(Image: Zen Buddha Silence by Marilyn Barbone.)
January 30, 2022
Peter Lynch is one of the great investors. When Lynch managed Fidelity Magellan from 1977 to 1990, the fund averaged 29.2% per year—more than doubling the annual return of the S&P 500 Index—making it the best performing mutual fund in the world.
In One Up On Wall Street: How to Use What You Already Know to Make Money in the Market (Fireside, 1989 and 2000), Lynch offers his best advice to individual investors.
Lynch explains how to find tenbaggers—stocks that increase by 10x—by looking among stocks that are too small for most professionals. Lynch also suggests that you pay attention to small businesses you may come across in your daily life. If you notice a company that seems to be doing well, then you should research its earnings prospects, financial condition, competitive position, and so forth, in order to determine if the stock is a bargain.
Moreover, Lynch notes that his biggest winners—tenbaggers, twentybaggers, and even a few hundredbaggers—typically have taken at least three to ten years to play out.
The main idea is that a stock tracks the earnings of the underlying company over time. If you can pay a cheap price relative to earnings, and if those earnings increase over subsequent years, then you can get some fivebaggers, tenbaggers, and even better as long as you hold the stock while the story is playing out.
Lynch also writes that being right six out of ten times on average works well over time. A few big winners will overwhelm the losses from stocks that don’t work out.
Don’t try to time the market. Focus on finding cheap stocks. Some cheap stocks do well even when the market is flat or down. But over the course of many years, the economy grows and the market goes higher. If you try to dance in and out of stocks, eventually you’ll miss big chunks of the upside.
Here are the sections in this blog post:
- Introduction: The Advantages of Dumb Money
- The Making of a Stockpicker
- The Wall Street Oxymorons
- Is This Gambling, or What?
- Personal Qualities It Takes to Succeed
- Is This a Good Market? Please Don’t Ask
- Stalking the Tenbagger
- I’ve Got It, I’ve Got It—What Is It?
- The Perfect Stock, What a Deal!
- Stocks I’d Avoid
- Earnings, Earnings, Earnings
- The Two-Minute Drill
- Getting the Facts
- Some Famous Numbers
- Rechecking the Story
- The Final Checklist
- Designing a Portfolio
- The Best Time to Buy and Sell
INTRODUCTION: THE ADVANTAGES OF DUMB MONEY
Lynch writes that two decades as a professional investor have convinced him that the ordinary individual investor can do just as well as—if not better than—than the average Wall Street expert.
Dumb money is only dumb when it listens to the smart money.
Lynch makes it clear that if you’ve already invested in a mutual fund with good long-term performance, then sticking with it makes sense. His point is that if you’ve decided to invest in stocks directly, then it’s possible to do as well as—if not better than—the average professional investor. This means ignoring hot tips and doing your own research on companies.
There are at least three good reasons to ignore what Peter Lynch is buying: (1) he might be wrong! (A long list of losers from my own portfolio constantly reminds me that the so-called smart money is exceedingly dumb about 40 percent of the time); (2) even if he’s right, you’ll never know when he’s changed his mind about a stock and sold; and (3) you’ve got better sources, and they’re all around you…
If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighborhood shopping mall, and long before Wall Street discovers them… and if you work in the industry, so much the better. This is where you’ll find the tenbaggers. I’ve seen it happen again and again from my perch at Fidelity.
You can find tenbaggers even in weak markets, writes Lynch. If you have ten positions at 10% each, then one tenbagger will cause your total portfolio to increase 90% if the other nine positions are flat. If the other nine positions collectively lose 50% (perhaps in weak market), then your overall portfolio will still be up 45% if you have one tenbagger.
Most often, tenbaggers are in companies like Dunkin’ Donuts rather than in penny stocks that depend on a scientific breakthrough. Lynch also mentions La Quinta Motor Inns—a tenbagger from 1973 to 1983. (La Quinta modeled itself on Holiday Inn, but with 30% lower costs and 30% lower prices. If you’ve attended a Berkshire Hathaway Annual Shareholders meeting in the past decade, you may have stayed at La Quinta along with a bunch of other frugal Berkshire shareholders.)
- Note: When considering examples Lynch gives in his book, keep in mind that he first wrote the book in 1989. The examples are from that time period.
