This is an oldie but goodie – Peter Lynch on how to pick stocks. By chance we were also doing the Lynch book list and ran into some confusion if anyone knows please let us know
Here are the obvious three
[munger]
| One Up on Wall Street | Peter Lynch | 1989 |
| Beating the Street | Peter Lynch | 1993 |
| Learn to Earn | Peter Lynch | 1995 |
IE this The Davis Dynasty: Fifty Years of Successful Investing on Wall Street says its by
Enjoy
Investing in the stock market should not be intimidating; it does not require one to be educated. All one needs is skills, intelligence, patience and the ability to do some research.
In 1990, when Peter Lynch retired as manager of Fidelity Magellan, he had driven the company to a 2800% gain. His secret in beating the money market lay in picking the right stocks, rather than timing the market. In the thirteen years as manager of Magellan, the market declined by 10% nine times. All the nine times his company too fell by over 10%. Stock picking cannot be learned overnight. However, everyone has inherent stock-picking skills.
People wonder why stocks are so important for the long-term investment program. This is because, in the long run, stocks give better returns than most other forms of investment. Studies have shown that stocks have returned about 10% yearly over the past six years. Other forms of investment like bonds and treasury bills have yielded lower returns, averaging 3% -6%. Though not a seemingly big difference, the power of compounding makes a large difference over a period of time.
When you put away a certain amount every month, earning 6% every year, the returns over say, thirty years may seem attractive. But after your investment is taxed, your returns are reduced. So if you don’t need that money until retirement, consider tax-deferred investments like 401k and 403b plans. Since you don’t pay taxes on the money until it is withdrawn, the power of compounding provides the best return. The longer the money compounds, the better the returns.
To get a 10% return every year would be tough without investing in the stock market.
However to get the best returns you need to be invested in the market long term. Stocks have beaten other forms of investment in the long term. So if you need the money sooner than perhaps ten years, keep away from the stock market. Remember – the stock market is volatile and if you’re not prepared to take the risk, stay away from it.
A good stock can take several years before it really pays off. Give your investments time to grow. No one can tell you when the right time to sell a stock is. You need to have patience. If you are averse to risk, the stock market is not for you.
Base your stock picking on your direct exposure to the companies as a consumer, as a professional or as a neighbor. Look for local companies whose products or services you or a friend or colleague have used and are happy with. Look for companies whose products or services are highly recommended by people you know.
Research the company and its products and services. Ask people why they’re using a certain product versus another. Ask them what they think of the product and if they would continue using it for years to come. Check what they like about it. Look for products and services that are the best, those who provide the best value.
Follow a handful of companies
With about 15,000 companies in the US alone and much more overseas, you just need to know a few very well. Research them well before you take the plunge.
Companies like McDonald’s and Coca-Cola have seen their earnings multiply many-fold in the past thirty years.
What makes these companies grow? While McDonald’s started with cheeseburgers and hamburgers on their lunch menu, they quickly added breakfast items, kept their costs low and went overseas. All this happened just as people thought there was no more room for this burger giant, but they were wrong.
The stock market is very volatile. Factors like wars, elections, rising interest rates, or bad economic conditions can push the market down. In the past century, there have been over fifty declines of over 10% – of these, fifteen have been 25% or more. In 1990 alone the market fell by over 20% from 3000. There was a recession; the banking system was in trouble. However many saw this as a good opportunity to buy good companies at some great prices.
Lynch quotes Fannie Mae as a good example.
In the third quarter of 1990, the S&P 500 fell 20%. Fannie Mae fell 38% to $26 per share from the previous high of $42. This was a good time to buy – the company was doing well, the management was great, the story was solid, and they had a very good business. This was the right time to buy.
13:23
“Basing a strategy on general maxims, such as ‘Sell when you double your money’ or ‘cut your losses by selling when the price falls 10%’ is absolute folly.”
According to Lynch, no two stocks behave in the same manner hence one cannot apply any particular formula to all stocks. Different stocks exhibit different qualities – they require different approaches and have different qualities. Each stock has a different story.
To do the job of researching more manageable, Lynch breaks stocks into categories; these categories serve as guidelines.
14:05
“There are basically five categories. One would be fast growers, two would be slow growers, three would be cyclicals, four would be asset players and the fifth one would be turnarounds.”
Companies may not always fit neatly into a particular category. Many are known to have changed categories at some point in time.
Fast Growers
14:39
“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 cyclicals again.”
Lynch encourages categories as guides. At the same time, he cautions against limiting the questions you ask or the research you do. One thing can be said about companies in general…
15:03
“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.”
Small companies have the potential to do increasingly better than bigger companies. But many big companies have been known to defy their size and find new and exciting ways to grow their earnings.
While many of us look to investing in fast growers – companies that grow at over 25% a year – there aren’t too many of these. The beauty of investing in these powerful companies is that you have plenty of time. You don’t have to be there in the first, second or third year. They continue to grow – for five, ten, twenty and many more years.
