One Up on Wall Street: How to Use What You Already Know to Make Money In

by Peter Lynch

  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. USX shows pension plan assets of $8.5 billion and vested benefits of $7.3 billion, so that’s not worrisome. Bethlehem Steel, on the other hand, reports pension assets of $2.3 billion and vested benefits of $3.8 billion, or a $1.5 billion deficit. This is a big negative if Bethlehem Steel gets into deeper financial trouble. It would mean that investors would put a lower value on the stock until the pension problem was cleared up.

  This used to be a guessing game, but now the pension situation is laid out in the annual report.

  GROWTH RATE

  That “growth” is synonymous with “expansion” is one of the most popular misconceptions on Wall Street, leading people to overlook the really great growth companies such as Philip Morris. You wouldn’t see it from the industry—cigarette consumption in the U.S. is growing at about a minus two percent a year. True, foreign smokers have taken up where the U.S. smokers left off. One out of four Germans now smokes Marlboros made by Philip Morris, and the company sends 747s full of Marlboros to Japan every week. But even the foreign sales can’t account for Philip Morris’s phenomenal success. The key to it is that Philip Morris can increase earnings by lowering costs and especially by raising prices. That’s the only growth rate that really counts: earnings.

  Philip Morris has lowered costs by installing more efficient cigarette-rolling machinery. Meanwhile, the industry raises prices every year. If the company’s costs increase 4 percent, it can raise prices 6 percent, adding 2 percent to its profit margin. This may not seem like much, but if your profit margin is 10 percent (about what Philip Morris’s is) a 2-percentage-point rise in the profit margin means a 20 percent gain in earnings.

  (Procter and Gamble was able to “grow” its earnings in toilet paper by gradually changing the character of the paper, in effect adding ridges to the sheets, making them softer and slowly reducing the roll from 500 to 350 sheets. Then, they marketed the smaller roll as a “squeezable” improvement. This was the cleverest maneuver in the annals of short sheeting.)

  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.

  You couldn’t raise prices the way Philip Morris does in the apparel industry or the fast-food industry or else you’d soon be out of business. But Philip Morris gets progressively richer and richer and can’t find enough things to do with the cash that piles up. The company doesn’t have to invest in expensive blast furnaces, and it doesn’t spend a lot to make a little. Moreover, the company’s costs were greatly reduced after the government told cigarette companies they couldn’t advertise on television! This is one time where there’s so much loose money around that even diworseification hasn’t hurt the shareholders.

  Philip Morris bought Miller Brewing and got mediocre results, then duplicated the feat with General Foods. Seven-Up was another disappointment, and still Philip Morris stock shot straight up. On October 30, 1988, Philip Morris announced that it had signed a definitive agreement to purchase Kraft, the packaged foods company, for $13 billion. Despite the price tag of the acquisition (which amounted to over 20 times Kraft’s 1988 earnings), the stock market took only 5% off Philip Morris’s stock price, recognizing that the company’s cash flow is so powerful it could pay off all the acquisition debt within five years. The big thing that may stop it is when the families of smoking victims start winning major lawsuit settlements.

  This company has forty years of progressively better earnings and would sell at a p/e of 15 or higher if it weren’t for the fear of lawsuits and the negative publicity about cigarette companies that keeps many investors away. It’s this sort of emotionally charged situation that favors the bargain hunters, including me. The numbers couldn’t be better. Today you can still buy this champion growth company at a p/e of 10, or half its growth rate.

  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:

  At the beginning of our exercise, Company A is selling for $20 a share (20 times earnings of $1), and by the end it sells for $123.80 (20 times earnings of $6.19). Company B starts out selling for $10 a share (10 times earnings of $1) and ends up selling for $26 (10 times earnings of $2.60).

  Even if the p/e ratio of Company A is reduced from 20 to 15 because investors don’t believe it can keep up its fast growth, the stock would still be selling for $92.85 at the end of the exercise. Either way, you’d rather own Company A than Company B.

  If we had given Company A a 25 percent growth rate, tenth-year earnings would have been $9.31 per share: even with a conservative 15 p/e that’s a stock price of $139. (Note that I didn’t work out the earnings for a 30 percent growth rate or higher. That level of growth is very difficult to sustain for three years, much less ten.)

  This in a nutshell is the key to the bigbaggers, and why stocks of 20-percent growers produce huge gains in the market, especially over a number of years. It’s no accident that the Wal-Marts and The Limiteds can go up so much in a decade. It’s all based on the arithmetic of compounded earnings.

  THE BOTTOM LINE

  Everywhere you turn these days you hear some reference to the “bottom line.” “What’s the bottom line?” is a common refrain in sports, business deals, and even courtship. So what is the real bottom line? It’s the final number at the end of an income statement: profit after taxes.

