In 1990, Peter Lynch retired as manager of Fidelity Magellan – the nation’s largest stock mutual fund and one of the most successful. In 13 years, he drove Magellan to a twenty-eight hundred percent gain. Quite simply, Lynch has been recognized as one of the greatest money managers ever. He beat the stock market for so long, not by timing the market, but by picking the right stocks. Of course, no one can promise you Peter’s record, but you can learn a lot from him and you don’t need a billion dollar portfolio to follow his rules.
Hi, my name is Peter Lynch.
You shouldn’t be intimidated; everyone can do well in the stock market. You have the skills, you have the intelligence, it doesn’t require any education. All you have to have is patience. Do a little research, you’ve got it. Don’t worry about it. Don’t panic.
For 13 years, I managed the Fidelity Magellan fund. Those are 13 amazing years. Nine times the market declined by 10 percent or more, and I was very consistent. All nine times Magellan fund fell 10 percent or more. I learned a lot of lessons. I think they’re true now, I think they were true 20 years ago, I think they’ll be true 20 years from now. I think I can help you do a better job of investing.
You can’t learn years of stock-picking experience in one night, but you have better stock picking skills than you realize, and you have advantages that no one in Wall Street has. In the stock shop, I’m here to help you find them and use them. You may be wondering why stocks are so important for long term investment program. The short answer: over time stocks produce better returns than other investments. The past 60 years stocks have returned about 10 percent a year, bonds have averaged 6 percent a year, Treasury bills or Bank CDs around 3. That doesn’t seem like a big difference, does it? But the power of compounding makes an enormous difference over time. Suppose you invest $50 a month and earn 6%. After 30 years you have over $50,000. Go ahead and play with the numbers yourself. If you clicked on the assumptions button on the previous interactive screens, you noticed that the worksheets do not take taxes into account.
When your investment is taxed the government reduces your return every year. If you know you won’t need the money until retirement, you should place as much of your investments as possible into tax-deferred accounts like IRAs, Kiyo’s, 401k or 403b plans. Because you don’t pay taxes on the money until it is withdrawn from the accounts, the power of compounding achieves the maximum effect, providing you the best return possible. The more time you have to let your earnings compound, the better results you’ll get. A 20-year-old who invest $200 a month and earns 10% on his money all along will have 1.1 million dollars by the time he was sixty. Thirty-five year old would have to invest $800 a month to have the same 1.1 million dollars at age 60. You’re going to have a tough time getting that 10% return without at least some stocks in your portfolio. Before you start to invest, ask yourself one question: When will I need to use this money? The stock market is a long-term investment. If you need to use the money any time soon you should not invest in stocks.
This is money you’re willing to put in the market and leave it there for five, ten, twenty, thirty years. That’s the kind of money you can do well with. If you’re worried about it, don’t invest it. The stock market is volatile. Individual stocks are volatile. The average range for stock in a year is fifty percent between its high as its low. Stocks go up and down. The market goes up and down. If you’re investing with a one or two-year time horizon, you shouldn’t be in individual stocks, you shouldn’t be in inequity mutual funds. If you’ve been lucky enough to save up lots of money to send your children to college and they’re starting school in two years, what are you going to do if the market goes down?
In the long term – 10, 15, 20 years or more – stocks have beaten bonds and bank certificates of deposit. But in the short term, there is no telling what will happen. In 1987 the S&P’ 500 fell 33 percent from its August top to its October bottom. If you had the stomach to ride through that drop, you would have filed the ESPY performance from 1987 through 1992. Still, I performed treasury bills and long-term government bonds, despite that decline. If you want to double your money quickly and safely, fold it in half and put it in your wallet. Any other way, you’re simply gambling. A good stock can take two, three, even five years before it really pays off. It’s not two or three weeks, it’s not two or three months. My best stocks have been my fifth, sixth, seventh year. Give your investments time to grow. Many people ask me, “When is the right time to sell a stock?” Selling stocks is a matter of comparing stories. If story A is better than Story B, then sell B and buy more A.
If you own eight companies, you’re playing eight simultaneous games of poker. So only stay in the games that you have the best chance of success. But remember that stories rarely change overnight. It may take years for a good one to be recognized by the market. Give your good stories the time to grow. Your advantage in picking stocks is your direct experience with companies as a consumer, on your job as a professional or as a neighbor. Use those advantages as a place to start looking for good stocks. You have several things that you possess that will make you a good investor. They’re inherent to your life. It’s the field you work in, it’s the area where you live, there may be some local company that’s terrific. You’re a consumer, you see some products, you see some services that are terrific.
