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

by Peter Lynch

  During a lifetime of buying cars or cameras, you develop a sense of what’s good and what’s bad, what sells and what doesn’t. If it’s not cars you know something about, you know something about something else, and the most important part is, you know it before Wall Street knows it. Why wait for the Merrill Lynch restaurant expert to recommend Dunkin’ Donuts when you’ve already seen eight new franchises opening up in your area? The Merrill Lynch restaurant analyst isn’t going to notice Dunkin’ Donuts (for reasons I’ll soon explain) until the stock has quintupled from $2 to $10, and you noticed it when the stock was at $2.

  GIGGING THE GIGAHERTZ

  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.

  I heard about one such opportunity just the other day. According to a report somebody left on my desk, this was a fantastic chance to invest in a company that makes the “one megabit S-Ram, C-mos (complementary metal oxide semiconductor); bipolar risc (reduced instructive set computer), floating point, data I/O array processor, optimizing compiler, 16-bytes dual port memory, unix operating system, whetstone megaflop polysilicon emitter, high band width, six gigahertz, double metalization communication protocol, asynchronous backward compatibility, peripheral bus architecture, four-way interleaved memory and 15 nanoseconds capability.”

  Gig my gigahertz and whetstone my megaflop, if you couldn’t tell if that was a racehorse or a memory chip you should stay away from it, even though your broker will be calling to recommend it as the opportunity of the decade to make countless nanobucks.

  A POX ON THE CABBAGE PATCH

  Does that mean I think you ought to buy shares in every new fast-food franchise, every business that has a hot product, or every public company that opens an outlet in the local mall? If it were that simple, I wouldn’t have lost money on Bildner’s, the yuppie 7-Eleven right across the street from my office. If only I’d stuck to the sandwiches and not to the stock, fifty shares of which would scarcely buy you a tuna on rye. More on this later.

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

  Finding the promising company is only the first step. The next step is doing the research. The research is what helps you to sort out Toys “R” Us from Coleco, Apple Computer from Televideo, or Piedmont Airlines from People Express. Now that I mention it, I wish I’d done more checking into what was happening at People Express. Maybe then I wouldn’t have bought that one, either.

  All my failures notwithstanding, during the twelve years I’ve managed Fidelity Magellan, it has risen over twentyfold per share—partly thanks to some of the little-known and out-of-favor stocks I’ve been able to discover and then research on my own. I’m confident that any investor can benefit from the same tactics. It doesn’t take much to outsmart the smart money, which, as I’ve said, isn’t always very smart.

  This book is divided into three sections. The first, Preparing to Invest (Chapters 1 through 5), deals with how to assess yourself as a stockpicker, how to size up the competition (portfolio managers, institutional investors, and other Wall Street experts), how to evaluate whether stocks are riskier than bonds, how to examine your financial needs, and how to develop a successful stockpicking routine. The second, Picking Winners (Chapters 6 through 15), deals with how to find the most promising opportunities, what to look for in a company and what to avoid, how to use brokers, annual reports, and other resources to best advantage, and what to make of the various numbers (p/e ratio, book value, cash flow) that are often mentioned in technical evaluations of stocks. The third, The Long-term View (Chapters 16 through 20), deals with how to design a portfolio, how to keep tabs on companies in which you’ve taken an interest, when to buy and when to sell, the follies of options and futures, and some general observations about the health of Wall Street, American enterprise, and the stock market—things I’ve noticed in twenty-odd years of investing.

  Part I

  PREPARING TO INVEST

  Before you think about buying stocks, you ought to have made some basic decisions about the market, about how much you trust corporate America, about whether you need to invest in stocks and what you expect to get out of them, about whether you are a short-or long-term investor, and about how you will react to sudden, unexpected, and severe drops in price. It’s best to define your objectives and clarify your attitudes (do I really think stocks are riskier than bonds?) beforehand, because if you are undecided and lack conviction, then you are a potential market victim, who abandons all hope and reason at the worst moment and sells out at a loss. It is personal preparation, as much as knowledge and research, that distinguishes the successful stockpicker from the chronic loser. Ultimately it is not the stock market nor even the companies themselves that determine an investor’s fate. It is the investor.

  1

  The Making of a Stockpicker

  There’s no such thing as a hereditary knack for picking stocks. Though many would like to blame their losses on some inbred tragic flaw, believing somehow that others are just born to invest, my own history refutes it. There was no ticker tape above my cradle, nor did I teethe on the stock pages in the precocious way that baby Pelé supposedly bounced a soccer ball. As far as I know, my father never left the pacing area to check on the price of General Motors, nor did my mother ask about the ATT dividend between contractions.

