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

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One Up on Wall Street: How to Use What You Already Know to Make Money In Page 11

by Peter Lynch


  Perhaps a winning investment seems so unlikely in the first place that people can best imagine it happening as far away as possible, somewhere off in the Great Beyond, just as we all imagine that perfect behavior takes place in heaven and not on earth. Therefore the doctor who understands the ethical drug business inside out is more comfortable investing in Schlumberger, an oil-service company about which he knows nothing; while the managers of Schlumberger are likely to own Johnson & Johnson or American Home Products.

  True, true. You don’t necessarily have to know anything about a company for its stock to go up. But the important point is that (1) the oil experts, on average, are in a better position than doctors to decide when to buy or to sell Schlumberger; and (2) the doctors, on average, know better than oil experts when to invest in a successful drug. The person with the edge is always in a position to outguess the person without an edge—who after all will be the last to learn of important changes in a given industry.

  The oilman who invests in SmithKline because his broker suggests it won’t realize that patients have abandoned Tagamet and switched to a rival ulcer drug until the stock is down 40 percent and the bad news has been fully “discounted” in the price. “Discounting” is a Wall Street euphemism for pretending to have anticipated surprising developments.

  On the other hand, the oilman will be among the earliest to observe the telltale signs of revival in the oil patch, a revival that will inspire Schlumberger’s eventual comeback.

  Though people who buy stocks about which they are ignorant may get lucky and enjoy great rewards, it seems to me they are competing under unnecessary handicaps, just like the marathon runner who decides to stake his reputation on a bobsled race.

  THE DOUBLE EDGE

  Here we’ve been talking about the oil executive and his knowledge, and lumping him and it together in the same chapter with the knowledge of the customers in the checkout line at Pep Boys. Of course it’s absurd to contend that the one is equal to the other. One is a professional’s understanding of the workings of an industry; the other is a consumer’s awareness of a likable product. Both are useful in picking stocks, but in different ways.

  The professional’s edge is especially helpful in knowing when and when not to buy shares in companies that have been around awhile, especially those in the so-called cyclical industries. If you work in the chemical industry, then you’ll be among the first to realize that demand for polyvinyl chloride 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. All this means higher profits for existing companies that make the product.

  Or if you own a Goodyear tire store and suddenly after three years of sluggish sales you notice that you can’t keep up with new orders, you’ve just received a strong signal that Goodyear may be on the rise. You already know that Goodyear’s new high-performance tire is the best. You call up your broker and ask for the latest background information on the tire company, instead of waiting for the broker to call to tell you about Wang Laboratories.

  Unless you work in some job that’s related to computers, what good is a Wang tip to you? What could you possibly know that thousands of other people don’t know a lot better? If the answer is “nada,” then you haven’t got an edge in Wang. But if you sell tires, make tires, or distribute tires, you’ve got an edge in Goodyear. All along the supply lines of the manufacturing industry, people who make things and sell things encounter numerous stockpicking opportunities.

  It might be a service industry, the property-casualty insurance business, or even the book business where you can spot a turnaround. Buyers and sellers of any product notice shortages and gluts, price changes and shifts in demand. Such information isn’t very valuable in the auto industry, since car sales are reported every ten days. Wall Street is obsessed with cars. But in most other endeavors the grassroots observer can spot a turnaround six to twelve months ahead of the regular financial analysts. This gives an incredible head start in anticipating an improvement in earnings—and earnings, as you’ll see, make stock prices go higher.

  It doesn’t have to be a turnaround in sales that gets your attention. It may be that companies you know about have incredible hidden assets that don’t show up on the balance sheet. If you work in real estate, maybe you know that a department store chain owns four city blocks in downtown Atlanta, carried on the books at pre– Civil War prices. This is a definite hidden asset, and similar opportunities might be found in gold, oil, timberland, and TV stations.

  You’re looking for a situation where the value of the assets per share exceeds the price per share of the stock. In such delightful instances you can truly buy a great deal of something for nothing. I’ve done it myself numerous times.

  Thousands of employees of Storer Communications and its affiliates, plus countless others who work in cable TV or network TV, could have figured out that Storer’s TV and cable properties were valued at $100 per share, while the stock was selling for $30. Executives knew this, programmers could have known it, cameramen could have known it, and even the people who come around to hook up the cable to the house could have known it. All any of them had to do was buy Storer at $30 or $35 or $40 or $50 and wait for the Wall Street experts to figure it out. Sure enough, Storer was taken private in late 1985 at $93.50 a share—which by 1988 turned out to have been a bargain price.

  I could go on for the rest of the book about the edge that being in a business gives the average stockpicker. On top of that, there’s the consumer’s edge that’s helpful in picking out the winners from the newer and smaller fast-growing companies, especially in the retail trades. Whichever edge applies, the exciting part is that you can develop your own stock detection system outside the normal channels of Wall Street, where you’ll always get the news late.

  MY WONDERFUL EDGE

  Who could have had a greater advantage than yours truly, sitting in an office at Fidelity during the boom in financial services and in the mutual funds? This was my chance to make up for missing Pebble Beach. Perhaps I can be forgiven for that incredible asset play. Golf and sailing are my summer hobbies, but mutual funds are my regular business.