We bought a Volvo. It was better than the American station wagons. It was safer. The price was right. I did a little bit of research. I found out Volvo the stock, a Swedish company, was selling equal to its cash. You’re paying almost nothing for the company. They had lots of other divisions that were doing terrific. Buying that car turned out to be a great way to begin researching the stock. Sometimes, people take things for granted. My field was the mutual fund industry. In the early 1970s, the industry grew slowly, but then it took off in the 80s. Money piled in the money market funds to equity funds. Like an idiot, I missed talks like Dreyfus, Pioneer, Tiróprice, Strategic Investments, Franklin Resources – there were lots of companies that went up dramatically. These are my own field! All I had to do was buy these things. It was really dumb.
Back in the 1950s, a fireman from New England noticed the factory in his town seemed to be hiring and expanding all of the time. This person didn’t have a Cray computer, he wasn’t a professional investor, he was just an observant neighbor. He decided to put $2,000 per year into Tan Brands, then called Tampax. By 1972 the fireman was a millionaire just from using his local edge.
Investing is a personal thing. You have to do it by yourself. You don’t do it with a committee. You have to be able to have the emotional strength to stand the volatility of the market in general, and stocks in general. If the key organ here is not the brain, it’s the stomach. Do you have the stomach for this? Do you have the patience for it? You should be able to look in the mirror and say to yourself, “What am I going to do if the market goes down?”
if you know something that will drive a company’s earnings higher, you know something that will drive the company stock higher, sooner or later. But you can’t just guess at it. You have to have some reasons such as costs are coming down, or new products that are going to be a big hit. Research is developing a company’s story, an idea of why earnings should go up or down. It doesn’t mean sitting in the library for hours, reading SEC filings or fiddling with a calculator. Research is exciting, it’s very little math. When I owned Chrysler, it was the biggest position of my fund. When I was at a movie theater, at a sports event, I’d run into somebody driving a minivan and I’d ask them, “What do you think of the minivan? Would you buy another one? What do you like about it?” Some people would say that it’s a little underpowered – they only have a four-cylinder engine. I knew they are already working on a six-cylinder engine, so this is research.
Research starts with the things you know – your edge. If you’re a mechanic look at the tools you us. Which are the best? Which are the best value? Or if you’re a doctor, see what new technology saves the insurer money or software systems that reduce costs at hospitals. You probably already know a few companies quite thoroughly. The amateur investor probably can follow between five and eight companies. They could lecture in these five or eight companies. They know them very well. There are 10 to 15,000 public companies in the United States. There’s lots more overseas so you don’t have to be experts on lots of companies. You just have to know a few very well.
It’s a lot of fun. It only takes a few hours a month. It’s not a full-time job. I own Dunkin Donuts for 12 years. I think I might have talked to him once every year. The story didn’t change a lot. You don’t have to worry about low-cost imports coming from Korea when you own a donut company. You don’t have to worry about the economy. You don’t have to worry about in someone inventing a new computer chip. The story doesn’t change that much.
McDonald’s earnings have gone up, I think, more than 80 fold over the last 30 years. The stocks went up a hundredfold. What made McDonald’s earnings continue to grow? If they just stuck with a cheap cheeseburger and a cheap hamburger at lunch, they probably would have run into earnings problems 10-15 years ago. But they expanded their menu, they kept the cost low, they added breakfast, they went overseas… Every day they add two or three more restaurants. People thought there was no room for more McDonald’s 5, 10, 15 years ago. They were wrong. If they had done the research, they would have said, “Well is a couple of hundred countries out there, there are lots of places to grow.”
Actual bad economic news, rising interest rates, wars, elections, any of these can push the market down. If you are one of those people that pore over graphs, economic statistics, or astrology charts, trying to figure out what the stock market is going to do next, you are wasting your time. No one can predict the market.
You have to understand: the market goes down. There have been 95 years this century, we’ve
had 50 declines of over 10 percent. Of those 50 declines, 15 have been 25% more. So about once every two years, the market falls 10%. But once every six years it falls 25%. These are big drops. You have to understand that. That’s the nature of the market.
In 1990, Saddam Hussein went into Kuwait. The banking system was in trouble. We had a recession. He had all his background noise. Lots of good companies had nothing to do with wars, nothing to do with banking, they all went down in 1990. The market fell from 3000. It fell over 20%. This gave you a great opportunity to buy terrific companies at very good prices.
Behind every stock is a company. If the company does terrific for a long period of time, the stock will do terrific. If the company does lousy, the stock is going to do lousy. That’s all you’re betting on. This is a company that’s had 35 years of double-digit earnings growth every single quarter. We’ve had changes in the Supreme Court, we have the stock market goes up and down, we had changes in presidents, we’ve had recessions, we’ve had wars – all these things had no effect on automatic data processing. So every time the market went down it gave you a chance to buy it.
You’re saying, “I believe strongly [that] this company’s going to do well.” If you start to see symptoms that that’s not going to happen, the stock is going to very rapidly respond to that. If the company runs out of steam, the stocks going to run out of steam.