Lynch says he came across many of his best investment ideas while he was out and about:
Taco Bell, I was impressed with the burrito on a trip to California; La Quinta Motor Inns, somebody at the rival Holiday Inn told me about it; Volvo, my family and friends drive this car; Apple Computer, my kids had one at home and then the systems manager bought several for the office; Service Corporation International, a Fidelity electronics analyst… found on a trip to Texas; Dunkin’ Donuts, I loved the coffee…
Many individual investors think the big winners must be technology companies, but very often that’s not the case:
Among amateur investors, for some reason it’s not considered sophisticated practice to equate driving around town eating donuts with the initial phase of an investigation into equities. People seem more comfortable investing in something about which they are entirely ignorant. There seems to be an unwritten rule on Wall Street: If you don’t understand it, then put your life savings into it. Shun the enterprise around the corner, which can at least be observed, and seek out the one that manufactures an incomprehensible product.
Lynch is quick to point out that finding a promising company is only the first step. You then must conduct the research.
THE MAKING OF A STOCKPICKER
Lynch describes his experience at Boston College:
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.
Granted, since Lynch first wrote this book in 1989, more quantitative investors—using computer-based models—have come along. But when it comes to picking stocks that can do well if held for many years, the majority of successful investors still follow a much more traditional process: gathering information through observation, massive reading, and scuttlebutt, and then making investment decisions that are often partly qualitative in nature. Here is a partial list of successful stockpickers:
- Bill Ackman, David Abrams, Lee Ainslie, Chuck Akre, Bruce Berkowitz, Christopher Browne, Warren Buffett, Michael Burry, Leon Cooperman, Christopher Davis, David Einhorn, Jean-Marie Eveillard, Thomas Gayner, Glenn Greenberg, Joel Greenblatt, Mason Hawkins, Carl Icahn, Seth Klarman, Stephen Mandel, Charlie Munger, Bill Nygren, Mohnish Pabrai, Michael Price, Richard Pzena, Robert Rodriguez, Stephen Romick, Thomas Russo, Walter Schloss, Lou Simpson, Guy Spier, Arnold Van Den Berg, Prem Watsa, Wallace Weitz, and Donald Yacktman.
THE WALL STREET OXYMORONS
Lynch observes that professional investors are typically not able to invest in most stocks that become tenbaggers. Perhaps the most important reason is that most professional investors never invest in microcap stocks, stocks with market caps below $500 million. Assets under management (AUM) for many professional investors are just too large to be able to invest in microcap companies. Moreover, even smaller funds usually focus on small caps instead of micro caps. Often that’s a function of AUM, but sometimes it’s a function of microcap companies being viewed as inherently riskier.
There are thousands of microcap companies. And many micro caps are good businesses with solid revenues and earnings, and with healthy balance sheets. These are the companies you should focus on as an investor. (There are some microcap companies without good earnings or without healthy balance sheets. Simply avoid these.)
If you invest in a portfolio of solid microcap companies, and hold for at least 10 years, then the expected returns are far higher than would you get from a portfolio of larger companies. There is more volatility along the way, but if you can just focus on the long-term business results, then shorter term volatility is generally irrelevant. Real risk for value investors is not volatility, or a stock that goes down temporarily. Real risk is the chance of suffering a permanent loss—when the whole portfolio declines and is unable to bounce back.
Fear of volatility causes many professional investors only to look at stocks that have already risen a great deal, so that they’re no longer micro caps. You’ll miss a lot of tenbaggers and twentybaggers if you can’t even look at micro caps. That’s a major reason why individual investors have an advantage over professional investors. Individual investors can look at thousands of microcap companies, many of which are in very good shape.
Furthermore, even if a professional investor could look at microcap stocks, there are still strong incentives not to do so. Lynch explains:
…between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the normal mutual-fund manager, pension-fund manager, or corporate-portfolio manager would jump at the latter. Success is one thing, but it’s more important not to look bad if you fail.
As Lynch says, if you’re a professional investor and you invest in a blue chip like General Electric which doesn’t work, clients and bosses will ask, ‘What is wrong with GE?’ But if you invest in an unknown microcap company and it doesn’t work, they’ll ask, ‘What is wrong with you?’
Lynch sums it up the advantages of the individual investor:
You don’t have to spend a quarter of your waking hours explaining to a colleague why you are buying what you are buying. [Also, you can invest in unknown microcap companies…] There’s nobody to chide you for buying back a stock at $19 that you earlier sold at $11—which may be a perfectly sensible move.
IS THIS GAMBLING, OR WHAT?
In general, stocks have done better than bonds over long periods of time.
