Book Summary: One Up On Wall Street: How to Use What You Already Know to Make Money in the Market by Peter Lynch

Note: These are notes I’ve highlighted in the book, that I can go back to for re-reading. This is not a complete summary of the book.

PART I: PREPARING TO INVEST

Introduction: The Advantages of Dumb Money

• The nice thing about investing in familiar companies such as L’eggs or Dunkin’ Donuts is that when you try on the stockings or sip the coffee, you’re already doing the kind of fundamental analysis that they pay Wall Street analysts to do. Visiting stores and testing products is one of the critical elements of the analyst’s job

• There seems to be an unwritten rule on Wall Street: If you don’t understand it, then put your life savings into it.

• And how about Coleco? Just because the Cabbage Patch doll was the best-selling toy of this century, it couldn’t save a mediocre company with a bad balance sheet, and although the stock rose dramatically for a year or so, spurred on first by home video games and then by the Cabbage Patch enthusiasm, eventually it dropped from a high of $65 in 1983 to a recent $1¾ as the company went into Chapter 11, filing for bankruptcy in 1988.

• Finding the promising company is only the first step. The next step is doing the research. The research is what helps you to sort out Toys “R” Us from Coleco, Apple Computer from Televideo, or Piedmont Airlines from People Express.

Chapter 1: The Making of a Stockpicker

• Looking back on it, I realize there was less risk of losing all one’s money in the stock market of the 1950s than at any time before or since. This taught me not only that it’s difficult to predict markets, but also that small investors tend to be pessimistic and optimistic at precisely the wrong times, so it’s self-defeating to try to invest in good markets and get out of bad ones.

• 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. Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage.

• Actually Wall Street thinks just as the Greeks did. The early Greeks used to sit around for days and debate how many teeth a horse has. They thought they could figure it out by just sitting there, instead of checking the horse. A lot of investors sit around and debate whether a stock is going up, as if the financial muse will give them the answer, instead of checking the company.

• I also found it difficult to integrate the efficient-market hypothesis (that everything in the stock market is “known” and prices are always “rational”) with the random-walk hypothesis (that the ups and downs of the market are irrational and entirely unpredictable). Already I’d seen enough odd fluctuations to doubt the rational part, and the success of the great Fidelity fund managers was hardly unpredictable.

Chapter 2: The Wall Street Oxymorons

• Since 70 percent of the shares in major companies are controlled by institutions, it’s increasingly likely that you’re competing against oxymorons whenever you buy or sell shares.

• Under the current system, a stock isn’t truly attractive until a number of large institutions have recognized its suitability and an equal number of respected Wall Street analysts have put it on the recommended list. With so many people waiting for others to make the first move, it’s amazing that anything gets bought.

• There’s an unwritten rule on Wall Street: “You’ll never lose your job losing your client’s money in IBM.”

• If IBM goes bad and you bought it, the clients and the bosses will ask: “What’s wrong with that damn IBM lately?” But if La Quinta Motor Inns goes bad, they’ll ask: “What’s wrong with you?

• This unpleasant problem for the pension department is soon avoided if the managers of various accounts pick stocks from the same approved batch. That way, it’s very likely that both Smith and Jones will enjoy the same result, or at least the difference will not be great enough to make either of them mad. Almost by definition the result will be mediocre, but acceptable mediocrity is far more comfortable than diverse performance.

• I continue to think like an amateur as frequently as possible.

Chapter 3: Is This Gambling, or What?

• But two months later the stock market had rebounded, and once again stocks were outperforming both money-market funds and long-term bonds. Over the long haul they always do. Historically, investing in stocks is undeniably more profitable than investing in debt.

• People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences.

Chapter 4: Passing the Mirror Test

• Only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.

• It seems to me the list of qualities ought to include patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit to mistakes, and the ability to ignore general panic.

• The unwary investor continually passes in and out of three emotional states: concern, complacency, and capitulation

Chapter 5: Is This a Good Market? Please Don’t Ask

• Two thousand years later we’re still looking backward for signs of the upcoming menace, but that’s only if we can decide what the upcoming menace is.

• The last time we prepared for inflation we got a recession, and then at the end of the recession we prepared for more recession and we got inflation.

• When the neighbors tell me what to buy and then I wish I had taken their advice, it’s a sure sign that the market has reached a top and is due for a tumble.

• Don’t overestimate the skill and wisdom of professionals.