Look at FannieMae from July through October 1990, the Standard & Poor’s 500 fell 21%. Fannie Mae fell from about 42 dollars a share to about 26, even though earnings are still increasing. This was a terrific time to buy FannieMae. The company was doing well, management was still great, the story was solid and they had a very good business. But you got to buy the stock at a 38% discount. If you start by looking at the entire universe of stocks – more than 3000 stocks on the New York Stock Exchange alone and over 13,000 public companies in total – you will blow a gasket. So I break stocks into categories, partly to make the job of researching more manageable. Putting stocks into categories is the first step in developing the story. At least you’ll know what kind of story it’s supposed to be. The category tells you what questions you should be asking about a company. You simply can’t expect all stocks to behave the same. Basing a strategy on general maxims like sell when you double your money, or sell when the price falls 10 percent, is absolute folly. No formula will apply to all stocks. Different stocks behave differently, so they require different approaches, different expectations and different kinds of stories.
Suppose you’ve made a 50% gain on two companies: one is a fast grower with a long way to go; the other is a big lumbering slow growth company that has already saturated 95 percent of its market, and that market itself is growing slowly. The 50% return is fantastic for the slow grower. The chances are, it’s time to sell it. The same 50% return could be just the tip of the iceberg for the fast grower. There are basically five categories: one would be fast growers; two would be slow growers; three would be cyclicals; four would be asset plays; and the fifth one would be turnarounds.
At the end of this presentation, you’ll have an opportunity to explore each category in more detail. In the meantime, remember categories are guidelines. They are not hard rules. Some companies may not fit neatly into a category, others may seem to be in two categories at once. Almost all companies change categories at some time throughout their lifetimes.
Fast growers, if successful, will always eventually slow their growth. They’ll run out of places to go. Cyclicals experiencing long down cycles may become turnarounds. Once recovered, they probably will be cyclical again. Use the categories as guides to help you build your story, but don’t let them limit the questions you ask or the research you do. One thing we can say about companies in general: it’s easier to go from 100 million in sales to 200 million dollars in sales, than it is to go from 10 billion in sales to 20 billion dollars in sales. So smaller companies tend to have more upside potential than larger companies, but don’t dismiss all big companies out of hand. Some big companies defy their size and find exciting new ways to grow their earnings. As well, good opportunities exist in companies that are cyclical, regardless of their size.
When most people think about investing in the stock market, they dream about investing in a fast grower – a company that is growing at over 25 percent a year. At 25 percent a year a company’s profits will double in 3, they quadruple in 6, give up 8 fold in 9 years. That’s how you get a huge stock in a decade. There’s not a lot of these, but they’re very powerful. And the best part is you don’t have to catch them just as they’re taking off. The beauty of growth companies is you have plenty of time. If they’re going to grow 4, 5, 10, 20, 30 years you don’t have to be there the first year, or the second year. You could have bought Walmart 10 years after they went public made 30 times your money.
What makes a company grow earnings so quickly? Either it is a rapidly growing industry, or it’s a rapidly growing company in a slow growth industry. Rapid revenue growth and rapid earnings growth are the hallmarks of a fast grower. They just can’t buy any stock with hot earnings and hot sales. You have to check the balance sheet. Make sure the company can keep growing.
One way you can look at growth companies is think of baseball. A normal baseball game has 9 innings. You should look at a growth company and say, “I don’t want to buy it when they’re in the first inning, I want to buy it when they’re in the second or third inning. They’ve got the formula right, they have got lots of room to go.” So you want to say to yourself, “This is a company that’s very early in its cycle. Like a McDonald’s when they’re only in a few stores or be limited when they’re only in a hundred stores and they had lots of malls to go to.”
Microsoft was a company you could have bought 3 years after it went public, and made over 20 times your money. Sales and earnings were growing at several times the rate of the company in the S&P500, in an industry that was exploding by leaps and bounds. And it had a lot of potential both overseas and domestically. This was only the beginning of a 15 to 20-year growth cycle. You had plenty of time to get involved.
There is an amazing company called Superior Industries. I think the stock went up over a hundredfold. They were very good at making aluminum wheels. A lot of car companies went to aluminum wheels. The industry for autos wasn’t growing. Aluminum wheels growing dramatically and they were the best at it. The fast growers get all the attention in the media, but there’s nothing wrong with slow-growing stock, provided you get it at a very decent price. Some would say to you, “I’m going to sell you a business for $100,000” and they’re earning $50,000 a year. You say, “What’s the bad news?” Let’s say the bad news is the earnings are never going to grow they earn $50,000 for you forever. So this is a price-earnings multiple of two. You pay $100,000, with $50,000 earnings, but they’re never going to grow. You say, “I don’t care. I’m going to get a $50,000 return every year. In two years I get all my money back, then I make $50,000 a year on my hundred thousand dollar investment forever.” So sometimes if the company has a very low growth rate of their earnings. if the stock is selling at the right price, it may still be a very good deal, a slow to moderate grower, of earnings growth of 3 to 15% a year. One company that I was very lucky with Service Corp International. It’s a funeral home company that bought up local family funeral homes. A very steady business. Service Corp could grow earnings at 15% a year when I owned it with very little problems.