Historically, investing in stocks is undeniably more profitable than investing in debt. In fact, since 1927, common stocks have recorded gains of 9.8 percent a year on average, as compared to 5 percent for corporate bonds, 4.4 percent for government bonds, and 3.4 percent for Treasury bills.
The long-term inflation rate, as measured by the Consumer Price Index, is 3 percent a year, which gives common stocks a real return of 6.8 percent a year. The real return on Treasury bills, known as the most conservative and sensible of all places to put money, has been nil. That’s right. Zippo.
Many people get scared out of stocks whenever there is a large drop of 20-40% (or more). But both the U.S. economy and U.S. stocks are very resilient and have always bounced back quickly. This is especially true since the Great Depression, which was a prolonged period of deep economic stagnation caused in large part by policy errors. A large fiscal stimulus and/or a huge program of money-printing (monetary stimulus) would have significantly shortened the Great Depression.
Lynch defines good investing as a system of making bets when the odds are in your favor. If you’re right 60% of the time and you have a good system, then you should do fine over time. Lynch compares investing to stud poker:
You can never be certain what will happen, but each new occurrence—a jump in earnings, the sale of an unprofitable subsidiary, the expansion into new markets—is like turning up another card. As long as the cards suggest favorable odds of success, you stay in the hand.
…Consistent winners raise their bets as their position strengthens, and they exit the game when the odds are against them…
Consistent winners also resign themselves to the fact that they’ll occasionally be dealt three aces and bet the limit, only to lose to a hidden royal flush. They accept their fate and go on to the next hand, confident that their basic method will reward them over time. People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game… They realize the stock market is not pure science, and not like chess, where the superior position always wins. If seven out of ten of my stocks perform as expected, then I’m delighted. If six out of ten of my stocks perform as expected, then I’m thankful. Six out of ten is all it takes to produce on enviable record on Wall Street.
Lynch concludes the chapter by saying that investing is more like 70-card poker than 7-card poker. If you have ten positions, it’s like playing ten 70-card hands at once.
PERSONAL QUALITIES IT TAKES TO SUCCEED
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 mistakes, and the ability to ignore general panic…
It’s also important to be able to make decisions without complete or perfect information. Things are almost never clear on Wall Street, or when they are, then it’s too late to profit from them. The scientific mind that needs to know all the data will be thwarted here.
And finally, it’s crucial to be able to resist your human nature and your ‘gut feelings.’ It’s the rare investor who doesn’t secretly harbor the conviction that he or she has a knack for divining stock prices or gold prices or interest rates, in spite of the fact that most of us have been proven wrong again and again. It’s uncanny how often people feel most strongly that stocks are going to go up or the economy is going to improve just when the opposite occurs. This is borne out by the popular investment-advisory newsletter services, which themselves tend to turn bullish and bearish at inopportune moments.
According to information published by Investor’s Intelligence, which tracks investor sentiment via the newsletters, at the end of 1972, when stocks were about to tumble, optimism was at an all-time high, with only 15 percent of the advisors bearish. At the beginning of the stock market rebound in 1974, investor sentiment was at an all-time low, with 65 percent of the advisors fearing the worst was yet to come…. At the start of the 1982 sendoff into a great bull market, 55 percent of the advisors were bears, and just prior to the big gulp of October 19, 1987, 80 percent of the advisors were bulls again.
…Does the success of Ravi Batra’s book The Great Depression of 1990 almost guarantee a great national prosperity?
…The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.
IS THIS A GOOD MARKET? PLEASE DON’T ASK
There’s another theory that we have recessions every five years, but it hasn’t happened that way so far… Of course, I’d love to be warned before we do go into a recession, so I could adjust my portfolio. But the odds of my figuring it out are nil. Some people wait for these bells to go off, to signal the end of a recession or the beginning of an exciting new bull market. The trouble is the bells never go off. Remember, things are never clear until it’s too late.
… No matter how we arrive at the latest financial conclusion, we always seem to be preparing ourselves for the last thing that’s happened, as opposed to what’s going to happen next. This penultimate preparedness is our way of making up for the fact that we didn’t see the last thing coming along in the first place.
I don’t believe in predicting markets. I believe in buying great companies—especially companies that are undervalued and/or underappreciated.
Lynch explains that the stock market itself is irrelevant. What matters is the current and future earnings of the individual business you’re considering. Lynch:
Several of my favorite tenbaggers made their biggest moves during bad markets. Taco Bell soared through the last two recessions.