  • Take advantage of what you already know.
  • Look for opportunities that haven’t yet been discovered and certified by Wall Street—companies that are “off the radar scope.”
  • Invest in a house before you invest in a stock.
  • Invest in companies, not in the stock market.
  • Ignore short-term fluctuations.
  • Large profits can be made in common stocks.
  • Large losses can be made in common stocks.
  • Predicting the economy is futile.
  • Predicting the short-term direction of the stock market is futile.
  • The long-term returns from stocks are both relatively predictable and also far superior to the long-term returns from bonds.
  • Keeping up with a company in which you own stock is like playing an endless stud-poker hand.
  • Common stocks aren’t for everyone, nor even for all phases of a person’s life.
  • The average person is exposed to interesting local companies and products years before the professionals.
  • Having an edge will help you make money in stocks.
  • In the stock market, one in the hand is worth ten in the bush.

PART II: Picking Winners

Chapter 6: Stalking the Tenbagger

• In general, if you polled all the doctors, I’d bet only a small percentage would turn out to be invested in medical stocks, and more would be invested in oil; and if you polled the shoe-store owners, more would be invested in aerospace than in shoes, while the aerospace engineers are more likely to dabble in shoe stocks. Why it is that stock certificates, like grasses, are always greener in somebody else’s pasture I’m not sure.

• Perhaps a winning investment seems so unlikely in the first place that people can best imagine it happening as far away as possible, somewhere off in the Great Beyond, just as we all imagine that perfect behavior takes place in heaven and not on earth. Therefore the doctor who understands the ethical drug business inside out is more comfortable investing in Schlumberger, an oil-service company about which he knows nothing; while the managers of Schlumberger are likely to own Johnson & Johnson or American Home Products.

Chapter 7: I’ve Got It, I’ve Got It—What Is It?

• Once I’ve established the size of the company relative to others in a particular industry, next I place it into one of six general categories: slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds.

• THE SLOW GROWERS

  • Usually these large and aging companies are expected to grow slightly faster than the gross national product. Slow growers didn’t start out that way. They started out as fast growers and eventually pooped out, either because they had gone as far as they could, or else they got too tired to make the most of their chances. When an industry at large slows down (as they always seem to do), most of the companies within the industry lose momentum as well.
  • Another sure sign of a slow grower is that it pays a generous and regular dividend. As I’ll discuss more fully in Chapter 13, companies pay generous dividends when they can’t dream up new ways to use the money to expand the business

• STALWARTS

  • I always keep some stalwarts in my portfolio because they offer pretty good protection during recessions and hard times.

• FAST GROWERS

  • while the smaller fast growers risk extinction, the larger fast growers risk a rapid devaluation when they begin to falter. Once a fast grower gets too big, it faces the same dilemma as Gulliver in Lilliput. There’s simply no place for it to stretch out.
  • But for as long as they can keep it up, fast growers are the big winners in the stock market. I look for the ones that have good balance sheets and are making substantial profits. The trick is figuring out when they’ll stop growing, and how much to pay for the growth.

• CYCLIVALS are the most misunderstood

• Putting stocks in categories is the first step in developing the story. Now at least you know what kind of story it’s supposed to be. The next step is filling in the details that will help you guess how the story is going to turn out.

Chapter 8: The Perfect Stock, What a Deal!

• 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 the good news compels them to buy in, thus sending the stock price even higher. If a company with terrific earnings and a strong balance sheet also does dull things, it gives you a lot of time to purchase the stock at a discount. Then when it becomes trendy and overpriced, you can sell your shares to the trend-followers.

• The literature sent to shareholders explaining the spinoff is usually hastily prepared, blasé, and understated, which makes it even better than the regular annual reports. Spinoff companies are often misunderstood and get little attention from Wall Street.

• If you hear about a spinoff, or if you’re sent a few fractions of shares in some newly created company, begin an immediate investigation into buying more. A month or two after the spinoff is completed, you can check to see if there is heavy insider buying among the new officers and directors. This will confirm that they, too, believe in the company’s prospects

• If you find a stock with little or no institutional ownership, you’ve found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner.

• 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 that kind of result by cutting costs or selling more widgets.

Chapter 9: Stocks I’d Avoid

• If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train—and succumbing to the social pressure, often buy

• If you aren’t clever at selling hot stocks (and the fact that you’ve bought them is a clue that you won’t be), you’ll soon see your profits turn into losses, because when the price falls, it’s not going to fall slowly, nor is it likely to stop at the level where you jumped on.