A slow grower that turns into a no grower is a very bad news situation. So when you start researching the stock, look for these signs:
- Steady earnings growth: You can find annual earnings growth rates in the research section, as well as estimates for the coming year.
- Rising dividends: Companies that raise their dividend each year have to have the earnings to do so. A rising dividend is normally a good sign for a stockroom
- Room to keep growing: You want slow growers to go on forever. That’s one reason I like Service corp International so much. This was a great stock to me in the 1980s. At that point, it had a long way to go.
Cyclical companies rise and fall with the economy. Typically, they make expensive big-ticket items that people buy when the economy is good. Things like houses, cars and furniture. The economy is bad and people worried about losing their jobs, they don’t buy big-ticket items. They’re too broke or too scared that they will go broke. Don’t try a cyclical stock if you don’t have intimate knowledge of the business; if you don’t have an investor’s edge. Everyone in Wall Street tries to time cyclical stocks, too. Because the stock market looks forward, you could be left with a sinking stock, even though the company’s earnings are terrific. You make your best money in a cyclical when earnings go from rotten to mediocre or from mediocre pretty good. The danger point is when earnings go from great to spectacular. Somewhere between these two points, WallStreet will figure out there’s only one way to go – that’s for profits to go down some point in the future. Just don’t buy in the hope, wait for things to get better, prices to get better, capacity to shrink, inventories to go down, scrap prices to get better… Something ought to be happening. So you just want to wait for something to happen, and then when it happens it’s going to be big.
Let’s take a look at Chrysler. In 1990, the company was selling for $10 a share, the economy was lousy and people were talking about Chrysler going out of business. But guess what? The economy came back, and everyone’s old car was falling apart. As people made more money, they started buying new cars. And because Chrysler had great products, the minivan, the Jeep and its first new full-size truck in 20 years, the stock was big. In addition, very importantly, the balance sheet was decent in 1990. This was not a company about to go bankrupt.
If it’s a Cyclical, you’re hoping for a dramatic turnaround in earnings, it’s going to happen over two or three years, earnings going to go from a loss to huge profit, stocks are going to go up and you’re going to get out. Make sure you’re picking a strong company that can survive when the cycle goes down. That means good cash flow and low debt. If its cash flow is spotty or its debt is high, when the downturn comes, the company faces the danger of going bankrupt.
Turnarounds – these are stocks that are battered down, or they’re hated companies, or they’ve been forgotten about. The depressant price. But you have determined something, or a few things, that have the potential for reversing this company’s fortunes, independent of the industry getting better or the economy getting better. You will always have to do a balance sheet check on any company, and this includes turnarounds. Do they have enough cash to make it through the next 12 months, the next 24 months? Do they have a lot of debt that’s due? Right now, these are important questions to answer. Make sure you understand and believe in the plan to restore corporate profits.
It’s all internal. They’re doing something: either a new product, new management, cutting costs, getting rid of something – something inside the company that allows them to improve themselves. Lots of turnarounds never happen, but a few winners can make up for lots of losers. What’s important is to wait for the actual evidence of the turnaround occurring, not just the symptoms. With a turnaround you have plenty of time, so just don’t buy on the hope. Wait for the reality. Turnarounds are so big, it’s worth waiting to get some real evidence.
SS Kresge was a company going nowhere, in real trouble. They invented the Kmart formula, They rolled it out across the country. The stock went up over 50 fold. Kmart became a massive stock.
Sometimes two and two equals eight. How could this be? Because a company has a hidden asset that isn’t reflected in the stock price. When Wall Street wakes up to the hidden assets, the stock could be terrific. Want a great example? Let’s look at Disney. Walt Disney is an example of an asset play. After they opened up Disney World and after they’d opened up Epcot, the company’s growth rate sort of slowed down. They weren’t growing very fast. And then they discovered there’s a lot of assets inside the company. There was the name Walt Disney. They started the DisneyChannel. They started selling things that they sold at Disney World into Disneyland. They started selling them everywhere. They use their licenses for Mickey Mouse and all their characters, and made a fortune on that. These are on the books for nothing. The company was loaded with assets. In addition, they had all that land inside of Disney World. Everybody had hotels outside of Disney World, and they decided to use their land inside to develop more parks and even other companies come in. These companies paid their money to build inside of Epcot or inside of areas of Disney World.
So what are hidden assets? Many companies, particularly old-line companies, companies that have been around 20, 40, 50, 100 years or more have real estate holdings whose true market value is not reflected on the balance sheet in the annual reporting. In many cases the hidden asset is the company’s name and its reputation. Disney is one example of a company with a great name, so is Coca-Cola. That name can be a huge asset when the company rolls out a new product. This name is carried at little or no value on the balance sheet, whereas it is incredibly valuable. Companies like Intel and AT&T not only make great products, but they have numerous patents on these great products. As long as they have those patents, no one can make the exact same product – that’s a tremendous aid in any business. Back in 1987 when the stock market had a major correction, Dreyfuss fell to below its price of cash per share, the stock fell from over 50 to under 20. At that point it was selling for less than its cash. Anytime you buy a stock at less than its cash after subtracting all debt, and it has good business, you’re getting something for nothing.
