always a potential candidate. Majority of turnarounds fail, but the occasional major success makes the turn around business very exciting, and very rewarding overall. Investors must stay away from the tragedies where the outcome is unmeasurable. Turnarounds that are likely to be successful are the ones that focus on its core business and get out of other businesses they entered to diversify business.
6. THE ASSET PLAYS
An asset play is any company that is sitting on something valuable that you have known about, but the crown has overlooked. The asset play is where the Local edge can be used to greatest advantage. In short, you are looking for a business with assets whether it’s cash, investments, properties, machines, etc that is worth more than the price you will pay for the stock.
Companies don’t stay in the same category forever. High growth companies cannot maintain the double digit growth forever. Fast growing companies will become stalwarts and slow growers and may go so far down that they become a turnaround candidate.
Putting stocks in categories is the first step in developing the story so that you know the kind of story it’s supposed to be. The next step is filling in the details.
It’s much easier to develop a company if it’s business is simpler and thus easier to understand.
"Any idiot can run this business is one characteristic of the perfect company, the kind of stock I dream about."The following thirteen attributes will make it easy for you to find the company:
1. IT SOUNDS DULL—OR, EVEN BETTER, RIDICULOUS
“The perfect stock would be attached to the perfect company, and the perfect company has to be engaged in a perfectly simple business, and the perfectly simple business ought to have a perfectly boring name. The more boring it is, the better.”
2. IT DOES SOMETHING DULL
“I get even more excited when a company with a boring name also does something boring.”
“A company that does boring things is almost as good as a company that has a boring name, and both together is terrific. Both together is guaranteed to keep the oxymorons away until finally good news compels them to buy in, thus sending the stock price even higher.”
3. IT DOES SOMETHING DISAGREEABLE
“Better than boring alone is a stock that’s boring and disgusting at the same time. Something that makes people shrug, retch, or turn away in disgust is ideal.”
4. IT’S A SPINOFF
“Spinoffs of divisions or parts of companies into separate, freestanding entities—such as Safety-Kleen out of Chicago Rawhide or Toys “R” Us out of Interstate Department Stores—often result in astoundingly lucrative investments.”
A large parent company doesn’t want its spin-off to get into trouble as it reflects poorly on the parent company. Hence, spin-off usually gets independence with a strong balance sheet.
“...spinoffs normally have strong balance sheets and are well-prepared to succeed as independent entities. And once these companies are granted their independence, the new management, free to run its own show, can cut costs and take creative measures that improve the near-term and longer term companies.”
5. THE 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 that no analyst has even visited, or that no analyst would admit to know about, and you have got a double winner.”
6. THE RUMORS ABOUND; IT’S INVOLVED WITH TOXIC WASTE AND/OR THE MAFIA
A company surrounded by rumors trades at a steep discount as wall street and other institutional investors stay away from it. For example, a company with toxic waste or Mafia involvement rumor may be an excellent opportunity.
7. THERE’S SOMETHING DEPRESSING ABOUT IT
The mortuary business is a good example.
“If there’s anything Wall Street would rather ignore besides toxic waste, it’s mortality.”
8. IT’S A NO-GROWTH INDUSTRY
“That’s where the biggest winners are developed.”
“In a no-growth industry especially one that’s boring and upsets people, there’s no problem with competition. You don’t have to protect your flanks from potential rivals because nobody else is going to be interested. That gives you the leeway to continue to grow, to gain market share...“
“There’s nothing thrilling about the thrilling high-growth industry, except watching the stocks go down. Carpets in the 1950s, electronics in the 1960s, computers in the 1980s, were all exciting high-growth industries, in which numerous major and minor companies unerringly failed to prosper for long.”
9. IT’S GOT NICHE
“I always look for niches. The perfect company would have to have one.”
“Drug companies and chemical companies have niches—products that no one else is allowed to make.”
“Chemical companies have niches in pesticides and herbicides. It’s not any easier to get a poison approved than it is to get a cure approved.”
