by Peter Lynch
15
The Final Checklist
All of this research I’ve been talking about takes a couple of hours, at most, for each stock. The more you know the better, but it isn’t imperative that you call the company. Nor do you have to study the annual report with the concentration of a Dead Sea scroll scholar. Some of the “famous numbers” apply only to specific categories of stocks and otherwise can be ignored altogether.
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. That’s the floor on the stock.
SLOW GROWERS
• Since you buy these for the dividends (why else would you own them?) 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. Cars get older and they have to be replaced. People can put off replacing cars for a year or two longer than expected, but sooner or later they are back in the dealerships.
The worse the slump in the auto industry, the better the recovery. Sometimes I root for an extra year of bad sales, because I know it will bring a longer and more sustainable upside.
Lately we’ve had five years of good car sales, so I know we are in the middle, and perhaps somewhere close to the end, of a prosperous cycle. But 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. It was with L’eggs, but not with Lexan.
• 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. When I first visited Pic ’N’ Save, they were established in southern California and were just beginning to talk about expanding into northern California. There were forty-nine other states to go. Sears, on the other hand, is everywhere.
• 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). For stocks of companies such as Sensormatic Electronics, whose sales are primarily “one-shot” deals—as opposed to razor blades, which customers have to keep on buying—a slowdown in growth can be devastating. Sensormatic’s growth rate was spectacular in the late seventies and early eighties, but to increase earnings they had to sell more new systems each year than they had sold the year before. The revenue from the basic electronic surveillance system (the one-time purchase) far overshadowed whatever they got from selling those little white tags to their established customers. So, in 1983, when the rate of growth slowed, earnings didn’t just slow, they dived. And so did the stock, from $42 to $6 in twelve months.
• 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, so once again you knew it wasn’t going out of business.)
What is the debt structure, and how long can it operate in the red while working out its problems without going bankrupt? (International Harvester—now Navistar—was a potential turnaround that has disappointed investors, because the company printed and sold millions of new shares to raise capital. This dilution resulted in the company’s having turned around, but not the stock.)
• 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? This can make a big difference in earnings. For example, in 1980 Lockheed earned $8.04 per share from its defense business, but it lost $6.54 per share in its commercial aviation division because of its L-1011 TriStar passenger jet. The L-1011 was a great airplane, but it suffered from competition with McDonnell Douglas’s DC10 in a relatively small market. And in the long-distance market, it was getting killed by the 747. These losses were persistent, and in December, 1981, the company announced that it would phase out the L-1011. This resulted in a large write-off in 1981 ($26 per share), but it was a one-time loss. In 1982, when Lockheed earned $10.78 per share from defense, there were no more losses to deal with. Earnings had gone from $1.50 to $10.78 per share in two years! You could have bought Lockheed for $15 at the time of the L-1011 announcement. Within four years it hit $60, for a fourbagger.
Texas Instruments was another classic turnaround. In October, 1983, the company announced it would leave the home-computer business (another hot industry with too many competitors). It had lost over $500 million from home computers in that year alone. Again, the decision made for big write-offs, but it meant that the company could concentrate on its strong semiconductor and defense-electronics businesses. The day after the announcement, TI stock spurted from $101 to $124. And four months later it was $176.
Time also has sold off divisions and dramatically cut costs. It is one of my favorite recent turnarounds. Actually it’s an asset play as well. The cable-TV part of the busine
ss is potentially worth $60 a share, so if the stock sells for $100, you’re buying the rest of the company for $40.
• Is business coming back? (This is what’s happening at Eastman Kodak, which has benefited from the new boom in film sales.)
• Are costs being cut? If so, what will the effect be? (Chrysler cut costs drastically by closing plants. It also began to farm out the making of a lot of the parts it used to make itself, saving hundreds of millions in the process. It went from being one of the highest-cost producers of automobiles to one of the lowest.
The turnaround in Apple Computer was harder to predict. However, if you’d been close to the company, you might have noticed the surge in sales, the cost-cutting, and the appeal of the new products, which all came at once.)
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?
Here are some pointers from this section:
• 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.
• Separate all stock tips from the tipper, even if the tipper is very smart, very rich, and his or her last tip went up.