The price of a stock will follow the direction of earnings. In almost every case you can generally state, if the company’s earnings go up sharply, the stock is going to go up. If earnings go from very poor to mediocre, the stocks are probably going to rise. If they go from mediocre to good, it’s probably enough another rise. If it goes from good to excellent, it’s probably gonna have another rise. Or if a company’s earnings grow dramatically over a long period of time, the stock is probably going to go up dramatically.
Even if you have a Waterford crystal ball, you probably can’t predict a company’s earnings. But Wall Street is a whole army of people who make such predictions. By computer, you can get Wall Street earnings estimates in the research section of the stock shop or through many other online services. Or you can go to your local library and find earnings estimates in Value Line or Standard & Poors. Obviously, you want to invest in companies whose earnings are expected to rise. But again, these are just estimates. If you really understand a company, you should know how it plans to make earnings rise. If you know it has good growth prospects, then you’ll be better able to evaluate the company as an investment. You can’t predict the future, but can learn from the past. A company with a long history of earnings increases and dividend increases is obviously a stable performer that has a reasonable chance to continue to perform well in the industry. Many times that’s a good company to investigate further. Johnson & Johnson has raised its earnings something like 19 in the last 20 years. It’s raised its dividend over 30 years in a row. But just because a company has had a great recompense does not mean earnings will grow terrifically well in the future. You have to have reasons for it. Strong growth and Research and Development, cost cutting, new products, great brand name and a terrific balance sheet were the items that made me optimistic about Johnson & Johnson. What’s the outlook that’s going to keep continuing to grow. They run out of steam, stocks going to run out of steam.
Price-earnings ratio is something that some people make very complex. It’s actually very simple. If a company is selling $100 a share and they’re earning $10, that is a price earnings multiple of 10. The P/E ratio can be thought of as the number of years it will take the company to turn back the amount of your initial investment, assuming of course that the company’s earnings stay constant. Why look at P/E? It will tell you if you’re paying too much for the stock. The higher the P/E the more expensive the stock relative to the company’s future earning power. The lower the P/E, the cheaper the stock. I use a rule of thumb to level out these differences. Fairly priced stock is a P/E that’s about equal to the expected annual growth rate over the next three to five years. If the P/E is substantially higher than the growth rate, the stock is normally expensive. If the P/E is substantially lower, the stock is probably cheap. Stock P/E, in part, depends on the industry it’s in. When you look at a growth company, compare the company’s growth rate and its own P/E to that of the industry. All other things being equal, if you find a company with a much lower P/E and higher growth rate you’re off to a good start. You can also compare a company’s P/E to its own historical P/E. If a company normally sells for 25 times earnings, and now it’s selling at 15 or less, you have to ask yourself why. The company could be maturing, competition may be entering the field, and its growth prospects may be uncertain. But maybe it’s simply been beaten down by some other factors and it’s possibly a bargain. It’s worth researching.
Back in the 1970s, electronic data systems, or EDS, had a P/E of 500 times earnings. If you would invest in a company with a P/E this high when Columbus discovered America, the company’s earnings stayed constant, you’d just be breaking even today. In 1974, EDS performed very well, but the stock fell from 40 to 3, simply because the stock was so grossly overpriced relative to current earnings. Dividends, or cash payments the companies make the shareholders, usually every quarter. Nearly half the return the S&P500 the past 50 years has come from dividends. Dividends come from profits. If a company earns five dollars a share, they have the choice of paying out some of it to the shareholders in the form of a cash dividend. A stock’s yield is the annual dividend payout divided by its current price. The yields return you get on your investment every year. One drawback: the IRS considers dividends as income so you have to pay taxes on dividends. Not all companies pay a dividend. Fast growers for example almost never pay a dividend. They reinvest all of their earnings back into the company. Slow growers tend to pay out profits and dividends – it’s their way of rewarding shareholders. Over time those dividends can add up. Some people have bought stocks for five dollars a share and 20 years later they’re getting $10 a share of dividends per year. Dividends do make a difference. Dividends are a great way to measure company success, particularly a slow growing company. When a company raises dividends every year, it raises the bar for its financial performance for the years that follow.