“Brand names such as Robitussin or Tylenol, Coca-Cola or Marlboro, are almost as good as niches. It costs a fortune to develop public confidence in a soft drink or a cough medicine. The whole process takes years.”
10. PEOPLE HAVE TO KEEP BUYING IT
“I’d rather invest in a company that makes drugs, soft drinks, razor blades, or cigarettes than in a company that makes toys. In the toy industry, somebody can make a wonderful doll that every child has to have, but every child gets only one each.”
“Why take chances on fickle purchases when there’s so much steady business round?”
11. IT’S A USER OF TECHNOLOGY
“Instead of investing in computer companies that struggle to survive in an endless price war, why not invest in a company that benefits from the price war.”
“Instead of investing in a company that makes automatic scanners, why not invest in the supermarkets that install the scanners? If a scanner helps a supermarket company cut costs just three percent, that alone might double the company’s earnings.”
12. THE INSIDERS ARE BUYERS
“There’s no better tip-off to the probable success of a stock than that people in the company are putting their own money into it.”
“When management owns stock, then rewarding the shareholders becomes a first priority, whereas when management simply collects a paycheck, then increasing salaries become a first priority”
“There’s only one reason that insiders buy: They think the stock price is undervalued and will eventually go up.”
13. 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, just as the shareholders do?
“When stock is bought in by the company, it is taken out of circulation, therefore shrinking the number of outstanding shares. This can have a magical effect on 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 stay the same, the earnings per share have just doubled. Few companies could get the kind of result by cutting costs or selling more widgets.”
HOTTEST STOCK IN THE HOTTEST INDUSTRY
This is the stock everyone gets to hear about. Hot stocks go up fast, but when price falls, it falls steeply too. Most people buy because others are buying it with a hope that the price will rise sharply soon.
“If you had to live off the profits from investing in the hottest stock in each successive hot industry, soon you’d be on welfare.”BEWARE THE NEXT SOMETHING
“Another stock I’d avoid is a stock in a company that’s been touted as the next IBM, the next McDonald’s, the next Intel, or the next Disney etc. In my experience the next of something almost never is.”Value for shareholders is lost when the company overpays for acquisitions, and when the acquisitions are completely beyond their realm of understanding. In most cases, buying back shares or raising dividends is a better option than acquisitions. The trick is to find the right acquisitions in related business and manage successfully.
From time to time, people will tell you about a company that they think is a great investment opportunity. Most likely they have been telling about this company to every other person. Those are whisper stock with a hypnotic effect and a psychological appeal.
BEWARE THE MIDDLEMAN
“The company that sells 25 to 50 percent of its wares to a single customer is in a precarious situation. If the loss of one customer would be catastrophic to a supplier, I’d be wary of investing in the supplier.”“As often as a dull name in a good company keeps early buyers away, a flashy name in a mediocre company attracts investors and gives them a false sense of security. As long as it has “advanced,” “leading,” “micro,” or something with an x in it, or it’s a mystifying acronym, people will fall in love with it.”What makes a company valuable and why it will be more valuable tomorrow is earnings and assets. Especially earnings. Sometimes it takes years for the stock price to catch up to a company’s value, but sooner or later value always wins.
When you analyze a company on the basis of earnings and assets, it is no different from buying an apartment, drugstore or McDonald’s franchise. It is important to remember that a share of stock is part ownership, not lottery ticket.
The net asset is the book value after subtracting all liabilities from the asset. But if the company is not liquidated and sold off to the creditors, the value of the company comes from its assets’ capacity to earn income. The next step is to put company in of the six categories discussed in the chapter # 7: Slow grower, stalwarts, fast growers, cyclicals asset plays and turnarounds.
The success rate of fast growers is higher than stalwarts. But if and when the fast grower succeeds it boosts its income by a huge margin. When you buy a stock in a fast-growing company, you’re really betting on its chances to earn more money in the future. And when earnings are up, stock price is up.
Relationship between the stock price and the earnings of the company.