• If you had to live off the profits from investing in the hottest stocks in each successive hot industry, soon you’d be on welfare.

• From an investor’s point of view, the only two good things about diworseification are owning shares in the company that’s being acquired, or in finding turnaround opportunities among the victims of diworse-ification that have decided to restructure.

• These are the longshots, also known as whisper stocks, and the whiz-bang stories. They probably reach your neighborhood about the same time they reach mine: the company that sells papaya juice derivative as a cure for slipped-disc pain (Smith Labs); jungle remedies in general; high-tech stuff; monoclonal antibodies extracted from cows (Bioresponse); various miracle additives; and energy breakthroughs that violate the laws of physics. Often the whisper companies are on the brink of solving the latest national problem: the oil shortage, drug addiction, AIDS. The solution is either (a) very imaginative, or (b) impressively complicated.

• Whisper stocks have a hypnotic effect, and usually the stories have emotional appeal. This is where the sizzle is so delectable that you forget to notice there’s no steak. If you or I regularly invested in these stocks, we both would need part-time jobs to offset the losses. They may go up before they come down, but as a long-term proposition I’ve lost money on every single one I’ve ever bought

• What all these longshots had in common besides the fact that you lost money on them was that the great story had no substance. That’s the essence of a whisper stock.

Chapter 10: Earnings, Earnings, Earnings

• A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies—such as Shoney’s, The Limited, or Marriott—when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well. [It sure would have worked with Avon!] I’m not necessarily advocating this practice, but I can think of worse strategies.

THE FAMOUS P/E RATIO

• price/earnings ratio—also known as the p/e ratio, the price-earnings multiple, or simply, the multiple. This ratio is a numerical shorthand for the relationship between the stock price and the earnings of the company.

• Like the earnings line, the p/e ratio is often a useful measure of whether any stock is overpriced, fairly priced, or underpriced relative to a company’s money-making potential.

• The p/e ratio can be thought of as the number of years it will take the company to earn back the amount of your initial investment — assuming, of course, that the company’s earnings stay constant. Let’s say you buy 100 shares of K mart for $3,500. Current earnings are $3.50 per share, so your 100 shares will earn $350 in one year, and the original investment of $3,500 will be earned back in ten years. However, you don’t have to go through this exercise because the p/e ratio of 10 tells you it’s ten years.

• With all the low p/e opportunities around, why then would anybody buy a stock with a high p/e? Because they’re looking for Harrison Ford at the lumber yard. Corporate earnings do not stay constant any more than human earnings do.

• Some bargain hunters believe in buying any and all stocks with low p/e’s, but that strategy makes no sense to me. We shouldn’t compare apples to oranges. What’s a bargain p/e for a Dow Chemical isn’t necessarily the same as a bargain p/e for a Wal-Mart.

• In 1972, McDonald’s was the same great company it had always been, but the stock was bid up to $75 a share, which gave it a p/e of 50. There was no way that McDonald’s could live up to those expectations, and the stock price fell from $75 to $25, sending the p/e back to a more realistic 13. There wasn’t anything wrong with McDonald’s. It was simply overpriced at $75 in 1972.

• When Avon Products sold for $140 a share, it had an extremely high p/e ratio of 64—though nowhere near as extreme as EDS’s. The important thing here is that Avon was a huge company. It’s a miracle for even a small company to expand enough to justify a p/e of 64, but for a company the size of Avon, which already had over a billion in sales, it would have had to sell megabillions worth of cosmetics and lotions. In fact, somebody calculated that for Avon to justify a 64 p/e it would have to earn more than the steel industry, the oil industry, and the State of California combined. That was the best-case scenario. But how many lotions and bottles of cologne can you sell? As it was, Avon’s earnings didn’t grow at all. They declined, and the stock price promptly plummeted to $18⅝ in 1974.

• The stock market as a whole has its own collective p/e ratio, which is a good indicator of whether the market at large is overvalued or undervalued. I know I’ve already advised you to ignore the market, but when you find that a few stocks are selling at inflated prices relative to earnings, it’s likely that most stocks are selling at inflated prices relative to earnings. That’s what happened before the big drop in 1973–74, and once again (although not to the same extent) before the big drop of 1987.

• During the five years of the latest bull market, from 1982 to 1987, you could see the market’s overall p/e ratio creep gradually higher, from about 8 to 16. This meant that investors in 1987 were willing to pay twice what they paid in 1982 for the same corporate earnings—which should have been a warning that most stocks were overvalued.

