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

by Peter Lynch

  After that, the survivors of the fire came down out of the trees and ran as far away from woods as possible. They built new houses out of stone, particularly along a craggy fissure. Soon enough, the world was destroyed by an earthquake. I don’t remember the fourth bad thing that happened—maybe a recession—but whatever it was, the Mayans were going to miss it. They were too busy building shelters for the next earthquake.

  Two thousand years later we’re still looking backward for signs of the upcoming menace, but that’s only if we can decide what the upcoming menace is. Not long ago, people were worried that oil prices would drop to $5 a barrel and we’d have a depression. Two years before that, those same people were worried that oil prices would rise to $100 a barrel and we’d have a depression. Once they were scared that the money supply was growing too fast. Now they’re scared that it’s growing too slow. The last time we prepared for inflation we got a recession, and then at the end of the recession we prepared for more recession and we got inflation.

  Someday there will be another recession, which will be very bad for the stock market, as opposed to the inflation that is also very bad for the stock market. Maybe there will already have been a recession between now and the time this is published. Maybe we won’t get one until 1990, or 1994. You’re asking me?

  THE COCKTAIL THEORY

  If professional economists can’t predict economies and professional forecasters can’t predict markets, then what chance does the amateur investor have? You know the answer already, which brings me to my own “cocktail party” theory of market forecasting, developed over years of standing in the middle of living rooms, near punch bowls, listening to what the nearest ten people said about stocks.

  In the first stage of an upward market—one that has been down awhile and that nobody expects to rise again—people aren’t talking about stocks. In fact, if they lumber up to ask me what I do for a living, and I answer, “I manage an equity mutual fund,” they nod politely and wander away. If they don’t wander away, then they quickly change the subject to the Celtics game, the upcoming elections, or the weather. Soon they are talking to a nearby dentist about plaque.

  When ten people would rather talk to a dentist about plaque than to the manager of an equity mutual fund about stocks, it’s likely that the market is about to turn up.

  In stage two, after I’ve confessed what I do for a living, the new acquaintances linger a bit longer—perhaps long enough to tell me how risky the stock market is—before they move over to talk to the dentist. The cocktail party talk is still more about plaque than about stocks. The market’s up 15 percent from stage one, but few are paying attention.

  In stage three, with the market up 30 percent from stage one, a crowd of interested parties ignores the dentist and circles around me all evening. A succession of enthusiastic individuals takes me aside to ask what stocks they should buy. Even the dentist is asking me what stocks he should buy. Everybody at the party has put money into one issue or another, and they’re all discussing what’s happened.

  In stage four, once again they’re crowded around me—but this time it’s to tell me what stocks I should buy. Even the dentist has three or four tips, and in the next few days I look up his recommendations in the newspaper and they’ve all gone up. When the neighbors tell me what to buy and then I wish I had taken their advice, it’s a sure sign that the market has reached a top and is due for a tumble.

  Do what you want with this, but don’t expect me to bet on the cocktail party theory. I don’t believe in predicting markets. I believe in buying great companies—especially companies that are undervalued, and/or underappreciated. Whether the Dow Jones industrial average was at 1,000 or 2,000 or 3,000 points today, you’d be better off having owned Marriott, Merck, and McDonald’s than having owned Avon Products, Bethlehem Steel, and Xerox over the last ten years. You’d also be better off having owned Marriott, Merck, or McDonald’s than if you’d put the money into bonds or money-market funds over the same period.

  If you had bought stocks in great companies back in 1925 and held on to them through the Crash and into the Depression (admittedly this wouldn’t have been easy), by 1936 you would have been very pleased at the results.

  WHAT STOCK MARKET?

  The market ought to be irrelevant. If I could convince you of this one thing, I’d feel this book had done its job. And if you don’t believe me, believe Warren Buffett. “As far as I’m concerned,” Buffett has written, “the stock market doesn’t exist. It is there only as a reference to see if anybody is offering to do anything foolish.”

  Buffett has turned his Berkshire Hathaway into an extraordinarily profitable enterprise. In the early 1960s it cost $7 to buy a share in his great company, and that same share is worth $4,900 today. A $2,000 investment in Berkshire Hathaway back then has resulted in a 700-bagger that’s worth $1.4 million today. That makes Buffett a wonderful investor. What makes him the greatest investor of all time is that during a certain period when he thought stocks were grossly overpriced, he sold everything and returned all the money to his partners at a sizable profit to them. The voluntary returning of money that others would gladly pay you to continue to manage is, in my experience, unique in the history of finance.

  I’d love to be able to predict markets and anticipate recessions, but since that’s impossible, I’m as satisfied to search out profitable companies as Buffett is. I’ve made money even in lousy markets, and vice versa. Several of my favorite tenbaggers made their biggest moves during bad markets. Taco Bell soared through the last two recessions. The only down year in the stock market in the eighties was 1981, and yet it was the perfect time to buy Dreyfus, which began its fantastic march from $2 to $40, the twentybagger that yours truly managed to miss.

  Just for the sake of argument, let’s say you could predict the next economic boom with absolute certainty, and you wanted to profit from your foresight by picking a few high-flying stocks. You still have to pick the right stocks, just the same as if you had no foresight.