Focus on specific companies rather than the market as a whole. Because you’re not restricted as an individual investor—you can look at microcap companies and you can look internationally—there are virtually always bargains somewhere.
A few good quotes from Warren Buffett on forecasting:
Market forecasters will fill your ear but never fill your wallet.
We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.
Charlie and I never have an opinion on the market because it wouldn’t be any good and it might interfere with the opinions we have that are good.
STALKING THE TENBAGGER
If you work in a particular industry, this can give you an edge:
If you work in the chemical industry, then you’ll be among the first to realize that demand…is going up, prices are going up, and excess inventories are going down. You’ll be in a position to know that no new competitors have entered the market and no new plants are under construction, and that it takes two to three years to build one.
Lynch also argues that if you’re a consumer of particular products, then you may be able to gain insight into companies that sell those products. Again, you still need to study the financial statements in order to understand earnings and the balance sheet. But noticing products that are doing well is a good start.
I’VE GOT IT, I’VE GOT IT—WHAT IS IT?
Most of the biggest moves—from tenbaggers to hundredbaggers—occur in smaller companies. Microcap companies are the best place to look for these multi-baggers, while small-cap companies are the second best place to look.
Lynch identifies six general categories: slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds. (Slow growers and stalwarts tend to be larger companies.)
Many large companies grow slowly, but are relatively dependable and may pay dividends. A conservative investor may consider this category.
These companies tend to grow annual earnings at 10 to 12 percent a year. If you buy the stock when it’s a bargain, you can make 30 to 50 percent, then sell and repeat the process. This is Lynch’s approach to Stalwarts. Also, Stalwarts can offer decent protection during weak markets.
Some small, aggressive new companies can grow at 20 to 25 percent a year:
If you choose wisely, this is the land of the 10- to 40-baggers, and even the 200-baggers.
Of course, you have to be careful to identify the risks. Many younger companies may grow too quickly or be underfinanced. So look for the fast growers with good balance sheets and good underlying profitability.
A cyclical is a company whose sales and profits rise and fall regularly. If you can buy when the company and the industry are out of favor—near the bottom of the cycle—then you can do well with a cyclical. (You also need to sell when the company and the industry are doing well again unless you think it’s a good enough company to hold for a decade or longer.)
Some cyclical stocks—like oil stocks—tend to have a low level of correlation with the broader stock market. This can help a portfolio, especially when the broader stock market offers few bargains.
Turnaround stocks make up lost ground very quickly… The best thing about investing in successful turnarounds is that of all the categories of stocks, their ups and downs are least related to the general market.
Again, a low correlation with the broader market is especially an advantage when the broader market is overvalued. You do have to be careful with turnarounds, though. As Buffett has said, ‘Turnarounds seldom turn.’
A company may have something valuable that the market has overlooked. It may be as simple as a pile of cash. Sometimes it’s real estate. It may be unrecognized intellectual property. Or it could be resources in the ground.
THE PERFECT STOCK, WHAT A DEAL!
Similar to Warren Buffett, Lynch prefers simple businesses:
Getting the story on a company is a lot easier if you understand the basic business. That’s why I’d rather invest in panty hose than in communications satellites, or in motel chains than in fiber optics. The simpler it is, the better I like it. When somebody says, ‘Any idiot could run this joint,’ that’s a plus as far as I’m concerned, because sooner or later any idiot probably is going to be running it.
… For one thing, it’s easier to follow. During a lifetime of eating donuts or buying tires, I’ve developed a feel for the product line that I’ll never have with laser beams or microprocessors.
Lynch then names thirteen attributes that are important to look for:
It Sounds Dull—Or, Even Better, Ridiculous
Lynch says a boring name is a plus, because that helps a company to stay neglected and overlooked, often causing the stock to be cheap. Bob Evans Farms is an example of a perfect name.
It Does Something Dull
Crown, Cork, and Seal makes cans and bottle caps, says Lynch. The more boring the business, the better. Again, this will help keep the stock neglected, often causing the stock to be cheap.
It Does Something Disagreeable
Safety-Kleen provides gas stations with a machine that washes greasy auto parts. Gas stations love it. But it’s a bit disgusting, which can cause the stock to be neglected and thus possibly cheap.
It’s a Spinoff
Large companies tend to make sure that divisions they spin off are in good shape. Generally spinoffs are neglected by most professional investors, often because the market cap of the spinoff is too small for them to consider.