Useful measure of whether any stock is overpriced, fairly priced, or underpriced relative to a company's money-making potential.
Calculated as Current Price / Earnings per share for the prior 12 months or fiscal year
Can be thought of the number of years it will take the company to earn back the amount of your initial investment. A ratio of 10 means the original investment will be earned back in ten years.
P/E level tend to be lowest for the slow growers and highest for the fast growers
First step could be to look at P/E ratios of various stocks you own or looking to own are low, high, or average, relative to the industry norms.
Before you buy a stock, you might want to track it’s p/e ratio back through several years to get a sense of its normal levels. If you buy Coca-Cola, for instance, it’s useful to know whether what you’re paying for the earnings is in line with what others have paid for the earnings in the past. The p/e ratio can tell you that.
If you remember nothing else about p/e ratios, remember to avoid socks with excessively high ones. You’ll save yourself a lot of grief and a lot of money if you do. With few exceptions, an extremely high p/e ratio is a handicap to a stock, in the same way that extra weight in the saddle is a handicap to a racehorse.
A company with a high p/e must have incredible earnings growth to justify the high price that’s been put on the stock.
FUTURE EARNINGS
The best way is the educated guess based on current earnings
You need to try and project what’s going to happen to earnings in the next month, the next year, or the next decade.
Earnings are supposed to grow, and every stock price carries with it a built-in growth assumption.
If you can’t predict future earnings, at least you can find out how a company plans to increase its earnings. Then you can check periodically to see if the plans are working out.
There are five basic ways a company can increase earnings: reduce cost; raise prices, expand into new markets; sell more of its products in the old markets or to old/existing customers; or revitalize, close, or otherwise dispose of a losing operation.
First step is to know whether you are dealing with a fast grower, a slow grower, a stalwart, a cyclical, a turnaround or an asset play. And, the p/e ratio has given you a rough idea of whether the stock, as currently priced, is undervalued or overvalued. The next step is to learn as much as possible about the company and what it is going to do to bring about the added prosperity. This is known as the “story”.
Before you buy a stock, you should be able to give a two-minute monologue that covers the reasons you are interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path.
Here are some examples of two-minute monologue:
Slow grower — focus on dividend
"this company has increased earnings every year for the last ten, it offers an attractive yield, it's never reduced or suspended a dividend, and in fact, it's raised the dividend during good times and bad, including the last three recessions. it's a telephone utility, and the new cellular operations may add a substantial kicker to the growth rate."
Cyclical — focus on business conditions, inventories and prices.
"There has been a three-year business slump in the auto industry, but this year things have turned around. I know that because car sales are up across the board for the first time in recent memory. I notice that GM's new models are selling well, and in the last eighteen months the company has closed five inefficient plants, cut twenty percent off labor costs, and earnings are about to turn sharply higher."
Asset play — focus on assets and how much they worth
"The stock sells for $8, but the videocassette division alone is worth $4 a share and the real estate is worth $7. That's a bargain in itself, and I'm getting the rest of the company for minus $3. Insiders are buying, and the company has steady earnings, and there's nto debt to speak of."
Turnaround — Focus on how has the company gone about improving its fortunes, and is the plan working so far?
"General Mills has made great progress in curing its diworseification. It's gone from eleven basic businesses to two. By selling off Eddie Bauer, Talbot's... etc... and getting top dollar for these excellent companies, General Mills has returned to doing what it does best: restaurants and packaged foods. The company has been buying back millions of its shares. The seafood subsidiary, Gortons, has grown from 7 percent of the seafood market to 25 percent. They are coming out with low-cal yogurt, no-cholesterol Bisquick, and microwave brownies. earnings are up sharply."
Stalwart — focus on P/E ratio and whether the stock has had a dramatic run-up in price in recent months, and what if anything is happening to accelerate growth rate.
