Introduction: ‘One Up on Wall Street’ is fantastic book written by Peter Lynch, the portfolio manager of Fidelity Magellan Equity Mutual Fund, and John Rothchild on investing in stock. It is based on ‘New York Stock Exchange’ and on ‘S&P 500’. It is mainly divided in three parts namely ‘Preparing to Invest’, ‘Picking Winners’, and ‘The Long-term View’. The summary of second part is described in this blog. This book explains how to invest wisely in the stock market to gain reasonable profit annually, which stocks to choose and which to avoid, when to buy and when to sell, importance of earnings, P/E ratio, profit margin, book value, dividends etc. in evaluating the important benchmarks.
Picking Winners
Stalking the Tenbagger
One can discover tenbaggers (stocks that goes up tenfolds) in the backyard, in shopping mall or wherever someone happens to work. Generally we are busy examining and buying stocks which are totally opposite to our profession. For instance, doctors are busy buying oil company stocks and workers in oil industry are busy in buying ethical drug manufacturing company stocks. Yes, you can buy stocks in any industry. But doctors are well aware of when to sell the drug manufacturing company’s stocks. If tenbaggers are around you in your profession why to search them elsewhere; as the professionals are well aware of respective company’s popularity.
The employees, contractors of new plants, buyers and other related people of the successful company might have noticed its success and bought stocks in it after doing a little research on it. They have noticed the respective company’s progress far before the analysts at Wall Street. People are looking for a tenbagger while a tenbagger is itself searching them. Edge could be easily found out 4-5 times a year in our own surrounding.
I’ve Got It, I’ve Got It—
What Is It?
Found a successful product, it is not a buy signal. After finding an edge proper research on the company manufacturing it should be carried out. It is referred as homework here. The research takes 2-3 hours, similar time you take to choose the product out of two substitutes to be the best to buy. The first stage of preparing the story is to classify the stock into one out of the six categories mentioned below:
(1)THE SLOW GROWERS: Usually the large and aging companies are kept in this category. The chart of such companies looks like topographical map of Delaware without hills. It is denoted as sluggards here. Another sign of a slow grower is regular dividends. Growth rate of such companies in general is 2-4 percent. Their size is so huge that investor should be delighted on getting 20-30 percent return in two years.
(2)THE STALWARTS: They are not exactly agile climbers but they are faster than slow growers. Depending on when you buy them and at what price, you can make a sizable profit in stalwarts. Coca-Cola, Bristol-Myers, Ralston Purina etc. are stalwarts. 10-12 percent annual growth in earnings is there. It is unusual to get a tenbagger out of stalwart. If the stock price goes up 50% in a year or two, then you should be wonder and start thinking about selling it. They offer pretty good protection during recessions and hard times.
(3)THE FAST GROWERS: Small, aggressive new enterprises that grow at 20-25 percent annually. If choice is made wisely then this is a land to get 10 to 40 and even 200 baggers. A fast growing company doesn’t necessarily have to belong to a fast growing industry. There’s plenty of risk in fast growers, especially in the younger companies that tend to be overzealous and underfinanced.
(4)THE CYCLICALS: A cyclical is a company whose sales and profits rise and fall in regular if not completely predictable fashion. In cyclical industry, business expands and contracts, then expands and contracts again. AMR Corporation, the parent of American Airlines, is a cyclical, and so is Ford Motor. Chart of a cyclical looks like the photograph of liars or the maps of the Alps. Coming into a vigorous economy, the cyclicals flourish. But, going into recession, the cyclicals suffer. Timing is everything in cyclicals.
(5)TURNAROUNDS: These are not slow growers. These are potential facilities. Turnaround stocks make up lost ground very quickly. The best thing about investing in successful turnarounds is that of all categories of stocks, their ups and downs are least related to the general market. It’s not easy to compile lists of failed turnarounds except from memory, because their existence is wiped out of the S&P books, the chart books, and the stockbrokers’ records, and these companies are never heard from again. In spite of this, the occasional major success makes turnaround business very exciting, and very rewarding overall.
(6)THE ASSET PLAYS: An asset play is a company that’s sitting on something valuable that you know about, but that the Wall Street crowd has overlooked. The asset play may be as simple as a pile of cash. Sometimes it’s real estate. There are asset plays in metals and in oil, in newspaper and in TV stations, in patented drugs and even sometimes in a company’s losses. Asset opportunities are everywhere. Sure they require a working knowledge of the company that owns the assets, but once that’s understood, all you need is patience.
The Perfect Stock,
What a Deal!
In this chapter, the most important thirteen favorable attributes of the perfect company are discussed by the author. They are:
(1) IT SOUNDS DULL―OR, EVEN BETTER, RIDICULOUS
(2) IT DOES SOMETHING DULL
(3) IT DOES SOMETHING DISAGREEABLE
(4) IT IS A SNIPOFF
(5) THE INSTITUTIONS DON’T OWN IT, ND THE ANALYSTS DON’T FOLLOW IT
(6) THE RUMORS ABOUND: IT’S INVOLVED WITH TOXIC WASTE AND/OR THE MAFIA
(7) THERE’S SOMETHING DEPRESSING ABOUT IT
(8) IT IS A NO-GRPWTH INDUSTRY
(9) IT’S GOT A NICHE
(10) PEOPLE HAVE TO KEEP BUYING IT
(11) IT’S A USER OF TECHNOLOGY
(12) THE INSIDERS ARE BUYERS
(13) THE COMPANY IS BUYING BACK SHARES
Stocks I’d Avoid
The hottest stock in the hottest industry is the one which the author instructs to be avoided at any cost. Home Shopping Network was a hot stock in the hot teleshop industry and the price of it within 16 months went from $3 to $47, and back to $3½. Another stock to be avoided is a company that’s been touted as the next something, like the next IBM. In fact, when people tout a stock as the next of something, it often marks the end of prosperity not only of imitator but also for the original to which it is being compared.