• Interest rates have a large effect on the prevailing p/e ratios, since investors pay more for stocks when interest rates are low and bonds are less attractive. But interest rates aside, the incredible optimism that develops in bull markets can drive p/e ratios to ridiculous levels, as it did in the cases of EDS, Avon, and Polaroid. In that period, the fast growers commanded p/e ratios that belonged somewhere in Wonderland, the slow growers were commanding p/e ratios normally reserved for fast growers, and the p/e of the market itself hit a peak of 20 in 1971.

• 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 costs; raise prices; expand into new markets; sell more of its product in the old markets; or revitalize, close, or otherwise dispose of a losing operation. These are the factors to investigate as you develop the story. If you have an edge, this is where it’s going to be most helpful.

Chapter 11: The Two-Minute Drill

• Already you’ve found out whether you’re dealing with a slow grower, a stalwart, a fast grower, a turnaround, an asset play, or a cyclical. The p/e ratio has given you a rough idea of whether the stock, as currently priced, is undervalued or overvalued relative to its immediate prospects. The next step is to learn as much as possible about what the company is doing to bring about the added prosperity, the growth spurt, or whatever happy event is expected to occur. This is known as the story.

• With the possible exception of the asset play (where you can sit back and wait for the value of the real estate or the oil reserves or the TV stations to be recognized by others), something dynamic has to happen to keep the earnings moving along. The more certain you are about what that something is, the better you’ll be able to follow the script.

• The analyst’s reports on the company you get from your broker, and the short essays in the Value Line give you the professional version of the story, but if you’ve got an edge in the company or in the industry, you’ll be able to develop your own script in useful detail.

• Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. Once you’re able to tell the story of a stock to your family, your friends and so that even a child could understand it, then you have a proper grasp of the situation.

• If it’s a slow-growing company you’re thinking about, then presumably you’re in it for the dividend, (Why else own this kind of stock?) Therefore, the important elements of the script would be: “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.”

• If it’s a cyclical company you’re thinking about, then your script revolves around 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.”

• If it’s an asset play, then what are the assets, how much are 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 a minus $3. Insiders are buying, and the company has steady earnings, and there’s no debt to speak of.”

• If it’s a turnaround, then 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, Kenner, and Parker Brothers 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.”

• If it’s a stalwart, then the key issues are the p/e ratio, whether the stock already has had a dramatic run-up in price in recent months, and what, if anything, is happening to accelerate the growth rate. You might say to yourself: “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 the year before, and the Spanish upped their consumption by 26 percent. 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.”

• If it is a fast grower, then where and how can it 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 Quinta has found something of a niche. It has a long way to go before it has saturated the market.”

Chapter 12: Getting the Facts

• In the top column marked Current Assets, I notice that the company has $5.672 billion in cash and cash items, plus $4.424 billion in marketable securities. Adding these two items together, I get the company’s current overall-cash position, which I round off to $10.1 billion. Comparing the 1987 cash to the 1986 cash in the right-hand column, I see that Ford is socking away more and more cash. This is a sure sign of prosperity.

• Then I go to the other half of the balance sheet, down to the entry that says long-term debt. Here I see that the 1987 long-term debt is $1.75 billion, considerably reduced from last year’s long-term debt. 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.

• Subtracting the long-term debt from the cash, I arrive at $8.35 billion, Ford’s net cash position. The cash and cash assets alone exceed the debt by $8.35 billion. When cash exceeds debt it’s very favorable. No matter what happens, Ford isn’t about to go out of business. (You may have noticed Ford’s short-term debt of $1.8 billion. I ignore short-term debt in my calculations. The purists can fret all they want about this, but why complicate matters unnecessarily? I simply assume that the company’s other assets [inventories and so forth] are valuable enough to cover the short-term debt, and I leave it at that.)

• I discover that there are 511 million shares outstanding. I can also see that the number has been reduced in each of the past two years. This means that Ford has been buying back its own shares, another positive step.

• Dividing the $8.35 billion in cash and cash assets by the 511 million shares outstanding, I conclude that there’s $16.30 in net cash to go along with every share of Ford

• It tells you about cash and debt, summarizes the long-term record so you can see what happened during the last recession, whether earnings are on the upswing, whether dividends have always been paid, etc. Finally, it rates companies for financial strength on a simple scale of 1 to 5, giving you a rough idea of a company’s ability to withstand adversity.