"Coca-Cola is selling at the low end of its P/E range. The stock hasn't gone anywhere for two years. The company has improved itself in several ways. It sold half its interest in Columbia Pictures to the public. Diet drinks have sped up the growth rate dramatically. Last year, the Japanese drank 36 percent more Cokes than they did they year before, the Spanish upped their consumption by 26%. That's phenomenal progress. Foreign sales are excellent in general. Through a separate stock offering, Coca Cola Enterprises, the company has bought out many of its independent regional distributors. Now the company has better control over distribution and domestic sales. Because of these factors, Coca-Cola may do better than people think."
Fast Grower — focus on where and how it plans to continue to grow fast
"La Quinta is a motel chain that started out in Texas. It was very profitable there. The company successfully duplicated its successful formula in Arkansas and Louisiana. Last year it added 20 percent more motel units than the year before. Earnings have increased every quarter. The company plans rapid future expansion. The debt is not excessive. Motels are a low-growth industry, and very competitive, but La Quitnta has found something of a niche. It has a long way to go before it has saturated the market."
The more you know the better. In many cases, you need to devote several hours to developing a script.
Rumors are usually more exciting, but as an investor you need to focus on getting the facts. Annual reports and quarterly reports are the best resource for facts. What you can’t get from the annual report you can get by asking your broker, by calling the company, by visiting the company, or by doing some grassroots research, also known as kicking the tires.
GETTING THE MOST OUT OF A BROKER
If your broker recommends a stock, as your broker about a category of stock (fast grower, slow grower, stalwarts, cyclical, turnaround, asset play), recent growth in earnings, p/e ratio relative to historic levels, expansion plans, debt situation, insider buy, buying back share etc.
CALLING THE COMPANY
If you have specific questions, the investor relations office is a good place to get the answers. Before you call, prepare your questions. All you are trying to do is to get a reaction to whatever script you have been trying to develop. It’s always better that you lead off with a question that shows you’ve done some research on your own, such as: “I see in the last annual report that you reduce debt by $500 million”.
Visiting headquarters, meeting Investor Relations in prison and attending annual meetings are other ways to get more information. One other way Peter discovered that wandering through stores and tasting things is very insightful. Before he bought La Qunita (motel chain), he spent three nights in one of their motels.
READING THE REPORTS
There is no better resource than annual reports.
Check cash and marketable securities in the current assets section. If together it exceeds long-term debt in the long-term liability section, it’s very favorable. No matter what happens, the company isn’t about to go out of business.
Assume other current assets including a/c receivable, inventories and other current assets are valuable enough to cover short term debt.
If long-term debt exceeds cash, the cash has been shrinking and debt has been growing, the company is in weak financial shape.
“Debt reduction is another sign of prosperity. When cash increases relative to debt, it’s an improving balance sheet. When it’s the other way around, it’s a deteriorating balance sheet.”
Check whether the shares outstanding has been reduced in the last 10 years or increased. Buying back shares leads to an increase in Earning Per Share and thus the share price.
Here, and not in any particular order of importance, are the various numbers worth noticing:
PERCENT OF SALES
If you are interested in a company because of a particular product, the first thing you want to know is what that product means to the company. In other words, what percentage of the sales it accounts for.
THE PRICE/EARNINGS RATIO
The p/e ratio of any company that’s fairly priced will equal its growth rate of earnings. If the p/e ratio is less than than growth rate, you may have found yourself a bargain. A p/e ratio that’s half the growth rate of earnings is very positive, and one that’s twice the growth rate is very negative.
THE DEBT FACTOR
One quick way to determine financial strength is to compare debt to equity. How much does the company owe, and how much does it own. It’s not different from an individual’s debt and equity position. For example, if you own a house worth $400,000 but you still own $100,000 to the bank on the mortgage you took for buying the house. Hence, your debt is $100,000 and equity is $300,000; your debt to equity ratio (debt/equity) is 0.25 or 25%.
Stronger balance sheet might have 1 percent debt and 99 percent equity. A weak balance sheet, on the other hand, might have 80 debt and 20 percent equity.
Pay special attention to the debt situation of turnaround and young companies. But more important is the kind of debt they have. There’s bank debt and there’s funded debt.