Companies often prefer to blow the money on foolish acquisitions. The dedicated diworseifier seeks out merchandise that is (1) overpriced, and (2) completely beyond his or her realm of understanding. These frequent episodes of acquiring and then regretting, only to divest and acquire and regret once again, could be applauded as a form of transfer payment from the shareholders of the large and cash-rich corporation to the shareholders of the smaller entity being taken over, since the large corporations so often overpay.
Often the whisper (must be avoided) 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. They may go up before they come down, but as a long-term propositions author have lost money on every single one he have ever bought. Also beware of stocks with exiting name, like “advanced”, “leading”, or “micro” in it, because it would have guaranteed a big institutional following from the start.
Earnings, Earnings,
Earnings
To author, what makes a company valuable, and why it will be more valuable tomorrow than it is today is earnings and assets. Although it is easy to forget something, a share of stock is not a lottery ticket. It is part ownership of a business. When you buy a stock in a fast-growing company, you’re really betting on its chances to earn more money in the future. You can see the importance of earnings on any chart that has an earnings line running alongside the stock price.
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 that the company’s earnings stay constant. An example is stated as; let’s say you buy 100 shares of xyz for $3500. Current earnings are $3.50 per share, so your 100 shares will earn $350 in one year, and the original investment of $3500 will be earned back in ten years.
If you remember nothing else about p/e ratios, remember to avoid stocks with excessively high ones. An extremely high p/e ratio is a handicap to a stock, in the same way that extra weight in the saddle is a handicap to a racehorse. A company with high p/e must have incredible earnings growth to justify the high price that’s been put on the stock. An average p/e for a utility (7-9) will be lower than the average p/e for a stalwart (10-14), and that in turn will be lower than the average p/e of a fast grower (14-20). 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.
The Two-Minute Drill
Before buying a stock, author likes to be able to give a two-minute monologue that covers the reasons he is interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. Two examples are given here, one a situation that the author checked out properly, and the other where there was something he forgot to ask. The first was La Quinta, which has been a fifteenbagger, and the second was Bildner’s, a fifteenbagger in reverse.
It is never too late not to invest in an unproven enterprise.
Getting the Facts
Author says that a fund manager can get the facts more easily, but it became easy even for the amateur investor to get the facts now a day. These days, companies are required to tell nearly all in their prospectuses, their quarterlies, and their annual reports.
If you use the broker as advisor, then ask the broker to give you the two minutes speech on the recommended stocks. Many useful information can be known from a full-service brokerage firm, like recent growth in earnings, p/e ratio relative to historic levels, new franchises are making profit or not?, debt situation, insiders buying, stock price versus the earnings for the last five years, dividends, percentage of shares held by the institutions and the number of analysts following the company.
Visiting the headquarters also helps you to get the facts. Author believes that wandering through store and tasting things is a fundamental investment strategy. After finding an edge you have to get the facts and prepare the story, but good companies can be found out by this. A basic idea of reading the reports is given here by considering the 1987 annual report of ford. Consolidated balance sheet is printed on a cheaper paper. The balance sheet lists assets and liabilities.
Some Famous Numbers
When author is interested in a company because of a particular product, the first thing he wants to know is what that product means to the company in question. What percent of sales it represent? For instance, 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.
A slightly complicated formula enables us to compare growth rate to earnings, while also taking the dividends into account. Find long term growth rate (say, company X’s is 10), add the dividend yield (company X pays 3 percent), and divide by the p/e ratio (company X’s is 10). (12+3)/10 is 1.5. <1 is poor, and 1.5 is okay, but what you’re looking for is 2 or better.
How much does the company owe, and how much does it own? Debt versus Equity. This debt-to-equity is easy to determine. A corporate balance sheet has 75% equity and 25% debt. A very strong balance sheet might have 1% debt and 99% equity. A weak balance sheet, on the other hand, might have 80% debt and 20% equity.
Stocks that pay dividends are often favored over stocks that don’t pay dividends by investors who desire extra money. There’s nothing wrong with that. But the real issue, as author see it, is how the dividend, or the lack of a dividend, affects the value of a company and the price of its stock over time. If you do plan to buy a stock for its dividend, find out (using historic records) if the company is going to be able to pay it during recessions and bad times.
Companies that own natural resources carry those assets on their book at a fraction of the true value. Sometimes you’ll find an oil company or a refiner that’s kept inventory in the ground for forty years, and at the original cost of acquisition. The oil alone is worth more than the current price of all the shares of stock. Investors can make fortune in such opportunities. It’s no trouble to sell oil. Nobody cares if it’s this year’s oil or last year’s oil.
Cash flow is the amount of money a company takes in as a result of doing business. For instance, a $20 stock with $2 per share in annual cash flow gives a 10 percent return on cash. Similarly, a $20 stock with $4 per share cash flow fives a 20 percent return on cash, which is terrific. Free cash flow is talked about in the above case. Free cash flow is what’s left after the normal capital spending is taken out. Its cash that you’ve taken in that you don’t have to spend.
Rechecking the Story
Every few months it’s worthwhile to recheck the story. It may be possible that the company’s sales, profit, inventories, debts etc. increase or decrease suddenly in some few months. These changes can be known by rechecking the story every few months. Companies release their quarterlies. Apart from that the required changes to be known can also be known from following publication and journals related to business like value line. Some companies decline suddenly from top to bottom in just few months. If story is rechecked every few months these type of companies can be known and sold immediately. However, if the fundamentals sound good and there is nothing to worry about, then avoid general gossips and rumors, and patience should be kept.