The Institutions Don’t Own It, and the Analysts Don’t Follow It
With no institutional ownership, the stock may be neglected and possibly cheap. With no analyst coverage, the chance of neglect and cheapness is even higher. It’s not only microcap companies that are neglected. When popular stocks fall deeply out of favor, they, too, can become neglected.
Rumors Abound: It’s Involved with Toxic Waste
Waste Management, Inc. was a hundredbagger. People are so disturbed by sewage and waste that they tend to neglect such stocks.
There’s Something Depressing About It
Funeral home companies tend to be neglected and the stocks can get very cheap at times.
It’s a No-Growth Industry
In a no-growth industry, there’s much less competition. This gives companies in the industry room to grow.
It’s Got a Niche
The local rock pit has a niche. Lynch writes that if you have the only rock pit in Brooklyn, you have a virtual monopoly. A rival two towns away is not going to transport rocks into your territory because the mixed rocks only sell for $3 a ton.
People Have to Keep Buying It
Drugs, soft drinks, razor blades, etc., are products that people need to keep buying.
It’s a User of Technology
A company may be in a position to benefit from ongoing technological improvements.
The Insiders Are Buyers
Insider buying usually means the insiders think the stock is cheap.
Also, you want insiders to own as much stock as possible so that they are incentivized to maximize shareholder value over time. If executive salaries are large compared to stock ownership, then executives will focus on growth instead of on maximizing shareholder value (i.e., profitability).
The Company Is Buying Back Shares
If the shares are cheap, then the company can create much value through buybacks.
STOCKS I’D AVOID
Lynch advises avoiding the hottest stock in the hottest industry. Usually a stock like that will be trading at an extremely high valuation, which requires a great deal of future growth for the investor just to break even. When future growth is not able to meet lofty expectations, typically the stock will plummet.
Similarly, avoid the next something. If a stock is touted as the next IBM, the next Intel, or the next Disney, avoid it because very probably it will not be the next thing.
Avoid diworseifications: Avoid the stock of companies that are making foolish acquisitions of businesses in totally different industries. Such diworseifications rarely work out for shareholders. Two-thirds of all acquisitions do not create value. This is even more true when acquisitions are diworseifications.
Beware whisper stocks, which are often technological long shots or whiz-bang stories such as miracle drugs. Lynch notes that he’s lost money on every single whisper stock he’s ever bought.
One trick to avoiding whisper stocks is to wait until they have earnings. You can still get plenty of tenbaggers from companies that have already proven themselves. Buying long shots before they have earnings rarely works. This is a good rule for buying microcap stocks in general: Wait until the company has solid earnings and a healthy balance sheet.
EARNINGS, EARNINGS, EARNINGS
Lynch writes that a stock eventually will track the earnings of the business:
Analyzing a company’s stock on the basis of earnings and assets is no different from analyzing a local Laundromat, drugstore, or apartment building that you might want to buy. Although it’s easy to forget sometimes, a share of stock is not a lottery ticket. It’s part ownership of a business.
Lynch gives an example:
And how about Masco Corporation, which developed the single-handle ball faucet, and as a result enjoyed thirty consecutive years of up earnings through war and peace, inflation and recession, with the earnings rising 800-fold and the stock rising 1,300-fold between 1958 and 1987? What would you expect from a company that started out with the wonderfully ridiculous name of Masco Screw Products?
Lynch advises not to invest in companies with high price-to-earnings (p/e) ratios:
If you remember nothing else about p/e ratios, remember to avoid stocks with excessively high ones. You’ll save yourself a lot of grief and a lot of money if you do. With few exceptions, an extremely high p/e ratio is a handicap to a stock, in the same way that extra weight in the saddle is a handicap to a racehorse.
Future earnings may not be predictable, but you can at least check how the company plans to increase future earnings. Lynch:
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.
THE TWO-MINUTE DRILL
Warren Buffett has said that he would have been a journalist if he were not an investor. Buffett says his job as an investor is to write the story for the company in question. Lynch has a similar view. He explains:
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. The two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot. Once you’re able to tell the story of a stock to your family, your friends, or the dog… and so that even a child could understand it, then you have a proper grasp of the situation.
Usually there are just a few key variables for a given investment idea. As value investor Bruce Berkowitz has said:
We’ve always done very well when we can use sixth-grade math on the back of a postcard to show how inexpensive something is relative to its free cash.