Few companies want to cut the dividends. Investors clobber the stock, figuring dividend cut it’s a sign of worse things to come. So by raising a dividend twelve to fifteen percent this year, the company is saying it expects earnings to be at least as good next year as they are now and probably rising by at least twelve to fifteen percent. You can get a list of companies that raise their dividends many years in a row from Moody’s. There are some great names in this list. However, you can find warning signs in dividends as well. A high yield isn’t always a good thing. If a stock is thirty and it’s paying a three dollar dividend, you might say, “Wow that’s terrific, a ten percent yield.” But if the earnings are only three dollars and ten cents a share, then the company is essentially paying out all of its earnings in dividends. That’s only ten cents to
expand or to invest in more efficient equipment. If this continues for a number of quarters or years, the company will have very little room for any errors or setbacks. Eventually, the company will probably cut back or totally suspend its dividend. The stock price is going to tumble with it. Be careful with high-yield stocks, particularly when they’re paying out a very high percentage of their earnings. Any company’s operations can hit an air pocket from time to time. You’ve got to make sure your company can survive tough times.
The balance sheet tells you about the company’s financial structure. How much debt it has. How much cash it has. And how much equity its shareholders have. There’s nothing scary about a balance sheet. No story is complete without a check of the balance sheet. The basic concept of a balance sheet is that everything a company owns – its assets – are listed on one side, on the other side you find everything a company owes- its liabilities. The difference between what it owns and what it owes is its equity, also called its net worth. Go ahead and explore this fictional balance sheet. Click any of the items on this balance sheet for an explanation of it. When you’re ready to move on, click either the debt or cash buttons for a discussion of the two most important items on any balance sheet.
Does the company have a lot of cash on hand? That’s a great. A company with a lot of cash can buy more stocks, make an acquisition or pay off all its debt – all moves that shareholders love to see.
A company should have at least enough cash to pay off its short-term debt. If it doesn’t, it could have to keep borrowing more and more. If you subtract cash from short-term debt and long-term debt and the total is only one-quarter of net worth, the company has a decent balance sheet. However, if short-term debt and long-term debt combined minus cash equals or exceeds net worth the company as a weak balance sheet. It’s simple to recognize a strong balance sheet: no debt and lots of cash.
Suppose a company has 20 million dollars in cash after subtracting all debt. If the company has 4 million shares outstanding, it has 5 dollars of cash per share of stock. If you buy the company at $10 a share, you’re paying only $5 for the company and you’re getting $5 a share and cash. That’s a really amazing price in effect that means your real price is 5. If this company has a very solid, predictable business this extra cash is quite valuable. But if a company has lots of cash and then losing the money you still have to evaluate how quickly will they run through all that cash. That’s all you really have to know – it’s not much but you should know it, you can look it up in the stock shop. If you don’t check your company survivability, you’re not only skimping on your research, you’re gambling – that’s not why you invest in the stock market.
Check the debt. Most companies have some debt but how much is too much? Add up the company’s long-term debt and total equity – that’s a good approximation of the company’s total capitalization. The money the company has available to grow its business in the future.
Now I’ll compare the long-term debt to total capitalization. If total debt equals half of the company’s capitalization or more, beware. That’s quite a bit of debt. To service that much debt everything has to work right. Things don’t always work just right. If debt equals 20% of capitalization or less, that’s better. That’s fairly low debt. As usual, there is no rule without some exceptions. Debt in some industries, like banking, insurance, and financial services, routinely runs much higher than 20 to 50 percent. Know the industry and what is normal for it when you evaluate a balance sheet.
In many industries such as retailing and restaurants, companies have leases. They have commitments on buildings to rent for a long period of time. Often this form of debt will only appear in the footnotes. This is a very substantial form of debt. Look into the footnotes, see if you see capitalized lease obligations. Have this back, this is an important exercise.
5 or 10 years ago investment professionals had a big edge. They got more research and information than small investors and they got it sooner. But those days are long gone. Basic financial information is readily available from a dozen or more of different sources. Investment pros aren’t digesting all the good information and throwing just the scraps to the public anymore. Everyone has a seat at the table right now. Here are some places to get started.
If a balance sheet provides a snapshot of a company’s financial position. An income statement tells you how the company got there. Income statements tell you how much money the company made or lost from its operations over some period of time. The basic formula is simple. You are asking how things went over the period, usually a quarter or a year. Over that time, you add up all the money the company brought in from selling products or services, then subtract all of the money the company spent to create those products or deliver those services. What is left is the net income. Net income is also referred to as earnings or profits. I hope by now you’ve been convinced that your story should always include an explanation of how the company plans to improve its earnings or to sustain its growth rate over time. There are only two ways of coming to increase earnings: they can increase sales or reduce costs. Most companies work to do both of these things. The income statement can help you figure out if the company is succeeding. Click any of the items on this income statement for an explanation of it.
Once you’ve explored the income statement, click on increase sales or reduce costs to explore those topics some more. If earnings equal revenues minus costs, and valid way to raise earnings is to reduce costs, then reducing costs not only pushes up the earnings number, it makes a company more competitive. If two companies both produce competitive products of similar quality, then the one who can build it more cheaply has the advantage. They can choose to charge less for the product and sell more than a competitor or can sell it for the same price and make much more money than their competitors.