Lynch cites the example of Walmart as a fast grower. In ten years this giant grew investors’ money thirty-fold. Revenue and earnings that grow rapidly are the hallmarks of a fast grower. This master of the stocks game likens growth companies a baseball game.
16:34
“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.”
Another classic example of a fast grower is Microsoft. In the three years, it went public, it made twenty times the investment. Growing by leaps and bounds in its twenty-year growth cycle, it gave investors plenty of time to get involved.
So look out for a steady earnings growth and rising dividends.
Slow Growers
These have room to grow, and they go on forever.
Service Corporation International is a classic example of a slow grower and one of Lynch’s favorites. In the business of providing funeral goods and services, the company grew earnings at a steady 15% year after year.
In the 1980s this was a great stock for Lynch. At that point, it had a long way to go.
Cyclicals
These are directly connected to the economy of a country. Lynch warns against timing cyclicals, especially when earnings go from one-quarter to spectacular. The best time to invest in cyclicals is when earnings move upwards from bad to mediocre and a little beyond. Exercise caution when earnings start looking spectacular. These are items people will not buy when the economy is bad; when people worry about losing their jobs.
In 1990, when the economy was lousy, Chrysler was priced at $10. But when the economy improved, people sold their battered cars and started buying new ones, and Chrysler was a hot favorite.
20:59
“If it’s cyclical you’re hoping for a dramatic turnaround in earnings, it’s going to happen over two or three years. Earnings are 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, and the downturn comes, the company faces the danger of going bankrupt.
Turnarounds
These are companies that have been forgotten about or are less liked – or even hated. Or they’re companies whose stocks have taken a severe beating. However, if a balance sheet check on these companies shows that they have enough cash to make it through the next year or two and have very little debt it is a good indication that they have the potential for reversing fortunes independent of the economy improving or the industry getting better. They’re doing things to improve themselves – coming up with new products or have been taken over by a new management, or they’re cutting costs. Many turnarounds don’t happen, and there are more losers than there are winners. The important thing is to wait for evidence of the actual turnaround to happen. Don’t act on the symptoms.
Kresge was in real trouble and going nowhere till they introduced K Mart. They rolled it out, and the stock went up fifty-fold, making K Mart a massive stock.
Asset Players
Many companies have a hidden asset. This is not reflected in the stock price. When the stock exchange wakes up to hidden assets, the stock could be a runaway winner.
Walt Disney is an example of an asset player.
When Disney World and Epcot opened up, they weren’t doing too well. Then they discovered their hidden asset – their name: Walt Disney. They used the name to sell; they sold things under the Disney name. They started the Disney Channel. They used their licenses for their characters and made a fortune. They developed parks, and other companies paid money to come into Epcot and Disney Worlds to build and cash in on their success.
A hidden asset is a name – like Disney or Coca-Cola. It’s the reputation an old time company has built up over the years. Though not reflected on the balance sheet, it has incredible value and can be a huge asset when these companies roll out new products. AT&T and Intel are two more companies that fall into this category. No one can duplicate their products as long as they have those patents.
24:52
“Anytime you buy a stock at less than its cash after subtracting all debt, and it has a good business you’re getting something for nothing.”
Know how your company plans to increase its earnings. If it has good growth prospects, you’ll be in a better position to evaluate it as an investment. Learn from the past. If it has a long history of the increase in earnings and dividends, chances are it will continue to grow and outshine in performance. Johnson & Johnson has done exceptionally well in the last twenty years, raising its earnings some nineteen times in the same period. It has raised its dividends thirty years in a row. Introducing new products, cutting costs and showcasing a great balance sheet coupled with a terrific brand name is what this company is all about.
PE Ratio
This is the number of years it will take the company to return the amount of your initial investment assuming that the company’s earnings stay constant. The price-earnings (PE) tells you if you’re paying too much for a stock. A higher PE indicates an expensive stock as compared to the company’s earning power, and vice versa. Lynch uses this rule of thumb to level out the differences –
27:30
Fairly priced stock’s PE is about equal to the expected annual growth rate over the next three to five years. If the PE is substantially higher than the growth rate, the stock is normally expensive. IF the PE is substantially lower the stock is probably cheap.
When looking at a growth company, compare its growth rate and its own PE to that of the industry. A lower PE and higher growth rate is a good indication of a good company to invest in. A company’s own historical PE may also be compared for the purpose.
Dividends
When a company makes profits it rewards its investors with dividends. A company may choose to pay some of its profits by way of cash dividends. The drawback here is that dividends are classified as income by the IRS hence they are taxed.
Some companies, however, do not pay dividends. Fast growers, for example, reinvest their earnings into the company while slow growers pay them out by way of dividends. These dividends add up over time.
A company’s success is measured by the dividends it pays out. This is especially true of slow-growing companies. A cut in the dividend, on the other hand, is a sign of worse things to come.