One good way to gain insight is to ask the executive of a company what he or she thinks the competition is doing right. Lynch discovered La Quinta Motor Inns while he was talking to the vice president of United Inns, a competitor.
Lynch later learned that La Quinta’s strategy was simple: to have both costs and prices that are 30% lower than Holiday Inn. La Quinta had everything exactly the same as at a Holiday Inn—same size rooms, same size beds, etc. However:
La Quinta had eliminated the wedding area, the conference rooms, the large reception area, the kitchen area, and the restaurant—all excess space that contributed nothing to the profits but added substantially to the costs. La Quinta’s idea was to install a Denny’s or some similar 24-hour place next door to every one of its motels. La Quinta didn’t even have to own the Denny’s. Somebody else could worry about the food. Holiday Inn isn’t famous for its cuisine, so it’s not as if La Quinta was giving up a major selling point… It turns out that most hotels and motels lose money on their restaurants, and the restaurants cause 95 percent of the complaints.
GATHERING THE FACTS
If it’s a microcap business, then you may be able to speak with a top executive simply by calling the company. For larger companies, often you will only reach investor relations. Either way, you want to check the story you’ve developed—your investment thesis—against the facts you’re able to glean through conversation (and through reading the financial statements, etc.).
If you don’t have a story developed enough to check, there are two general questions you can always ask, notes Lynch:
- What are the positives this year?
- What are the negatives?
Often your ideas will not be contradicted. But occasionally you’ll learn something unexpected, that things are either better or worse than they appear. Such unexpected information can be very profitable because it is often not yet reflected in the stock price. Lynch says he comes across something unexpected in about one out of every ten phone calls he makes.
Lynch also often will visit headquarters. The goal, he says, is to get a feel for the place. What Lynch really appreciates is when headquarters is obviously shabby, indicating that the executives are keeping costs as low as possible. When headquarters is very nice and fancy, that’s generally a bad signal about management.
Kicking the tires can help. It’s not a substitute for studying the financial statements or for asking good questions. But it can help you check out the practical side of the investment thesis. Lynch used to make a point of checking out as many companies as possible this way.
Finally, in addition to reading the financial statements, Lynch recommends Value Line.
SOME FAMOUS NUMBERS
If you’re looking at a particular product, then you need to know what percent of sales that particular product represents.
Lynch then notes that you can compare the p/e and the growth rate:
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. A company, say, with a growth rate of 12 percent a year… and a p/e of 6 is a very attractive prospect. 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.
In general, a p/e that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative.
You can do a similar calculation by taking earnings, adding dividends, and comparing that sum to the growth rate.
High debt-to-equity is something to avoid. Turnarounds with high debt tend to work far less often than turnarounds with low debt.
Free cash flow is important. Free cash flow equals net income plus depreciation, depletion, and amortization, minus capital expenditures. (There may also be adjustments for changes in working capital.)
The important point is that some companies and some industries—such as steel or autos—are far more capital-intensive than others. Some companies have to spend most of their incoming cash on capital expenditures just to maintain the business at current levels. Other companies have far lower reinvestment requirements; this means a much higher return on invested capital. The value that any given company creates over time is the cumulative difference between the return on invested capital and the cost of capital.
Another thing to track is inventories. If inventories have been piling up recently, that’s not a good sign. When inventories are growing faster than sales, that’s a red flag. Lynch notes that if sales are up 10 percent, but inventories are up 30 percent, then you should be suspicious.
Like Buffett, Lynch observes that a company that can raise prices year after year without losing customers can make for a terrific investment. Such a company will tend to have high free cash flow and high return on invested capital over time.
A last point Lynch makes is about the growth rate of earnings:
All else being equal, a 20-percent grower selling as 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.
Lynch gives an example. Assume Company A and Company B both start with earnings of $1.00 per share. But assume that Company A grows at 20 percent a year while Company B grows at 10 percent a year. (So the stock of Company A starts at $20, while the stock of Company B is at $10.) What happens after 10 years, assuming the growth rates stay the same? Company A will be earning $6.19 while Company B will be earning $2.59.
If the multiples haven’t changed, then the stock of Company A will be at $123.80, while the stock of Company B will only be at $26. Even if the p/e for Company A falls to 15 instead of 20, the stock will still be at $92. Going from $20 to $92 (or $123.80) is clearly better than going from $10 to $26.
One last point. In the case of a successful turnaround, the stock of a relatively low-profit margin (and perhaps also high debt) company will do much better than the stock of a relatively high-profit margin (and low debt) company. It’s just a matter of leverage.