  Only in hindsight can I report that the Dow Jones industrial average was down on January 19, 1944, the day I was born, and declined further the week I was in the hospital. Though I couldn’t have suspected it then, this was the earliest example of the Lynch Law at work. The Lynch Law, closely related to the Peter Principle, states: Whenever Lynch advances, the market declines. (The latest proof came in the summer of 1987, when just after the publisher and I reached an agreement to produce this book, a high point in my career, the market lost 1,000 points in two months. I’ll think twice before attempting to sell the movie rights.)

  Most of my relatives distrusted the stock market, and with good reason. My mother was the youngest of seven children, which meant that my aunts and uncles were old enough to have reached adulthood during the Great Depression, and to have had firsthand knowledge of the Crash of ’29. Nobody was recommending stocks around our household.

  The only stock purchase I ever heard about was the time my grandfather, Gene Griffin, bought Cities Service. He was a very conservative investor, and he chose Cities Service because he thought it was a water utility. When he took a trip to New York and discovered it was an oil company, he sold immediately. Cities Service went up fiftyfold after that.

  Distrust of stocks was the prevailing American attitude throughout the 1950s and into the 1960s, when the market tripled and then doubled again. This period of my childhood, and not the recent 1980s, was truly the greatest bull market in history, but to hear it from my uncles, you’d have thought it was the craps game behind the pool hall. “Never get involved in the market,” people warned. “It’s too risky. You’ll lose all your money.”

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

  My father, an industrious man and former mathematics professor who left academia to become the youngest senior auditor at John Hancock, got sick when I was seven and died of brain cancer when I was ten. This tragedy resulted in my mother’s having to go to work (at Ludlow Manufacturing, later acquired by Tyco Labs), and I decided to help out by getting a part-time job myself. At the age of eleven I was hired as a caddy. That was on July 7, 1955, a day the Dow Jones fell from 467 to 460.

  To an eleven-year-old who’d already discovered golf, caddying was an ideal occupation. They paid me for walking around a golf course. In one afternoon I would outearn delivery boys who tossed newspapers onto lawns at six A.M. for seven days in a row. What could be better than that?

  In high school I began to understand the subtler and more important advantages of caddying, especially at an exclusive club such as Brae Burn, outside of Boston. My clients were the presidents and CEOs of major corporations: Gillette, Polaroid, and more to the point, Fidelity. In helping D. George Sullivan find his ball, I was helping myself find a career. I’m not the only caddy who learned that the quickest route to the boardroom was through the locker room of a club like Brae Burn.

  If you wanted an education in stocks, the golf course was the next best thing to being on the floor of a major exchange. Especially after they’d sliced or hooked a drive, club members enthusiastically described their latest triumphant investment. In a single round of play I might give out five golf tips and get back five stock tips in return.

  Though I had no funds to invest in stock tips, the happy stories I heard on the fairways made me rethink the family position that the stock market was a place to lose money. Many of my clients actually seemed to have made money in the stock market, and some of the positive evidence actually trickled down to me.

  A caddy quickly learns to sort his golfers into a caste system, beginning with the rare demigods (great golfer, great person, great tipper), moving down through the so-so golfers and so-so tippers, and eventually hitting bottom with the terrible golfer, terrible person, terrible tipper—a dreaded untouchable of the links. Mostly I caddied for average golfers and average spenders, but if it came down to a choice between a bad round with a big tipper, or a great round with a bad tipper, I learned to opt for the former. Caddying reinforced the notion that it helps to have money.

  I continued to caddy throughout high school and into Boston College, where the Francis Ouimet Caddy Scholarship helped pay the bills. In college, except for the obligatory courses, I avoided science, math, and accounting—all the normal preparations for business. I was on the arts side of school, and along with the usual history, psychology, and political science, I also studied metaphysics, epistemology, logic, religion, and the philosophy of the ancient Greeks.

  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. If stockpicking could be quantified, you could rent time on the nearest Cray computer and make a fortune. But it doesn’t work that way. All the math you need in the stock market (Chrysler’s got $1 billion in cash, $500 million in long-term debt, etc.) you get in the fourth grade.

  Logic is the subject that’s helped me the most in picking stocks, if only because it taught me to identify the peculiar illogic of Wall Street. Actually Wall Street thinks just as the Greeks did. The early Greeks used to sit around for days and debate how many teeth a horse has. They thought they could figure it out by just sitting there, instead of checking the horse. A lot of investors sit around and debate whether a stock is going up, as if the financial muse will give them the answer, instead of checking the company.

  In centuries past, people hearing the rooster crow as the sun came up decided that the crowing caused the sunrise. It sounds silly now, but every day the experts confuse cause and effect on Wall Street in offering some new explanation for why the market goes up: hemlines are up, a certain conference wins the Super Bowl, the Japanese are unhappy, a trendline has been broken, Republicans will win the election, stocks are “oversold,” etc. When I hear theories like these, I always remember the rooster.