Moody’s has a list of companies that regularly raise their dividends. When a company raises dividends every year, it raises its financial performance for the years to follow. A 10% yield is a good sign if a stock is $30 and pays $3 but if the earnings are only $3.10, the company has only ten cents to expand or grow. If this trend continues for a period of time, the company will have little room for errors or setbacks and will have to cut back or possibly totally suspend dividends eventually. The will result in the stock price tumbling.
The best way to learn about a company’s financial structure is to look into its balance sheet. The balance sheet will tell you how much debt and how much cash a company has and how much equity its shareholders have. If a company has a lot of cash on hand, it can buy more stock, make acquisitions or pay off debts, if any. This is what appeals to shareholders.
32:18
“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.
Check the Debt
Almost all companies have debt. A company’s total capitalization is derived by adding up its long-term debt and its total equity. This is the money available for the company to grow its business in the future. If a company’s total debt equals half of the company’s capitalization, it means there’s quite a bit of debt. If debt is less than 20% of capitalization, it’s fairly low debt. But of course, there are always exceptions.
When evaluating balance sheets, keep in mind the industry type. Debt in industries like financial services – banking, insurance – routinely runs higher than 20-50%.
Industries like retailing and restaurants, on the other hand, may have commitments on buildings to rent. This substantial form of debt will only appear in the footnotes. Check the footnotes for capitalized lease obligations.
In the past, investment professionals had a big edge over small investors. They had access to information sooner than investors. But now a company’s financial information is readily available from several different sources.
So while a balance sheet tells you of a company’s financial position, its income statement tells you how it got there and how much money it made or lost over a given period of time. Having gained this information, you then add up all the money the company made selling its products and services, then subtract the money is spent in creating and delivering those products and services. And what you are left with is the net income, aka earnings or profits.
In other words, the story you build should include the company’s plans to increase earnings which could be by either increasing sales or reducing costs. Most companies aim to do both. The income statement thus helps you figure out if the company is succeeding. If earnings equal revenues minus costs, the only way to raise earnings is by reducing costs. This, besides pushing up costs, makes a company more competitive. Given all things equal, the company that produces more cheaply has a cutting edge over its competitors. It can choose to either sell for the same price or make more money or charge less and hence sell more.
Profit Margin
The higher the profit margin, the more money the company makes for the products or services it sells. This is calculated by dividing the company’s earnings (before taxes) by the net revenue. With the profit margin as a tool, you can evaluate how successful the company has been in reducing costs. An upward trend in profit margins is an indication that costs are going down relative to revenues. It is a good exercise to compare the profit margin of a company to that of a competitor’s or the industry in general. However, when a highly profitable company resorts to cutting costs to boost its profits further one has to be skeptical.
Ask yourself these questions – is there a long road of margin-cutting in the years to come? Is the company already extremely efficient? How does a company plan to increase earnings? How does the company plan to make sales rise?
Sales Growth
Sales growth is the most important factor in growing earnings. To achieve this a company can either expand its customer base, or it can introduce new products. Or it can raise prices. However, the last strategy may drive customers away to competitors or encourage new ones to enter the market.
Once you have understood the plan, you a powerful tool to judge the stock, and you must use it wisely. You must pick the right time to buy a stock and the right time does not occur often. 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.
40:45
“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.”
If a start-up sounds exciting, keep an eye on it for a couple of years. If it survives and does well consider investing in it. Investors who bought McDonald’s in the 70s or Home Depot in the 80s were happy any time they bought these stocks. Market corrections did not bother them even if the stock dipped. They knew these stocks would give them good returns if they held on to them.
Finally, using the tools presented above, make a judgment on your stock. If the story is sound, check the price and use the PE ratio to find the right time to add or reduce your position. Focus on what the company is making and where its money is coming from and what the competition is. Ignore all the background noise. Know what category your stocks are in and how those stocks behave. In case your stock is behaving differently from what you expected, try and find out why. And remember, don’t expect to make a ton of money overnight. The stock market does provide the highest return, but only if you’re committed to tying down your investments over a long period of time.
Stock picking is not gambling. It is not for everyone; you need to have the stomach to take the downs of the stock market. You have to be prepared to do some work and have a little patience. You should not be intimidated. If you have the skills and the intelligence, then this can be a lot of fun.
A stock shop is a handy place where you can learn to pick stocks, research them, and follow your favorites. In the consultation part of the shop, Lynch gives tips on how he makes his choices and how he thinks about stocks. Let him guide you on how to construct your portfolio.
Remember stories unfold over time and companies are never stagnant. You have to stay tuned; you have to monitor the key elements of the company consistently and make adjustments. You may find that stock picking is not right for you, not until you’re more comfortable with the stock market and researching companies. Use stock shop to follow companies to follow companies in a paper portfolio 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 would like to start investing in stocks, your best option is equity mutual funds. This way you know your investments are diversified. Since the law requires a mutual fund to invest in at least twenty stocks at a time, you are protected from the danger of a couple of stock dropping sharply. These funds may be purchased through banks however they are not insured by the government. Equity mutual funds are also volatile, and you must research them to evaluate and choose one that meets your investment objectives and your temperament.