For a long-term stock that you’re going to hold through good times and bad, you want high profit margins and low debt. If you’re going to invest in a successful turnaround, then you want low profit margins and high debt, all else equal. (In practice, most turnarounds don’t work, and high debt should be avoided unless you want to specialize in equity stubs.)
RECHECKING THE STORY
Every few months, you should check in on the company. Are they on track? Have they made any adjustments to their plan? How are sales? How are the earnings? What are industry conditions? Are their products still attractive? What are their chief challenges? Et cetera. Basically, writes Lynch, have any new cards been turned over?
In the case of a growth company, Lynch holds that there are three phases. In the start-up phase, the company may still be working the kinks out of the business. This is the riskiest phase because the company isn’t yet established. The second phase is rapid expansion. This is generally the safest phase, and also where you can make the most money as an investor. The third phase is the mature phase, or the saturation phase, when growth has inevitably slowed down. The third phase can be the most problematic, writes Lynch, since it gets increasingly difficult to grow earnings.
THE FINAL CHECKLIST
Lynch offers a brief checklist.
- 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 (high 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.
Lynch also gives a checklist for each of the six categories. Then he gives a longer checklist summarizes all the main points (which have already been mentioned in the previous sections).
DESIGNING A PORTFOLIO
Some years you’ll make 30 percent, other years you’ll make 2 percent, and occasionally you’ll lose 20 or 30 percent. It’s important to stick to a disciplined approach and not get impatient. Stick with the long-term strategy through good periods and bad. (Even great investors have periods of time when their strategy trails the market, often even several years in a row.)
Regarding the number of stocks to own, Lynch mentions a couple of stocks in which he wouldn’t mind investing his entire portfolio. But he says you need to analyze each stock one at a time:
…The point is not to rely on any fixed number of stocks but rather to investigate how good they are, on a case-by-case basis.
In my view it’s best to own as many stocks as there are situations in which: (a) you’ve got an edge; and (b) you’ve uncovered an exciting prospect that passes all the tests of research. Maybe it’s a single stock, or maybe it’s a dozen stocks. Maybe you’ve decided to specialize in turnarounds or asset plays and you buy several of those; or perhaps you happen to know something special about a single turnaround or a single asset play. There’s no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors.
Lynch then recommends, for small portfolios, owning between 3 and 10 stocks. It makes sense to concentrate on your best ideas and on what you understand best. At the same time, it often happens that the tenbagger comes—unpredictably—from your 8th or 9th best idea. The value investor Mohnish Pabrai has had this experience.
- Important Note: One of the best edges you can have as an individual investor—in addition to being able to focus on microcap companies—is that you can have at least a 3- to 5-year holding period. Because so many investors focus on shorter periods of time, very often the best bargains are stocks that are cheap relative to earnings in 3 to 5 years.
Lynch advises against selling winners and holding on to losers, which is like pulling out the flowers and watering the weeds. But Lynch’s real point is that price movements are often random. Just because a stock has gone up or down doesn’t mean the fundamental value of the business has changed.
If business value has increased—or if fundamentals have improved—then it often makes sense to add to a stock even if it’s gone from $11 to $19.
If business value has not declined, or has improved, then it often makes sense to add to a stock that has declined. On the other hand, if business value has decreased—or if fundamentals have deteriorated—then it often makes sense to sell, regardless of whether the stock has gone up or down.
In general, as long as the investment thesis is intact and business value is sufficiently high, you should hold a stock for at least 3 to 5 years:
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.
THE BEST TIME TO BUY AND SELL
Often there is tax loss selling near the end of the year, which means it can be a good time to buy certain stocks.
As mentioned, you should hold for at least 3 to 5 years as long as the investment thesis is intact and normalized business value is sufficiently high. Be careful not to listen to negative nellies who yell ‘Sell!’ way before it’s time:
Even the most thoughtful and steadfast investor is susceptible to the influence of skeptics who yell ‘Sell’ before it’s time to sell. I ought to know. I’ve been talked out of a few tenbaggers myself.
Lynch took a big position in Toys ‘R’ Us in 1978. He had done his homework, and he loaded up at $1 per share:
…By 1985, when Toys ‘R’ Us hit $25, it was a 25-bagger for some. Unfortunately, those some didn’t include me, because I sold too soon. I sold too soon because somewhere along the line I’d read that a smart investor named Milton Petrie, one of the deans of retailing, had bought 20 percent of Toys ‘R’ Us and that his buying was making the stock go up. The logical conclusion, I thought, was that when Petrie stopped buying, the stock would go down. Petrie stopped buying at $5.