One way to measure cost reduction is to check out the costs listed on the income statement each quarter. But it’s difficult to do so, because what you really care about is how costs are changing relative to revenues. One way to measure this cost of revenues is the profit margin. This number is not shown on the income statement itself, but is calculated for you in the research section of the stock shop. To calculate the number for yourself, just divide the earnings before taxes by the net revenues. The higher the profit margin, the more money the company makes for each product it sells. Once we have the profit margin as a tool, we can evaluate how successful the company is being in reducing costs. Unless the company has raised prices significantly, if the profit margin goes up, then costs are going down relative to revenues. You can compare the profit margin of the company to the profit margin of a competitor, or to the average profit margin of the industry.
When a company that’s highly profitable already must depend on cost-cutting to boost its profits even further, you have to be skeptical. If its profit margins are unusually high compared to the rest of the industry, there’s a limit to how much additional profit it can squeeze out of the business by economizing. Ask yourself is there a long road of margin cutting ahead or are they already extremely efficient? Your goal is to feel as confident as possible with your story.
How does a company plan to increase earnings? Sales growth is the single most important factor in growing earnings long term. So you must ask yourself how the company is going to make the sales rise. The company can expand its customer base. Selling its existing products to new customers brings in new revenue. When evaluating this strategy, consider how far the company is from saturating the market or its products. If a company is already selling to 98 percent of its potential customers, there isn’t a lot left to reach. The company can introduce new products into its existing customer base – this is the most difficult, but potentially the most rewarding strategy. If the product catches on, it can breathe new life into the company. Advantages like brand names and a good reputation come in very useful here. A company can also raise prices to increase revenues. That way, even if unit sales stay constant, revenues will still grow. Of course, the danger of raising prices is that higher prices will drive customers to competitors or encourage new competitors to enter the market. The details of a company’s plans will vary by industry and by the individual company. Just make sure you understand that plan and include it in your story. Once you’ve built the story for your company, you have a powerful tool for judging the stock, but like any powerful instrument you must use it wisely and carefully or you will get burned. Use your story to pick the right time to buy a stock. I promise you that the right time to buy a stock does not occur often. When I’m following a stock, buying opportunities present themselves once or twice a year if I’m lucky.
I look for times when the potential upside is high and the potential downside is reduced. Understanding that balance is a key to successful stock investing.
You have to understand, stock picking is a risk-reward trade-off. You have to know how much you’re going to lose if you’re wrong, and how much you’re going to make if you’re right. The skill is to minimize your risk and maximize your reward. You can be wrong in this business. I’ve been wrong quite a bit, but you can be wrong and still make money as long as your good stocks more than offset your mistakes. I figure if I could be right 6 times out of 10 – that’s a good batting average. When I pick stocks, I think of risk as a measure of my confidence in the story I’ve built. When I feel that my story is optimistic, solid, and well researched then I’ve got a low-risk investment. If I’m not too sure about how the story will turn out, then the risk is considerably higher. Don’t try to categorize risk by other measures, like small companies are riskier than large. In the late 1970s or the early 1980s, Walmart was a lower risk investment than IBM, because the Walmart Story was nearly bulletproof. If a start-up company sounds exciting, keep an eye on it. Perhaps a year or two later it will be over the hump, the story will be solid, and there’s a good time to consider investing. If you believe strongly in your company’s story, then you shouldn’t waste your time waiting for the ultimate buying opportunity. Investors who bought McDonald’s in the 1970s or Home Depot in the 1980s were happy almost any time they bought the stock. Even with these great companies during stock market corrections, the stock dipped and the story was solid, but if you held on for a reasonable amount of time you are a very happy camper.
Watch out for ridiculously high prices when a company is selling at several times its growth rate and earnings. Remember, that’s what we talked about in the price-earnings presentation. But in general, if a story is good you probably want to own it. Later, if a buying opportunity comes along, the stock falls well below its growth rate and the story hasn’t changed, you can buy even more. Therefore, you can take advantage of market declines. Use the tools I’ve presented in this consultation to help make a judgment on your stock. If the story is sound, check the price, use the P/E ratio. Most importantly rely on your edge. First to build your story, then find the right times to add or reduce your position.
Focus on the company. What is it making? Where is its money coming from? What is the competition doing? Ignore all the background noise. Just keep checking that fundamental story. See if it’s valid, see if it’s getting better, see if it’s getting worse. Know what category your stock is in and how those stocks behave. If your stock is not behaving as you expect, then try and find out why. If the answer changes a story, then think again. Keep your story up-to-date. Don’t check on it three times a day, but don’t just ignore it either – and checking the price of the stock does not count. It’s checking the fundamental story. Don’t expect to make a ton of money overnight. The stock market does provide the highest return for long term investments, but that’s not a month or two months a year. If you need the money next winter, you don’t have the tolerance to keep it tied up for the long term, then stocks may not be for you. Don’t forget to use your edge. These are all kinds of things that you know about because of where you live, what you do… You have lots of edges – use them. And finally, remember that stock picking isn’t gambling, and it isn’t for everyone. You have to be prepared to do some work. You have to be prepared for market declines. If you enjoy doing research, if you enjoy learning about companies, and you have the stomach for the ups and downs of the stock market, then investing can be a lot of fun.