• 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
In this section I add my two cents to important matters such as how to design a portfolio to maximize gain and minimize risk; when to buy and when to sell; what to do when the market collapses; some silly and dangerous misconceptions about why stocks go up and down; the pitfalls of gambling on options, futures, and the shorting of stocks; and finally what’s new, old, exciting, and perturbing about companies and the stock market today.
16
Designing a Portfolio
I’ve heard people say they’d be satisfied with a 25 or 30 percent annual return from the stock market! Satisfied? At that rate they’d soon own half the country along with the Japanese and the Bass brothers. Even the tycoons of the twenties couldn’t guarantee themselves 30 percent forever, and Wall Street was rigged in their favor.
In certain years you’ll make your 30 percent, but there will be other years when you’ll only make 2 percent, or perhaps you’ll lose 20. That’s just part of the scheme of things, and you have to accept it.
What’s wrong with high expectations? If you expect to make 30 percent year after year, you’re more likely to get frustrated at stocks for defying you, and your impatience may cause you to abandon your investments at precisely the wrong moment. Or worse, you may take unnecessary risks in the pursuit of illusory payoffs. It’s only by sticking to a strategy through good years and bad that you’ll maximize your long-term gains.
If 25 to 30 percent isn’t a realistic return, then what is? Certainly you ought to do better in stocks than you’d do in bonds, so to make 4, 5, or 6 percent on your stocks over a long period of time is terrible. If you review your long-term record and find that your stocks have scarcely out-performed your savings account, then you know your technique is flawed.
By the way, when you are figuring out how you’re doing in stocks, don’t forget to include all the costs of subscriptions to newsletters, financial magazines, commissions, investment seminars, and long-distance calls to brokers.
Nine to ten percent a year is the generic long-term return for stocks, the historic market average. You can get ten percent, over time, by investing in a no-load mutual fund that buys all 500 stocks in the S&P 500 Index, thus duplicating the average automatically. That this return can be achieved without your having to do any homework or spending any extra money is a useful benchmark against which you can measure your own performance, and also the performance of the managed equity funds such as Magellan.
If professionals who are employed to pick stocks can’t outdo the index funds that buy everything at large, then we aren’t earning our keep. But give us a chance. First consider the kind of fund you’ve invested in. The best managers in the world won’t do well with a gold-stock fund when gold prices are dropping. Nor is it fair to judge a fund for a single year’s performance. But if after three to five years or so you find that you’d be just as well off if you’d invested in the S&P 500, then either buy the S&P 500 or look for a managed equity fund with a better record. For all the time and effort it takes to choose individual stocks, there ought to be some extra gain from it.
Given all these convenient alternatives, to be able to say that picking your own stocks is worth the effort, you ought to be getting a 12–15 percent return, compounded over time. That’s after all the costs and commissions have
been subtracted, and all dividends and other bonuses have been added.
Here’s another place where the person who holds on to stocks is far ahead of the person who frequently trades in and out. It costs the small investor a lot of money to trade in and out. Trading is cheaper than it used to be, thanks to the discount commissions and also to a modification in the so-called odd-lot surcharge—the extra fee tacked on to transactions of less than 100 shares. (Now if you put in your odd-lot order before the market opens, your shares are pooled with those of other odd-lotters and you all avoid the surcharge.) Even so, it still costs between one and two percent for Houndstooth to buy or sell a stock.
So if Houndstooth turns over the portfolio once a year, he’s lost as much as four percent to commissions. This means he’s four percent in the hole before he starts. So to get his 12–15 percent after expenses, he’s going to have to make 16–19 percent from picking stocks. And the more he trades, the harder it’s going to be to outperform the index funds or any other funds. (The newer “families” of funds may charge you a 3–8½ percent fee to join, but that’s the end of it, and from then on you can switch from stocks to bonds to money-market funds and back again without ever paying another commission.)
All these pitfalls notwithstanding, the individual investor who manages to make, say, 15 percent over ten years when the market average is 10 percent has done himself a considerable favor. If he started with $10,000, a 15 percent return will bring a $40,455 result, and a 10 percent return only $25,937.
HOW MANY STOCKS IS TOO MANY?
How do you design a portfolio to get that 12–15 percent return? How many stocks should you own? Right away I can tell you this: Don’t own 1,400 stocks if you can help it, but that’s my problem and not yours. You don’t have to worry about the 5-percent rule and the 10-percent rule and the $9 billion to manage.