  In 1963, my sophomore year in college, I bought my first stock—Flying Tiger Airlines for $7 a share. Between the caddying and a scholarship I’d covered my tuition, living at home reduced my other expenses, and I had already upgraded myself from an $85 car to a $150 car. After all the tips that I’d had to ignore, I finally was rich enough to invest!

  Flying Tiger was no wild guess. I picked it on the basis of some dogged research into a faulty premise. In one of my classes I’d read an article on the promising future of air freight, and it said that Flying Tiger was an air freight company. That’s why I bought the stock, but that’s not why the stock went up. It went up because we got into the Vietnam War and Flying Tiger made a fortune shunting troops and cargo in and out of the Pacific.

  In less than two years Flying Tiger hit $32¾ and I had my first five-bagger. Little by little I sold it off to pay for graduate school. I went to Wharton on a partial Flying Tiger scholarship.

  If your first stock is as important to your future in finance as your first love is to your future in romance, then the Flying Tiger pick was a very lucky thing. It proved to me that the bigbaggers existed, and I was sure there were more of them from where this one had come.

  During my senior year at Boston College I applied for a summer job at Fidelity, at the suggestion of Mr. Sullivan, the president—the hapless golfer, great guy, and good tipper for whom I’d caddied. Fidelity was the New York Yacht Club, the Augusta National, the Carnegie Hall, and the Kentucky Derby. It was the Cluny of investment houses, and like that great medieval abbey to which monks were flattered to be called, what devotee of balance sheets didn’t dream of working here? There were one hundred applications for three summer positions.

  Fidelity had done such a good job selling America on mutual funds that even my mother was putting $100 a month into Fidelity Capital. That fund, run by Gerry Tsai, was one of the two famous go-go funds of this famous go-go era. The other was Fidelity Trend, run by Edward C. Johnson III, also known as Ned. Ned Johnson was the son of the fabled Edward C. Johnson II, also known as Mister Johnson, who founded the company.

  Ned Johnson’s Fidelity Trend and Gerry Tsai’s Fidelity Capital outperformed the competition by a big margin and were the envy of the industry over the period from 1958 to 1965. With these sorts of people training and supporting me, I felt as if I understood what Isaac Newton was talking about when he said: “If I have seen further...it is by standing upon the shoulders of Giants.”

  Long before Ned’s great successes, his father, Mister Johnson, had changed America’s mind about investing in stocks. Mister Johnson believed that you invest in stocks not to preserve capital, but to make money. Then you take your profits and invest in more stocks, and make even more money. “Stocks you trade, it’s wives you’re stuck with,” said the always quotable Mister Johnson. He wouldn’t have won any awards from Ms. magazine.

  I was thrilled to be hired at Fidelity, and also to be installed in Gerry Tsai’s old office, after Tsai had departed for the Manhattan Fund in New York. Of course the Dow Jones industrials, at 925 when I reported for work the first week of May, 1966, had fallen below 800 by the time I headed off to graduate school in September, just as the Lynch Law would have predicted.

  RANDOM WALK AND MAINE SUGAR

  Summer interns such as me, with no experience in corporate finance or accounting, were put to work researching companies and writing reports, the same as the regular analysts. The whole intimidating business was suddenly demystified—even liberal arts majors could analyze a stock. I was assigned to the paper and publishing industry and set out across the country to visit companies such as Sorg Paper and
International Textbook. Since the airlines were on strike, I traveled by bus. By the end of the summer the company I knew most about was Greyhound.

  After that interlude at Fidelity, I returned to Wharton for my second year of graduate school more skeptical than ever about the value of academic stock-market theory. It seemed to me that most of what I learned at Wharton, which was supposed to help you succeed in the investment business, could only help you fail. I studied statistics, advanced calculus, and quantitative analysis. Quantitative analysis taught me that the things I saw happening at Fidelity couldn’t really be happening.

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

  It also was obvious that Wharton professors who believed in quantum analysis and random walk weren’t doing nearly as well as my new colleagues at Fidelity, so between theory and practice, I cast my lot with the practitioners. It’s very hard to support the popular academic theory that the market is irrational when you know somebody who just made a twentyfold profit in Kentucky Fried Chicken, and furthermore, who explained in advance why the stock was going to rise. My distrust of theorizers and prognosticators continues to the present day.

  Some Wharton courses were rewarding, but even if they’d all been worthless, the experience would have been worth it, because I met Carolyn on the campus. (We got married while I was in the Army, on May 11, 1968, a Saturday when the market was closed, and we had a week-long honeymoon during which the Dow Jones lost 13.93 points—not that I was paying attention. This is something I looked up later.)