  If you knew there was going to be a Florida real estate boom and you picked Radice out of a hat, you would have lost 95 percent of your investment. If you knew there was a computer boom and you picked Fortune Systems without doing any homework, you’d have seen it fall from $22 in 1983 to $1⅞ in 1984. If you knew the early 1980s was bullish for airlines, what good would it have done if you’d invested in People Express (which promptly bought the farm) or Pan Am (which declined from $9 in 1983 to $4 in 1984 thanks to inept management)?

  Let’s say you knew that steel was making a comeback, and so you took a list of steel stocks, taped it to a dart board, and threw a dart at LTV. LTV declined from $26½ to $1⅛ between 1981 and 1986, roughly the period in which Nucor, a company in the same industry, rose from $10 to $50. (I owned both, so why did I sell my Nucor and hold on to my LTV? I might as well have thrown darts, too.)

  In case after case the proper picking of markets would have resulted in your losing half your assets because you’d picked the wrong stocks. If you rely on the market to drag your stock along, then you might as well take the bus to Atlantic City and bet on red or black. If you wake up in the morning and think to yourself, “I’m going to buy stocks because I think the market is going up this year,” then you ought to pull the phone out of the wall and stay as far away as possible from the nearest broker. You’re relying on the market to bail you out, and chances are, it won’t.

  If you want to worry about something, worry about whether the sheet business is getting better at West Point-Pepperell, or whether Taco Bell is doing well with its new burrito supreme. Pick the right stocks and the market will take care of itself.

  That’s not to say there isn’t such a thing as an overvalued market, but there’s no point worrying about it. The way you’ll know when the market is overvalued is when you can’t find a single company that’s reasonably priced or that meets your other criteria for investment. The reason Buffett returned his partners’ money was that he said he couldn�
��t find any stocks worth owning. He’d looked over hundreds of individual companies and found not one he’d buy on the fundamental merits.

  The only buy signal I need is to find a company I like. In that case, it’s never too soon nor too late to buy shares.

  What I hope you’ll remember most from this section are the following points:

  • Don’t overestimate the skill and wisdom of professionals.

  • Take advantage of what you already know.

  • Look for opportunities that haven’t yet been discovered and certified by Wall Street—companies that are “off the radar scope.”

  • Invest in a house before you invest in a stock.

  • Invest in companies, not in the stock market.

  • Ignore short-term fluctuations.

  • Large profits can be made in common stocks.

  • Large losses can be made in common stocks.

  • Predicting the economy is futile.

  • Predicting the short-term direction of the stock market is futile.

  • The long-term returns from stocks are both relatively predictable and also far superior to the long-term returns from bonds.

  • Keeping up with a company in which you own stock is like playing an endless stud-poker hand.

  • Common stocks aren’t for everyone, nor even for all phases of a person’s life.

  • The average person is exposed to interesting local companies and products years before the professionals.

  • Having an edge will help you make money in stocks.

  • In the stock market, one in the hand is worth ten in the bush.

  Part II

  PICKING WINNERS

  In this section we’ll discuss how to exploit an edge, how to find the most promising investments, how to evaluate what you own and what you can expect to gain in each of six different categories of stocks, the characteristics of the perfect company, the characteristics of companies that should be avoided at all costs, the importance of earnings to the eventual success or failure of any stock, the questions to ask in researching a stock, how to monitor a company’s progress, how to get the facts, and how to evaluate the important benchmarks, such as cash, debt, price/earning ratios, profit margins, book value, dividends, etc.

  6

  Stalking the Tenbagger

  The best place to begin looking for the tenbagger is close to home—if not in the backyard then down at the shopping mall, and especially wherever you happen to work. With most of the tenbaggers already mentioned—Dunkin’ Donuts, The Limited, Subaru, Dreyfus, McDonald’s, Tambrands, and Pep Boys—the first sips of success were apparent at hundreds of locations across the country. The fireman in New England, the customers in central Ohio where Kentucky Fried Chicken first opened up, the mob down at Pic ’N’ Save, all had a chance to say, “This is great; I wonder about the stock,” long before Wall Street got its original clue.

  The average person comes across a likely prospect two or three times a year—sometimes more. Executives at Pep Boys, clerks at Pep Boys, lawyers and accountants, suppliers of Pep Boys, the firm that did the advertising, sign painters, building contractors for the new stores, and even the people who washed the floors all must have observed Pep Boys’ success. Thousands of potential investors got this “tip,” and that doesn’t even count the hundreds of thousands of customers.

  At the same time, the Pep Boys employee who buys insurance for the company could have noticed that insurance prices were going up—which is a good sign that the insurance industry is about to turn around—and so maybe he’d consider investing in the insurance suppliers. Or maybe the Pep Boys building contractors noticed that cement prices had firmed, which is good news for the companies that supply cement.

  All along the retail and wholesale chains, people who make things, sell things, clean things, or analyze things encounter numerous stockpicking opportunities. In my own business—the mutual-fund industry—the salesmen, clerks, secretaries, analysts, accountants, telephone operators, and computer installers, all could scarcely have overlooked the great boom of the early 1980s that sent mutual-fund stocks soaring.