Bank debt is the worst kind and is due on demand. Commercial paper is similar to bank debt, which is loaned from company to other for short periods. The important thing is that it’s due very soon and sometimes even due on call.
Funded debt is the best kind from shareholder's point of view and can never be called in as long as the borrower continues to pay the interest. Funded debt usually usually takes the form of regular corporate bonds with long maturities. No matter what happens, the bondholder cannot demand immediate repayment of principal the way a bank can, unless they have been given a put option, which gives bondholders the right to sell at a given price.
Two strong arguments in favour of companies that pay dividends are: companies that don’t pay dividends have a sorry history of blowing the money on a string of stupid acquisition and dividend-paying stocks can keep the stock price from falling as far as it would if there were no dividends.
Fast growing, aggressive young companies that don’t pay dividends are likely to grow much faster as they are plowing money into expansion.
"The reason that companies issue stock in the first place is so they can finance their expansion without having to burden themselves with debt from the bank. I’ll take an aggressive grower over a stodgy old dividend-payer any day."If you do plan to buy a stock for its dividend, find out whether the company has the capacity to pay it during recessions and bad times. A company with a 20- or 30-year record of regularly raising the dividend is your best bet.
Book value is an easier number to find but you have to have a detailed understanding of what those values really are. The book value often bears little relationship to the actual worth of the company. It often understates or overstates reality by a large margin.
"The closer you get to a finished product, the less predictable the resale value. You know how much cotton is worth, but who can be sure about an orange cotton shirt. You know what you can get for a bar of metal, but what is it worth as a floor lamp?"When Warren Buffett decided to close down the New Bedford textile plan in 1985, he hoped to get something out of selling the loom machinery which had a book value of $866,000. The machine brought in only $163,000 in actual cash.
MORE HIDDEN ASSETS
You can find many companies who carry assets at the fraction of the true value. Assets of companies that own natural resources (land, time, oil, etc.) are usually more valuable as they are carried at a historical cost than the current value. Hidden assets can also be intangible assets. For example, brand name of CocaCola, patents of drug companies and tech companies.
There can be hidden assets in the subsidiary businesses owned wholly or in part by a large parent company. There are also hidden assets when one company own shares of a separate company. Finally, tax breaks turn out to be a wonderful hidden asset in turnaround companies because of its tax-loss carryforward.
Cash flow is the amount of money a company takes in as a result of doing business. A company that takes more cash that it spends is a better investment. The more cash it takes relative to its spending, the better.
In cases where companies have to spend cash to make cash, they aren’t going to get very far. The companies that don’t depend on capital spending generate a lot of cash which translates into stock price for investors.
A company with modest earnings could be a great investment because of it’s free cash flow. Usually it's a company with a huge depreciation allowance for old equipment that doesn’t need to be replaced in the immediate future. The company continues to enjoy the tax breaks (the depreciation on equipment is tax deductible) as it spends as little as possible to modernize and renovate.
Dedicated asset buyers look a mundane company going nowhere, a lot of free cash flow, and owners who aren’t trying to build up the business. It might be a leasing company with a bunch of railroad containers that have a 12-year life. All the company wants to do is contract the old container business and squeeze as much cash out of it as possible.
A detailed note on inventories can be found in the section called “managerial discussion of earnings” in the annual report. You must check 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.
In an auto company an inventory buildup isn’t so disturbing because a new car is always worth something, and the manufacturer doesn’t have to drop the price very far to sell it. A $35,000 Jaguar isn’t going to be marked down to $3,500. But a $300 purple miniskirt that’s out of style might not sell for $3.
Investors must consider the consequence of stock options and pension plans. In profit sharing plans there is no obligation: no profit, no sharing. But in a pension plan where the plan is an absolute obligation to pay, always check to make sure the company doesn’t have an overwhelming pension obligation that it can’t meet, especially in turnaround. Even if a company goes bankrupt and ceases normal operations, it must continue to support the pension plan. Therefore, pension fund assets exceed vested pension liabilities.