These principles of investing work well for me. I hope they can help you. You should not be intimidated, everyone can do well in the stock market. You have the skills, you have the intelligence, it doesn’t require any education – all you have to have is the patience to do a little research and you’ve got it.
To start researching your stocks, just click on research and remember that you can come back to consult Peter at any time. Welcome to stock shop, where you can learn to pick stocks, research them and follow your favorites. The consultation part of the shop is where Peter Lynch explains how he thinks about stocks and how he makes his choices. These multimedia presentations describe some of the key concepts that will help you construct your portfolio. Just select the presentation of your choice from the list on the left and click the start button to share Peters thoughts and experiences. The research section is where you can create a list of companies that you want to research. You can download current data on any number of stocks and get Peter’s guidance on what to look for next. And you can start to compile your own story for every stock you follow. Just select a stock and click on ‘details; to view the fundamental data about your stock. And finally at the bottom of the screen are all the tools you’ll need to explore and keep track of your discoveries in the stock shop. And now you can either select one of Peters personal presentations, or if you want to get to work, go straight to research.
You can’t just go out and buy a stock and hope it goes up. You have to have a reason why you think a stock will go up. You should be able to tell those reasons to someone else in just a few minutes. People who love stocks don’t talk about sports, they don’t talk about their dog, they talk about stories. A story is what’s happening inside a company and signs that point to what’s likely to happen in the future.
I’ll be able to put it down to paragraphs. It could be something like earnings are turning around, a new product, somebody’s gone out of business that was competing with them, they’ve just discovered oil, they have a new management, their balance sheet is getting better, they’re getting rid of a losing division, there are lots of different elements, but that’s what a story is and that’s what you rely on. A good story is one that you could tell a fifth grader and he or she would understand. The more complicated the story, the more likely it is to fall apart. You just need one good simple story to buy a stock and then follow that story. Read through the story that I wrote for Toys R Us, back in 1978. You didn’t need a degree from Business School to realize this company had a great formula and had lots of room to grow. The thousands of people who shopped there knew the store was great. I did the rest of the research I needed to fill in the story and bought the stock. Building stories like this one is how I decide what company’s solid and which ones to stay away from. Remember that stories unfold over time, companies are never stagnant so you have to stay tuned and sometimes make adjustments, just like playing seven card stud poker or perhaps twenty-seven card stud poker. At the beginning of the game, you only know some of the cards, you must place your bet accordingly. But as each new card is revealed the game changes, you’re forced to alter your betting strategy, perhaps even drop out of the game altogether.
In the rest of this consultation, I’ll show you how you can build stories for companies and invest more prudently in their stock. This consultation is divided into three sections. The assessment section helps you decide whether stocks are the right investment for you. Stock picking is not for everyone. These presentations will help you assess yourself. In the story creation area, I’ll cover the basic concepts you need to create your story. You’ll learn how to approach a company’s story and why you have some advantages over even the most dedicated investment professionals. In the last section, we get down to brass tacks talking about the actual elements and numbers you’ll need to include in your story. Use the start and next presentation buttons to move through the presentations in order or explore on your own, using the list on the left. When you’re done, you’ll know how to build a story, how to monitor the key elements of the story and how to use that story to improve your understanding of when and when not to invest in company stock.
You may find that stock picking is not right for you, at least not until you feel more comfortable with the risks of the market and the volatility of stocks. Even if this is the case the stock shop can still help you become more comfortable with the stock market and researching companies. Use the stock shop to follow companies in a paper portfolio – a list of stocks you buy and sell only on paper. You develop your stock picking skills without taking any of the risks.
Before long, you may be ready to start investing your real hard earned cash. In the meantime, if you’d like to invest in stocks, your best option may be an equity mutual fund. If you want to get some of your money in the stock market, but you don’t have the time, you’re not willing to do the effort, you don’t have the stomach to do the research, equity mutual funds are a great answer. Investing in mutual funds is also a way of making sure your investments are diversified. Mutual funds, by law, must invest in at least 20 stocks at a time, though most funds invest in far more than that. As mutual fund investor you are protected from the danger of one or two stocks dropping sharply in price. At most, they would only represent five or ten percent of the fund. This would cushion the decline. Remember that mutual funds are like any other investment, they carry real risks of losing your money. And even though they can be purchased through many banks, they are not insured by the government. Since they are made up of individual stocks, equity mutual funds are also volatile. You must do some research to evaluate and choose a mutual fund that will meet your temperament and your investment objectives.