Chapter 13: Some Famous Numbers

• first thing I want to know is what that product means to the company in question. What percent of sales does it represent? L’eggs sent Hanes stock soaring because Hanes was a relatively small company. Pampers was more profitable than L’eggs, but it didn’t mean as much to the huge Procter and Gamble.

• The p/e ratio of any company that’s fairly priced will equal its growth rate. I’m talking about growth rate of earnings here.

• If the p/e of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown

• We use this measure all the time in analyzing stocks for the mutual funds.

• Ford had accumulated the $16.30 a share in cash beyond debt—as mentioned in the previous chapter. For every share of Ford I owned, there was this $16.30 bonus sitting there on paper like some delightful hidden rebate.

• The $16.30 bonus changed everything. It meant that I was buying the auto company not for $38 a share, the stock price at the time, but for $21.70 a share ($38 minus the $16.30 in cash). Analysts were expecting Ford to earn $7 a share from its auto operations, which at the $38 price gave it a p/e of 5.4, but at the $21.70 price it had a p/e of 3.1.

• A p/e of 3.1 is a tantalizing number, cycles or no cycles. Maybe I wouldn’t have been impressed if Ford were a lousy company or if people were turned off by its latest cars. But Ford is a great company, and people loved the latest Ford cars and trucks.

• I also knew that Ford’s financial services group—Ford Credit, First Nationwide, U. S. Leasing, and others—earned $1.66 per share on their own in 1987. For Ford Credit, which alone contributed $1.33 per share, it was “its 13th consecutive year of earnings growth.”

• Assigning a hypothetical p/e ratio of 10 to the earnings of Ford’s financial businesses (finance companies commonly have p/e ratios of 10) I estimated the value of these subsidiaries to be 10 times the $1.66, or $16.60 per share.

• So with Ford selling for $38, you were getting the $16.30 in net cash and another $16.60 in the value of the finance companies, so the automobile business was costing you a grand total of $5.10 per share. And this same automobile business was expected to earn $7 a share. Was Ford a risky pick? At $5.10 per share it was an absolute steal, in spite of the fact that the stock was up almost tenfold already since 1982.

• A normal corporate balance sheet has 75 percent equity and 25 percent debt. Ford’s equity-to-debt ratio is a whopping $18 billion to $1.7 billion, or 91 percent equity and less than 10 percent debt. That’s a very strong balance sheet. An even stronger balance sheet might have 1 percent debt and 99 percent equity. A weak balance sheet, on the other hand, might have 80 percent debt and 20 percent equity.

• Among turnarounds and troubled companies, I pay special attention to the debt factor. More than anything else, it’s debt that determines which companies will survive and which will go bankrupt in a crisis. Young companies with heavy debts are always at risk.

• GCA and Applied Materials. Both manufactured electronic capital equipment—machines to make computer chips. It’s one of those highly technical fields that’s best avoided, and these companies had proven it by falling off the ledge. In late 1985, GCA stock fell from $20 to $12, and Applied Materials did even worse, falling from $16 to $8. The difference was that when GCA got into trouble, it had $114 million in debt, and almost all of it was bank debt. It only had $3 million in cash, and its principal asset was $73 million of inventories—but in the electronics business, things change so fast that one year’s $73-million inventory could be a $20-million inventory the next. Applied Materials, on the other hand, had only $17 million in debt and $36 million in cash. When the electronic-components business picked up, Applied Materials rebounded from $8 to $36, but GCA wasn’t around to enjoy the revival. One company went kaput and was bought out at about 10 cents a share, while the other went up more than fourfold. The debt burden was the difference.

• There’s bank debt and there’s funded debt.

• Bank debt (the worst kind, and the kind that GCA had) is due on demand. It doesn’t have to come from a bank. It can also take the form of commercial paper, which is loaned from one company to another for short periods of time. The important thing is that it’s due very soon, and sometimes even “due on call.” That means that the lender can ask for his money back at the first sign of trouble. If the borrower can’t pay back the money, it’s off to Chapter 11. Creditors strip the company, and there’s nothing left for the shareholders after they get through with it.