The “growth” is synonymous with “expansion” is one of the most popular misconceptions, leading people to overlook the great growth companies. The ability for a company to increase earnings by lowering costs and especially by raising prices is the only growth rate that really counts.
“If you find a business that can get away with raising prices year after year without losing customers (an addictive product such as cigarettes fill the bill), you’ve got a terrific investment.”“A 20-percent grower selling at 20 times earnings (a p/e of 20) is a much better buy than a 10-percent grower selling at 10 times earnings (a p/e of 10. This may sound like an esoteric point, but it’s important to understand what happens to the earnings of the faster growers that propels the stock price.”THE BOTTOM LINE
The bottom line refers to the final number at the end of an income statement: profit after taxes. However, profit before taxes, also known as the pretax profit margin, is a tool I use in analyzing companies. That’s the amount left of a company’s annual sales dollar after all the costs, including depreciation and interest expenses, have been deducted.
It’s best to compare pretax profit margin of 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 chance of surviving if business conditions deteriorate.
Focus on 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.
Every few months it’s worthwhile to recheck the company story:
Earnings as expected
Merchandise is still attractive (it may involve checking the stores)
With fast grower, ask yourself what will keep them growing,
What phase of growth the company is in: Start-up, expansion, maturity
STOCKS IN GENERAL
The p/e ratio compare to similar companies within the same industry
Percentage of institutional ownership. The lower the better
Insider buying & whether the company itself is buying back shares. Both are positive.
Record of earnings growth and whether the earnings are sporadic or consistent.
Strong balance sheet or weak. Debt-to-equity ratio and cash position
You buy for dividends. Check the record of dividends and how routinely raised.
Check Dividend payout ratio - % of earnings paid out as dividends. If it’s low, then the company has a cushion in hard times. If high, then the dividend is riskier.
You’re looking for big companies - not likely to go out of business
Key issue is price - check p/e ratio
Check for unrelated acquisitions that may reduce earnings in the future
Check for long-term growth rate and whether it has kept up the momentum in recent years
If you plan to hold the stock forever, see how the company has fared during previous recessions and market drops.
Keep a close watch on inventories, and the supply-demand relationship. Watch for new entrants into the market.
Anticipate a shrinking p/e multiple over time as business recovers and investors look ahead to the end of the cycle when peak earnings are achieved.
If you know your cyclical, you’ve an advantage in figuring out the cycles. It’s easier to predict an upturn in a cyclical industry than it is to predict a downturn.
Investigate whether the product that’s supposed to enrich the company is a major part of the company’s business.
What the growth rate in earnings has been in recent years. 20 to 25 percent range is ideal. Be wary of companies growing faster than 25 percent.
Company has been able to duplicate its successes in more than one city or town, to prove that expansion will work.
Whether the expansion is speeding up three new motels last year and five new motels this year) or slowing down (five last year and three this year).
Few institutions own the stock and only a handful of analysts have ever heard of it. With fast growers on the rise this is a big plus.
Can the company survive a raid by its creditors? How much cash does the company have? How much debt?
If it’s bankrupt already, then what’s left for the shareholders?
How is the company supposed to be turning around? Has it rid itself of unprofitable divisions?
Is business coming back?
Are costs being cut? If so, what will the effect be?
What’s the value of the assets? Are there any hidden assets?
How much debt is there to detract from these assets?
Is the company taking on new debt, making the assets less valuable?
Is there a raider in the wings to help shareholders reap the benefits of the assets?
Some pointers from this section:
Understand the nature of the companies you own and the specific reasons for holding the stock. (“It is really going up!” doesn’t count.)
By putting your stocks into categories you’ll have a better idea of what to expect from them.
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 year.
Avoid hot stocks in hot industries.
Distrust diversifications, which usually turn 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 a 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 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 the 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 that consistently buy back their own shares.
Study the dividend record of a company over the years and also how its earnings have fared in past recessions.
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 from their salaries.