  Corporate profitability tends to be misunderstood by many in our society. In a survey I once saw, college students and other young adults were asked to guess the average profit margin on the corporate dollar. Most guessed 20–40 percent. In the last few decades the actual answer has been closer to 5 percent.

  Profit before taxes, also known as the pretax profit margin, is a tool I use in analyzing companies. That’s what’s left of a company’s annual sales dollar after all the costs, including depreciation and interest expenses, have been deducted. In 1987, Ford Motor had sales of $71.6 billion and earned $7.38 billion pretax, for a pretax profit margin of 10.3 percent. Retailers have lower profit margins than manufacturers—an outstanding supermarket and drugstore chain such as Albertson’s still earns only 3.6 percent pretax. On the other hand, companies that make highly profitable drugs, such as Merck, routinely make 25 percent pretax or better.

  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.

  Let’s say that Company A earns 12 percent pretax and Company B earns only 2 percent. Suppose there’s a business slowdown and both companies are forced to slash prices 10 percent to sell their merchandise. Sales drop by the same 10 percent. Company A is now earning 2 percent pretax and is still profitable, while Company B has fallen into the red with an 8 percent loss. It’s headed for the endangered species list.

  Without getting bogged down in the technicalities, 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 th
e 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. It happens again and again in the auto, chemical, paper, airline, steel, electronics, and nonferrous metals industries. The same potential exists in such currently depressed industries as nursing homes, natural gas producers, and many retailers.

  What you want, then, is a relatively high profit-margin in a long-term stock that you plan to hold through good times and bad, and a relatively low profit-margin in a successful turnaround.

  14

  Rechecking the Story

  Every few months it’s worthwhile to recheck the company story. This may involve reading the latest Value Line, or the quarterly report, and inquiring about the earnings and whether the earnings are holding up as expected. It may involve checking the stores to see that the merchandise is still attractive, and that there’s an aura of prosperity. Have any new cards turned over? With fast growers, especially, you have to ask yourself what will keep them growing.

  There are three phases to a growth company’s life: the start-up phase, during which it works out the kinks in the basic business; the rapid expansion phase, during which it moves into new markets; and the mature phase, also known as the saturation phase, when it begins to prepare for the fact that there’s no easy way to continue to expand. Each of these phases may last several years. The first phase is the riskiest for the investor, because the success of the enterprise isn’t yet established. The second phase is the safest, and also where the most money is made, because the company is growing simply by duplicating its successful formula. The third phase is the most problematic, because the company runs into its limitations. Other ways must be found to increase earnings.

  As you periodically recheck the stock, you’ll want to determine whether the company seems to be moving from one phase into another. If you look at Automatic Data Processing, the company that processes paychecks, you see that they haven’t even begun to saturate the market, so Automatic Data Processing is still in phase two.

  When Sensormatic was expanding its shoplifting detection system into store after store (the second phase), the stock went from $2 to $40, but eventually it reached the limit—no new stores to approach. The company was unable to think of new ways to maintain its momentum, and the stock fell from $42½ in 1983 to a low of $5⅝ in 1984. As you saw this time approaching, you needed to find out what the new plan was, and whether it had a realistic chance to succeed.

  When Sears had reached every major metropolitan area, where else could it go? When The Limited had positioned itself in 670 of the 700 most popular malls in the country, then The Limited finally was.

  At that point The Limited could only grow by luring more customers to its existing stores, and the story had begun to change. When The Limited bought Lerner and Lane Bryant, you got the feeling that the fast growth was over, and that the company didn’t really know what to do with itself. In the second phase it would have invested all its money in its own expansion.

  As soon as there’s a Wendy’s next door to every McDonald’s, the only way Wendy’s can grow is by winning over the McDonald’s customers. Where can Anheuser-Busch grow if it already has captured 40 percent of the beer-drinking market? Even Spuds MacKenzie the party dog can’t convince 100 percent of the nation to drink Bud, and at least a minority of brave souls is going to refuse to order Bud Light, even if they are zapped by lasers or abducted by aliens. Sooner or later Anheuser-Busch is going to slow down, and the stock price and the p/e multiple will both shrink accordingly.

  Or perhaps Anheuser-Busch will think of new ways to grow, the same way McDonald’s has. A decade ago investors began worrying that McDonald’s incredible expansion was a thing of the past. Everywhere you looked, there seemed to be a McDonald’s franchise, and sure enough the p/e ratio has been compressed from the 30 p/e of a fast grower down to the 12 p/e of a stalwart. But in spite of that vote of no confidence (the stock went sideways from ’72 to ’82), the earnings have been very strong. McDonald’s has maintained its growth in imaginative ways.