• Funded debt (the best kind, from the shareholder’s point of view) can never be called in no matter how bleak the situation, as long as the borrower continues to pay the interest. The principal may not be due for 15, 20, or 30 years. Funded debt usually takes the form of regular corporate bonds with long maturities. Corporate bonds may be upgraded or downgraded by the rating agencies depending on the financial health of the company, but whatever happens, the bondholders cannot demand immediate repayment of principal the way a bank can. Sometimes even the interest payments can be deferred. Funded debt gives companies time to wiggle out of trouble. (In one of the footnotes of a typical annual report, the company gives a breakdown of its long-term debt, the interest that is being paid, and the dates that the debt is due.)

• Micron’s survival was threatened by the bank debt it had built up, and its stock had fallen from $40 to $4. Its last hope was selling a large convertible debenture (a bond that can be converted into stock at the buyer’s discretion). This would enable the company to raise enough cash to pay off the bank debt and ride out its short-term difficulties, since the principal on the convertible debenture wasn’t due for several years. Fidelity bought a large part of that debenture. When the memory-chip business turned around and Micron returned to profitability, the stock rose from $4 to $24, and Fidelity made a nice gain.

• If you do plan to buy a stock for its dividend, find out if the company is going to be able to pay it during recessions and bad times.

• If a slow grower omits a dividend, you’re stuck with a difficult situation: a sluggish enterprise that has little going for it.

• Cyclicals are not always reliable dividend-payers: Ford omitted its dividend back in 1982 and the stock price declined to under $4 per share (adjusted for splits)—a 25-year low. As long as Ford doesn’t lose all its cash, nobody has to worry about their omitting dividends today.

• A textile company may have a warehouse full of fabric that nobody wants, carried on the books at $4 a yard. In reality, they couldn’t give the stuff away for 10 cents. There’s another unwritten rule here: 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?

• Overvalued assets on the left side of the balance sheet are especially treacherous when there’s a lot of debt on the right. Let’s say that a company shows $400 million in assets and $300 million in debts, resulting in a positive book value of $100 million. You know the debt part is a real number. But if the $400 million in assets will bring only $200 million in a bankruptcy sale, then the actual book value is a negative $100 million. The company is less than worthless.

• Just as often as book value overstates true worth, it can understate true worth. This is where you get the greatest asset plays. Companies that own natural resources—such as land, timber, oil, or precious metals—carry those assets on their book at a fraction of the true value. For instance, in 1987, Handy and Harman, a manufacturer of precious metals products, had a book value of $7.83 per share, including its rather large inventories of gold, silver, and platinum. But these inventories are carried on the books at the prices Handy and Harman originally paid for the metals—and that could have been thirty years ago. At today’s prices ($6.40 an ounce for silver and $415 for gold) the metals are worth over $19 per share.

• There are hidden assets when one company owns shares of a separate company—as Raymond Industries did with Teleco Oilfield Services. People close to either situation realized that Raymond was selling for $12 a share, and each share represented $18 worth of Teleco. By buying Raymond you were getting Teleco for minus $6. Investors who did their homework bought Raymond and got Teleco for minus $6, and investors who didn’t bought Teleco for $18. This sort of thing happens all the time.

• Finally, tax breaks turn out to be a wonderful hidden asset in turnaround companies. Because of its tax-loss carryforward, when Penn Central came out of bankruptcy it didn’t have to pay any taxes on millions in profits from the new operations it was about to acquire. In those years the corporate tax rates were 50 percent, so Penn Central could buy a company and double its earnings overnight, simply by paying no tax. The Penn Central turnaround took the stock from $5 in 1979 to $29 in 1985.

• Bethlehem Steel currently has $1 billion in operating-loss carryforwards, an extremely valuable asset if the company continues to recover. It means that the next $1 billion that Bethlehem earns in the U.S. will be tax-free.

• Occasionally I find a company that has modest earnings and yet is a great investment because of the 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.

• 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.

• There are two basic accounting methods to compute the value of inventories, LIFO and FIFO. As much as this sounds like a pair of poodles, LIFO actually stands for “last in, first out,” and FIFO stands for “first in, and first out.” If Handy and Harman bought some gold thirty years ago for $40 an ounce, and yesterday they bought some gold for $400 an ounce, and today they sell some gold for $450 an ounce, then what is the profit? Under LIFO, it’s $50 ($450 minus $400, and under FIFO it’s $410 ($450 minus $40).

• On the bright side, if a company has been depressed and the inventories are beginning to be depleted, it’s the first evidence that things have turned around.