  You don’t have to be a vice president at Exxon to sense the growing prosperity in that company, or a turnaround in oil prices. You can be a roustabout, a geologist, a driller, a supplier, a gas-station owner, a grease monkey, or even a client at the gas pumps.

  You don’t have to work in Kodak’s main office to learn that the new generation of inexpensive, easy-to-use, high-quality 35mm cameras from Japan is reviving the photo industry, and that film sales are up. You could be a film salesman, the owner of a camera store, or a clerk in a camera store. You could also be the local wedding photographer who notices that five or six relatives are taking unofficial pictures at weddings and making it harder for you to get good shots.

  You don’t have to be Steven Spielberg to know that some new blockbuster, or string of blockbusters, is going to give a significant boost to the earnings of Paramount or Orion Pictures. You could be an actor, an extra, a director, a stuntman, a lawyer, a gaffer, the makeup person, or the usher at a local cinema, where the standing-room-only crowds six weeks in a row inspire you to investigate the pros and cons of investing in Orion’s stock.

  Maybe you’re a teacher and the school board chooses your school to test a new gizmo that takes attendance, saving the teachers thousands of wasted hours counting heads. “Who makes this gizmo?” is the first question I’d ask.

  How about Automatic Data Processing, which processes nine million paychecks a week for 180,000 small and medium-sized companies? This has been one of the all-time great opportunities: The company went public in 1961 and has increased earnings every year without a lapse. The worst it ever did was to earn 11 percent more than the previous year, and that was during the 1982–83 recession when many companies reported losses.

  Automatic Data Processing sounds like the sort of high-tech enterprise I try to avoid, but in reality it’s not a computer company. It uses computers to process paychecks, and users of technology are the biggest beneficiaries of high-tech. As competition drives down the price of computers, a firm such as Automatic Data can buy the cheaper equipment, so its costs are continually reduced. This only adds to profits.

  Without fanfare, this mundane enterprise that came public at six cents a share (adjusted for splits) now sells for $40—a 600-bagger long-term. It got as high as $54 before the October stumble. The company has twice as much cash as debt and shows no sign of slowing down.

  The officers and employees of 180,000 client firms could certainly have known about the success of Automatic Data Processing, and since many of Automatic Data’s biggest and best customers are major brokerage houses, so could half of Wall Street.

  So often we struggle to pick a winning stock, when all the while a winning stock has been struggling to pick us.

  THE TENBAGGER IN ULCERS

  Can’t think of any such opportunity in your own life? What if you’re retired, live ten miles from the nearest traffic light, grow your own food, and don’t have a television set? Well, maybe one day you have to go to a doctor. The rural existence has given you ulcers, which is the perfect introduction to SmithKline Beckman.

  Hundreds of doctors, thousands of patients, and millions of friends and relatives of patients heard about the wonder drug Tagamet, which came on the market in 1976. So did the pharmacist who dispensed the pills and the delivery boy who spent half his workday delivering them. Tagamet was a boon for the afflicted, and a bonanza for investors.

  A great patients’ drug is one that cures an affliction once and for all, but a great investor’s drug is one that the patient has to keep buying. Tagamet was one of the latter. It provided fantastic relief from the suffering from ulcers, and the direct beneficiaries had to keep taking it again and again, making indirect beneficiaries out of the shareholders of Smith-Kline Beckman, the makers of Tagamet. Thanks largely to Tagamet, the stock rose from $7½ a share in 1977 to $72 a share at the 1987 high.

/>   These users and prescribers had a big lead on the Wall Street talent. No doubt some of the oxymorons suffered from ulcers themselves—this is an anxious business—but SmithKline must not have been included on their buy lists, because it was a year before the stock began its ascent. During the testing period for the drug, 1974–76, the price climbed from around $4 to $7, and when the government approved Tagamet in 1977, the stock sold for $11. From there it shot up to $72 (see chart).*

  Then if you missed Tagamet, you had a second chance with Glaxo and its own wonder drug for ulcers—Zantac. Zantac went through testing in the early eighties and got its U.S. approval in 1983. Zantac was just as well-received as Tagamet, and just as profitable to Glaxo. In mid-1983 Glaxo’s stock sold for $7.50 and moved up to $30 in 1987.

  Did the doctors who prescribed Tagamet and Zantac buy shares in SmithKline and Glaxo? Somehow I doubt that many did. It’s more likely that the doctors were fully invested in oil stocks. Perhaps they heard that Union Oil of California was a takeover candidate. Meanwhile, the Union Oil executives were probably buying drug stocks, especially the hot issues like American Surgery Centers, which sold for $18.50 in 1982 and fell to 5 cents.

  In general, if you polled all the doctors, I’d bet only a small percentage would turn out to be invested in medical stocks, and more would be invested in oil; and if you polled the shoe-store owners, more would be invested in aerospace than in shoes, while the aerospace engineers are more likely to dabble in shoe stocks. Why it is that stock certificates, like grasses, are always greener in somebody else’s pasture I’m not sure.