I got in at $1 and out at $5 for a fivebagger, so how can I complain? We’ve all been taught the same adages: ‘Take profits when you can,’ and ‘A sure gain is always better than a possible loss.’ But when you’ve found the right stock and bought it, all the evidence tells you it’s going higher, and everything is working in your direction, then it’s a shame if you sell.
Lynch continues by noting that individual investors are just as susceptible to selling early as are professional investors:
Maybe you’ve received the ‘Congratulations: Don’t Be Greedy’ announcement. That’s when the broker calls to say: ‘Congratulations, you’ve doubled your money on ToggleSwitch, but let’s not be greedy. Let’s sell ToggleSwitch and try KinderMind.’ So you sell ToggleSwitch and it keeps going up, while KinderMind goes bankrupt, taking all of your profits with it.
One major problem for all investors is that there are so many market, economic, and political forecasts. Market forecasts and economic forecasts can be very expensive if you follow them, as Buffett has often noted. The only thing you can really know is the individual company in which you’ve invested, and what its long-term business value is. Everything else is noise that can only interfere with your ability to focus on long-term business value.
I quoted Buffett earlier. Now let’s quote the father of value investing, Buffett’s teacher and mentor, Ben Graham:
… if I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.
This has happened in recent years, too. Ever since 2012 or 2013, some exceptionally intelligent and well-informed people have been predicting some sort of reversion to the mean or bear market. But it just hasn’t happened. Of course, there could be a bear market and/or recession at any time. But even then, there will be at least a few stocks somewhere in the world that perform well if bought cheaply enough.
The main point made by Graham and Buffett is that repeatedly buying stocks at bargain levels relative to business value can work very well over time if you’re patient and disciplined. Market forecasting can only distract you from what works.
What works is investing in businesses you can understand at sensible prices, and holding each one for at least 3 to 5 years, if not 10 years or longer, as long as the thesis is intact. Lynch:
Frankly, I’ve never been able to predict which stocks will go up tenfold, or which will go up fivefold. I try to stick with them as long as the story’s intact, hoping to be pleasantly surprised. The success of a company isn’t the surprise, but what the shares bring often is. I remember buying Stop & Shop as a conservative, dividend-paying stock, and then the fundamentals kept improving and I realized I had a fast grower on my hands.
It’s important to note that sometimes years can go by while the stock does nothing. That, in itself, doesn’t tell you anything. If the business continues to make progress, and long-term business value is growing (or is sufficiently high), then you should stick with it or perhaps add to the position:
Here’s something else that’s certain to occur: If you give up on a stock because you’re tired of waiting for something wonderful to happen, then something wonderful will begin to happen the day after you get rid of it. I call this the postdiverstiture flourish.
…Most of the money I make is in the third or fourth year that I’ve owned something… If all’s right with the company, and whatever attracted me in the first place hasn’t changed, then I’m confident that sooner or later my patience will be rewarded.
…It takes remarkable patience to hold on to a stock in a company that excites you, but which everybody else seems to ignore. You begin to think everybody else is right and you are wrong. But where the fundamentals are promising, patience is often rewarded…
Lynch again later:
… my biggest winners continue to be stocks I’ve held for three and even four years.
Lynch offers much commentary on a long list of macro concerns that are going to sink stocks. (Remember he was writing in 1989.) Here is a snipet:
I hear every day that AIDS will do us in, the drought will do us in, inflation will do us in, recession will do us in, the budget deficit will do us in, the trade deficit will do us in, and the weak dollar will do us in. Whoops. Make that the strong dollar will do us in. They tell me real estate prices are going to collapse. Last month people started worrying about that. This month they’re worrying about the ozone layer. If you believe the old investment adage that the stock market climbs a ‘wall of worry,’ take note that the worry wall is fairly good-sized now and growing every day.
Like Buffett, Lynch is very optimistic about America and long-term investing in general. Given the strengths of America, and all the entrepreneurial and scientific energy creating ongoing innovation, it seems to me that Buffett and Lynch are right to be long-term optimists. That’s not to say there won’t be setbacks, recessions, bear markets, and other problems. But such setbacks will be temporary. Over the long term, innovation will amaze, profits will grow, and stocks will follow profits higher.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: http://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: firstname.lastname@example.org
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.