Insider buying is a positive sign, especially when several individuals are buying 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. • Buying stocks based on stated book value alone is dangerous and illusory. It’s real value that counts.
When in doubt, tune in later.
Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.
PART III: THE LONG-TERM VIEW
It’s important to expect and plan for a reasonable return. You can easily get around 8-10% return by investing in index funds, ETFs, etc. Therefore, you ought to be getting a 12-15 percent return, compounded over time. That’s after all the cost and commission have been subtracted, and all dividends have been added
"In certain years you’ll make your 30 percent but there will be other years when you’ll only make 2 percent, or perhaps you’ll lose 20. That’s just part of the schedule of things, and you have to accept it."HOW MANY STOCK IS TOO MANY?
As many as you want as long as: a) you have an edge in understanding the company better; and b) you’ve uncovered an exciting prospect that passes all the tests of research. It may be 3, or it may be 30, but 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 portfolios, 3 to 10 will be ideal. Some of the benefits of owning more than one stock are:
If you are looking for tenbaggers the more stocks you own the more likely that one of them will become a tenbagger.
The more stocks you own, the more flexibility you have to rotate fund between them.
Spreading your money among several categories of sticks is another way to minimize downside risk (categories discussed in chapter 3). Slow growers and stalwarts are low risk investments with limited upside potential. Asset plays and Cyclical have a great upside potential given you can make the right investment at the right time. Additional tenbagers are likely to come from fst growers or from turnarounds-both high-risk, high-gain categories. Key is knowledgeable buying.
The key is to recheck and reexamine your story about the company from time to time. Rotating in and out of stocks depending on what has panned to the price as it related to the story.
"The best time to buy stocks will always be the day you've convinced yourself you've found solid merchandise at a good price—the same as at the department store.” However, the annual ritual of end-of-the-year tax selling and institutional investors also like to dump the losers at the end of the year so their portfolios are cleaned up for the upcoming evaluations present some opportunities. All the compound selling between October and December drives stock prices down. The second is during the collapses, drops, burps, hiccups, and freefalls that occur in the stock market every few years.
Stay away from stock market advice. Pay no attention to external economic conditions, whether interest rate is going up or down or the economy is heading into recession. Oil prices may have a huge impact on companies in the oil and gas industry but not on the healthcare industry. Here are some guidelines for different categories of stocks:
WHEN TO SELL A SLOW GROWER
Company has lost market share for two consecutive years
No new products are being developed, spending on research and development is curtailed
Two recent acquisitions of unrelated businesses and company 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
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
p/e strays too far beyond the normal range, you might think about selling it and waiting to buy it back later at a lower price-or buying something else
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 of 11-12.
No officer or director 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 (in housing starts, oil drilling, etc.)
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
The best time to sell is toward the end of the cycle as long as you are able to know when that is.
Costs have started to rise. Existing plants are operating at full capacity, and the company begins to spend money to add to capacity
Pay attention to rising inventories. When the parking lot is full of ingots, it’s certainly time to sell the cyclical.
Another useful sign is when the future price of a commodity is lower than the current, or spot, price.
Competition businesses are also a bad sign for cyclicals. The outsider will have to win customers by cutting prices, which forces everyone else to cut prices and leads to lower earnings for all the producers
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
Watch for the end of the second phase of rapid growth and/or when the company is entering into a mature phase
When Wall Street analysts are giving the stock their high recommendation, 60 percent of the shares are held by institutions, and three national magazines have fawned over the CEO, then it’s definitely time to think about selling.
All the characteristics of the Stock You’d Avoid (see Chapter 9) are characteristics of the Stock You’d Want to Sell
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 return from a “dog and pony” show telling an extremely positive story to institutional investors in twelve cities in two weeks
The stock is selling at a p/e of 30, while the most optimistic projections of earnings growth are 15-20 percent for the next two years
WHEN TO SELL A TURNAROUND
The best time to sell a turnaround is after it’s turned around. All the troubles are over and everybody knows it.
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
As long as the company isn’t going on a debt binge, thus reducing the value of the assets, then you’ll want to hold on.