• Even if a company goes bankrupt and ceases normal operations, it must continue to support the pension plan. Before I invest in a turnaround, I always check to make sure the company doesn’t have an overwhelming pension obligation that it can’t meet. I specifically look to see if pension fund assets exceed the vested benefit liabilities.

• If you find a business that can get away with raising prices year after year without losing customers (an addictive product such as cigarettes fills the bill), you’ve got a terrific investment.

• One more thing about growth rate: all else being equal, 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. Look at the widening gap in earnings between a 20-percent grower and a 10-percent grower that both start off with the same $1 a share in earnings:

• There’s not much to be gained in comparing pretax profit margins across industries, since the generic numbers vary so widely. Where it comes in handy is in comparing 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.

• pretax profit margin is one more factor to consider in evaluating a company’s staying power in hard times.

• This gets very tricky, because on the upswing, as business improves, the companies with the lowest profit margins are the biggest beneficiaries. Consider what happens to $100 in sales to our two companies in these two hypothetical situations: In the recovery, Company A’s profits have increased almost 50 percent, while Company B’s profits have more than tripled. This explains why depressed enterprises on the edge of disaster can become very big winners on the rebound

Chapter 15: The Final Checklist

• What follows is a summary of the things you’d like to learn about stocks in each of the six categories:

• STOCKS IN GENERAL

  • The p/e ratio. Is it high or low for this particular company and for similar companies in the same industry.
  • The percentage of institutional ownership. The lower the better.
  • Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs.
  • The record of earnings growth to date and whether the earnings are sporadic or consistent. (The only category where earnings may not be important is in the asset play.)
  • Whether the company has a strong balance sheet or a weak balance sheet (debt-to-equity ratio) and how it’s rated for financial strength.
  • The cash position. With $16 in net cash, I know Ford is unlikely to drop below $16 a share.

• SLOW GROWERS

  • Since you buy these for the dividends you want to check to see if dividends have always been paid, and whether they are routinely raised.
  • When possible, find out what percentage of the earnings are being paid out as dividends. If it’s a low percentage, then the company has a cushion in hard times. It can earn less money and still retain the dividend. If it’s a high percentage, then the dividend is riskier.

• STALWARTS

  • These are big companies that aren’t likely to go out of business. The key issue is price, and the p/e ratio will tell you whether you are paying too much.
  • Check for possible diworseifications that may reduce earnings in the future.
  • Check the company’s long-term growth rate, and whether it has kept up the same momentum in recent years.
  • If you plan to hold the stock forever, see how the company has fared during previous recessions and market drops. (McDonald’s did well in the 1977 break, and in the 1984 break it went sideways. In the big Sneeze of 1987, it got blown away with the rest. Overall it’s been a good defensive stock. Bristol-Myers got clobbered in the 1973–74 break, primarily because it was so overpriced. It did well in 1982, 1984, and 1987. Kellogg has survived all the recent debacles, except for ’73–’74, in relatively healthy fashion.)

• CYCLICALS

  • Keep a close watch on inventories, and the supply-demand relationship.
  • Watch for new entrants into the market, which is usually a dangerous development.
  • 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 have an advantage in figuring out the cycles. (For instance, everyone knows there are cycles in the auto industry. Eventually there are going to be three or four up years to follow three or four down years. There always are.
  • it’s much easier to predict an upturn in a cyclical industry than it is to predict a downturn.

• FAST GROWERS

  • 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. (My favorites are the ones in the 20 to 25 percent range. I’m wary of companies that seem to be growing faster than 25 percent. Those 50 percenters usually are found in hot industries, and you know what that means.)
  • That the company has duplicated its successes in more than one city or town, to prove that expansion will work.
  • That the company still has room to grow.
  • Whether the stock is selling at a p/e ratio at or near the growth rate.
  • 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).
  • That 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.

• TURNAROUNDS

  • Most important, can the company survive a raid by its creditors? How much cash does the company have? How much debt? (Apple Computer had $200 million in cash and no debt at the time of its crisis.)
  • What is the debt structure, and how long can it operate in the red while working out its problems without going bankrupt?
  • 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?
  • Are costs being cut? If so, what will the effect be?

• ASSET PLAYS

  • What’s the value of the assets? Are there any hidden assets?
  • How much debt is there to detract from these assets? (Creditors are first in line.)
  • 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?

• OVERVIEW

  • 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.
  • 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

Chapter 16: Designing a Portfolio

• There’s no use diversifying into unknown companies just for the sake of diversity.