  First, they installed the drive-in windows, which now account for over one-third of the business. Then there was breakfast, which added a whole new dimension to sales, and at a time when the building would otherwise have been empty. Adding breakfast expanded restaurant sales by over 20 percent at very low cost. Then there were salads, and chicken, both of which added to earnings and also ended the company’s dependence on the beef market. People assume that if beef prices go up, McDonald’s will get clobbered—but they’re talking about the old McDonald’s.

  As the construction of new franchises slows down, McDonald’s has proven it can grow within its existing walls. It’s also expanding rapidly in foreign countries, and it will be decades before there’s a McDonald’s on every street corner in England or in Germany. In spite of the lower p/e ratio, it’s not all over for McDonald’s.

  If you bought just about any company in the cable industry, you would have seen a series of growth spurts: first, from the rural installations; second, from pay services such as HBO, Cinemax, the Disney channel, etc.; third, from the urban installations; fourth, from the royalties from programs such as Home Shopping Network (cable gets a cut for every item sold); and lately from the introduction of paid advertising, which has a huge future profit potential. The basic story gets better and better.

  Texas Air is an example of a story that got worse, then better, then worse again in a matter of five years. I took a small position in the stock in mid-1983, only to watch the company’s principal asset, Continental Air, deteriorate and file for Chapter 11. Texas Air stock fell from $12 to $4¾, and Continental stock, in which Texas Air held the majority position, fell to $3. I kept a close eye on the situation as a potential turnaround. Texas Air cut costs; Continental won back its customers and returned from the accountant’s graveyard. On the strength of their improvement, I built up a large holding in both companies. By 1986 both stocks had tripled.

  In February, 1986, Texas Air announced it had purchased a large share of Eastern Airlines—also viewed as a favorable development. In a single year Texas Air stock tripled once again to a high of $51½, making it a tenbagger since it solved its problems in 1983.

  At this point my concern over the company’s outlook unfortunately turned to complacency, and because the potential earning power of Eastern and Texas Air was so terrific, I forgot to pay attention to the near-term realities. When Texas Air bought out the remaining Continental shares, I was forced to cash in over half of my position in Continental stock and some bonds convertible to Continental stock. It was a stroke of fortune, and I made a tidy profit. But instead of selling my remaining Texas Air shares and making a happy exit from the whole situation, I actually bought more shares at $48¼ in February, 1987. Given Texas Air’s mediocre balance sheet (total debt from all the various airlines was probably greater than that of several underdeveloped countries), and given that airlines are a precarious cyclical industry, why was I buying and not selling? I got blindsided because the stock price was going up. I fell for the latest, improved Texas Air story even when the fundamentals were falling apart.

  The new, improved story was as follows: Texas Air was benefiting from a leaner operation and sharply reduced labor costs. In addition to its interest in Eastern, it had just bought Frontier Air and People’s Express and planned to revive them in the same way it had revived Continental. The concept was great: acquire failed airlines, cut costs, and big profits would naturally follow.

  What happened? Like Don Quixote, I was so enamored of the promise that I forgot to notice I was riding a nag. I focused on the predictions of $15 per share earnings for Texas Air in 1988, ignoring the warning signs that appeared every day in the newspaper: lost bags, botched schedu
les, delayed arrivals, angry customers, and disgruntled employees at Eastern.

  An airline is a precarious business, the same as a restaurant. A few bad nights in a restaurant can ruin a fine reputation that took fifty years to develop. Eastern and Continental were having more than a few bad nights. The various parts didn’t fit together smoothly. The grumblings at Eastern were symptoms of a bitter rift between management and the various unions over wages and benefits. The unions fought back hard.

  Earnings at Texas Air started to deteriorate early in 1987. The idea was to cut $400 million out of Eastern’s operating costs, but I should have reminded myself that it hadn’t happened yet, and that there was a substantial likelihood that it would never occur. The existing labor contract didn’t expire for several months, and meanwhile both sides were at loggerheads. Finally I came to my senses and started selling the stock at $17–18 a share. It fell to $9 by the end of 1987. I still own some shares, and I’m going to stay tuned.

  Not only did I make a mistake by not cutting back on Texas Air in the summer of 1987, when the severe problems with Eastern became obvious and gave every evidence of persisting into 1988, but I should also have used this fundamental information to pick another winner: Delta Airlines. Delta was Eastern’s main competitor and the greatest beneficiary of Eastern’s operating problems and plans to reduce the size of Eastern on a permanent basis. I had a modest position in Delta, but I should have made it one of my top ten holdings. The stock went from $48 to $60 during the summer of 1987. In October, it fell to $35 and was only $37 at the end of the year. By mid-1988, it had risen sharply to $55. Thousands of people who flew Eastern and Delta could have seen the same things I saw and used their amateurs’ edge.