Although the share 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.
Twelve silliest things people say about stock prices that you must dismiss from your mind:
If it's gone down this much already, it can’t go much lower—there’s simply no rule that tells you how low a stock can go in principle.
You can always tell when a stock’s hit bottom—trying to catch the bottom on a falling stock is like trying to catch a falling knife.
If it’s gone this high already, how can it possibly go higher?—if the story is still good, the earnings continue to improve, and the fundamentals haven’t changed, “can’t go much higher” is a terrible reason to snub a stock.
It’s only $3 a share, what can I lose?—whether a stock costs $50 a share or $1 a share, if it goes to zero you still lose everything.
Eventually they always come back—there is no shortage of stocks that have never come back.
It’s always darkest before the dawn—there’s a very human tendency to believe that things that have gotten a little bad can’t get any worse.
When it rebounds to $10, I’ll sell—remind yourself that unless you’re confident enough in the company to buy more shares, you ought to be selling immediately.
What me worry? Conservative stocks don’t fluctuate much—companies are dynamic, and prospects change. There simply isn’t a stock you can own that you can afford to ignore.
It’s taking too long for anything to ever happen—if all’s right with the company, and whatever attracted you in the first place hasn’t changed, sooner or later your patience will be rewarded.
Look at all the money I’ve lost: I didn’t buy it!—you don’t lose anything by not owning a successful stock, even if it's a tenbagger.
I missed that one, I’ll catch the next one—there is no next Home Depot, no next Amazon, no next Costco.
The stock’s gone up, so I must be right, OR… The stock’s gone down so I must be wrong—don’t confuse prices with prospects unless you are a short-term trader looking for 20-percent gain in the short-term.
Unless you are a professional trader, it's nearly impossible to win the bets; 80 to 90 percent of the amateur players lose. Futures serve a great purpose for farmers to lock the price of their wheat that they can sell at in future, it may serve a purpose for airlines to lock the price of oil that they can buy at in future, but it is risky business for people who indulge into the game of gambling. The large potential return is attractive to many who are dissatisfied with getting rich slowly.
If you buy an Options, it gives you an option to buy or sell, but not obligation, at the agreed upon price in future. In order for one person to make money, another person has to lose. In short, it’s a zero-sum game; it has nothing to do with owning a share of a company.
“In the multibillion-dollar futures and options market, not a bit of money is put into constructive use. It doesn't finance anything, except the cars, planes and houses purchased by the brokers and the handful of winners. What we are witnessing here is a giant transfer payment from the unwary to the wary.”Shorting a stock means borrowing stock from an owner, selling at a high price and waiting for the price to go down so you could buy a replacement to return to the owner and keep the difference. Some drawbacks of shoring:
Owner gets all the dividends
You can’t spend the proceeds from shoring stocks until you have paid the shares back to the owner and closed out the transaction.
You are require to maintain the sufficient balance in your brokerage account to cover the value of shorted stock
You are convince that the company is in a lousy shape but investors may not think
Chapter 20: 50,000 Frenchmen Can Be Wrong
Market reacts dis-proportionally to major news and events which can provide you with an opportunity to buy stocks at a discounted price.
During Cuban missile crisis and naval blockade of the Russian ships—America faced the immediate prospect of nuclear war—the stock market fell less than 3 percent that day. Seven months later, when President Kennedy berated US Steel and forced the industry to roll back price, the market declined by more than 7 percent.
Almost every day you will hear about something new and so-called gurus will try to convince you to buy their opinions and arguments. Important is to stay the course; focus on the company, know why you should buy, trust in your reasoning and judgement, and let your patience be rewarded.
“The market, like individual stocks, can move in the opposite direction of the fundamentals over the short term.”If you take anything with you at all from this last section, 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—Wall Street’s definition of going down a lot—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 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.
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 at $50, $25, $5, or $2—everything you invested.
By 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
Hope you enjoyed reading! You can connect with me on Twitter @JalalSali
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