• In small portfolios I’d be comfortable owning between three and ten stocks. There are several possible benefits:

• I never put more than 30–40 percent of my fund’s assets into growth stocks. The rest I spread out among the other categories described in this book. Normally I keep about 10–20 percent or so in the stalwarts, another 10–20 percent or so in the cyclicals, and the rest in the turnarounds

• My idea is to stay in the market forever, and to rotate stocks depending on the fundamental situations.

• Some people automatically sell the “winners”—stocks that go up—and hold on to their “losers”—stocks that go down—which is about as sensible as pulling out the flowers and watering the weeds. Others automatically sell their losers and hold on to their winners, which doesn’t work out much better. Both strategies fail because they’re tied to the current movement of the stock price as an indicator of the company’s fundamental value.

• As we’ve seen, the current stock price tells us absolutely nothing about the future prospects of a company, and it occasionally moves in the opposite direction of the fundamentals.

• If you can’t convince yourself “When I’m down 25 percent, I’m a buyer” and banish forever the fatal thought “When I’m down 25 percent, I’m a seller,” then you’ll never make a decent profit in stocks.

• There’s simply no way to rely on stops as protection on the downside, nor on artificial objectives as goals on the upside. If I’d believed in “Sell when it’s a double,” I would never have benefited from a single big winner, and I wouldn’t have been given the opportunity to write a book. Stick around to see what happens—as long as the original story continues to make sense, or gets better—and you’ll be amazed at the results in several years.

Chapter 17: The Best Time to Buy and Sell

• The first is during the peculiar annual ritual of end-of-the-year tax selling. It’s no accident that the most severe drops have occurred between October and December. It’s the holiday period, after all, and brokers need spending money like the rest of us, so there’s extra incentive for them to call and ask what you might want to sell to get the tax loss.

• If you have a list of companies that you’d like to own if only the stock price were reduced, the end of the year is a likely time to find the deals you’ve been waiting for.

• WHEN TO SELL A SLOW GROWER

  • The company has lost market share for two consecutive years and is hiring another advertising agency.
  • No new products are being developed, spending on research and development is curtailed, and the company appears to be resting on its laurels.
  • Two recent acquisitions of unrelated businesses look like diworseifications, and the company announces it is looking for further acquisitions “at the leading edge of technology.”
  • The company has paid so much for its acquisitions that the balance sheet has deteriorated from no debt and millions in cash to no cash and millions in debt. There are no surplus funds to buy back stock, even if the price falls sharply.
  • The company has lost market share for two consecutive years and is hiring another advertising agency.
  • No new products are being developed, spending on research and development is curtailed, and the company appears to be resting on its laurels.
  • Two recent acquisitions of unrelated businesses look like diworseifications, and the company announces it is looking for further acquisitions “at the leading edge of technology.”
  • The company has paid so much for its acquisitions that the balance sheet has deteriorated from no debt and millions in cash to no cash and millions in debt. There are no surplus funds to buy back stock, even if the price falls sharply.
  • Even at a lower stock price the dividend yield will not be high enough to attract much interest from investors.

• WHEN TO SELL A STALWART

  • in a stalwart, and if the stock price gets above the earnings line, or if the 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, as I do.
  • New products introduced in the last two years have had mixed results, and others still in the testing stage are a year away from the marketplace.
  • The stock has a p/e of 15, while similar-quality companies in the industry have p/e’s of 11–12.
  • No officers or directors have bought shares in the last year.
  • A major division that contributes 25 percent of earnings is vulnerable to an economic slump that’s taking place (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. Rising inventories.
  • Future price of a commodity is lower than the current, or spot, price.
  • Price competition businesses

• WHEN TO SELL A FAST GROWER

  • Stock matured to be heavily bought by institutions
  • Pony marketing story for institutional investors
  • p/e of 30, optimistic projections of earnings growth are 15-20% for the next two years

• WHEN TO SELL A TURNAROUND

  • Turnaround is complete.
  • Increase in Debt, inventories.
  • The p/e is inflated relative to earnings prospects.
  • Slow down at a major customer (skewed customer concentration).

• WHEN TO SELL AN ASSET PLAY

  • Increase in Debt, institutional ownership.
  • Undersold divions sale.

Part III: The Long-Term View

• When you invest in stocks, you have to have a basic faith in human nature, in capitalism, in the country at large, and in future prosperity in general
• 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.
• Trying to predict the direction of the market over one year, or even two years, is impossible.
• 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.