  I’d been coming to work here for nearly two decades. I know half the officers in the major financial-service companies, I follow the daily ups and downs, and I could notice important trends months before the analysts on Wall Street. You couldn’t have been more strategically placed to cash in on the bonanza of the early 1980s.

  The people who print prospectuses must have seen it—they could hardly keep up with all the new shareholders in the mutual funds. The sales force must have seen it as they crisscrossed the country in their Winnebagos and returned with billions in new assets. The maintenance services must have seen the expansion in the offices at Federated, Franklin, Dreyfus, and Fidelity. The companies that sold mutual funds prospered as never before in their history. The mad rush was on.

  Fidelity isn’t a public company, so you couldn’t invest in the rush here. But what about Dreyfus? Want to see a chart that doesn’t stop? The stock sold for 40 cents a share in 1977, then nearly $40 a share in 1986, a 100-bagger in nine years, and much of that during a lousy stock market. Franklin was a 138-bagger, and Federated was up fiftyfold before it was bought out by Aetna. I was right on top of all of them. I knew the Dreyfus story, the Franklin story, and the Federated story from beginning to end. Everything was right, earnings were up, the momentum was obvious (see chart).

  How much did I make from all this? Zippo. I didn’t buy a single share of any of the financial services companies; not Dreyfus, not Federated, not Franklin. I missed the whole deal and didn’t realize it until it was too late. I guess I was too busy thinking about Union Oil of California, just like the doctors.

  Every time I look at the Dreyfus chart, it reminds me of the advice I’ve been trying to give you all along: Invest in thin
gs you know about. Neither of us should let an opportunity like this one pass us by again, and I didn’t. The 1987 market break gave me another chance with Dreyfus (see Chapter 17).

  The list below is only a partial record of the many tenbaggers I’ve either neglected to buy or sold too soon during the period I’ve managed Magellan. With a few of them I got a small part of the gain, and with others I managed to lose money through bad timing and fuzzy thinking. You’ll notice the list goes only up to m, but that’s only because I got tired of writing them down. This being an incomplete account, you can imagine how many opportunities must be out there.

  7

  I’ve Got It, I’ve Got It—What Is It?

  However a stock has come to your attention, whether via the office, the shopping mall, something you ate, something you bought, or something you heard from your broker, your mother-in-law, or even from Ivan Boesky’s parole officer, the discovery is not a buy signal. Just because Dunkin’ Donuts is always crowded or Reynolds Metals has more aluminum orders than it can handle doesn’t mean you ought to own the stock. Not yet. What you’ve got so far is simply a lead to a story that has to be developed.

  In fact, you ought to treat the initial information (whatever brought this company to your attention) as if it were an anonymous and intriguing tip, mysteriously shoved into your mailbox. This will keep you from buying a stock just because you’ve seen something you like, or worse, because of the reputation of the tipper, as in: “Uncle Harry’s buying it, and he’s rich, so he must know what he’s talking about.” Or: “Uncle Harry’s buying it, and so am I, because his last stock tip doubled.”

  Developing the story is really not difficult: at most it will take a couple of hours. In the next few chapters I’m going to tell you how I do it, and where you can find the most useful sources of information.

  It seems to me that this homework phase is just as important to your success in stocks as your previous vow to ignore the short-term gyrations of the market. Perhaps some people make money in stocks without doing any of the research I’ll describe, but why take unnecessary chances? Investing without research is like playing stud poker and never looking at the cards.

  For some reason the whole business of analyzing stocks has been made to seem so esoteric and technical that normally careful consumers invest their life savings on a whim. The same couple that spends the weekend searching for the best deal on airfares to London buys 500 shares of KLM without having spent five minutes learning about the company.

  Let’s go back to the Houndsteeth. They fancy themselves to be smart consumers, even going so far as to read the labels on pillowcases. They compare the weights and prices on the boxes of laundry soap to find the best buy. They calculate the watts-per-lumen of competing light bulbs, but all of their savings are dwarfed by Houndstooth’s fiascoes in the stock market.

  Isn’t that Houndstooth over there in his recliner, reading the Consumer Reports article on the relative thickness and absorbency of the five popular brands of toilet paper? He’s trying to figure out whether or not to switch to Charmin. But will he give equal time to reading the annual report of Procter and Gamble, the company that makes the Charmin, before he invests $5,000 in the stock? Of course not. He’ll buy the stock first and later toss the Procter and Gamble annual report into the garbage can.

  The Charmin syndrome is a common affliction, but it’s easily cured. All you have to do is put as much effort into picking your stocks as you do into buying your groceries. Even if you already own stocks, it’s useful to go through the exercise, because it’s possible that some of these stocks will not and cannot live up to your expectations for them. That’s because there are different kinds of stocks, and there are limits to how each kind can perform. In developing the story you have to make certain initial distinctions.

  WHAT’S THE BOTTOM LINE?

  Procter and Gamble is a good illustration of what I’m talking about. Remember I mentioned that L’eggs was one of the two most profitable new products of the 1970s. The other was Pampers. Any friend or relative of a baby could have realized how popular Pampers were, and right on the box it says that Pampers are made by Procter and Gamble.

  But on the strength of Pampers alone, should you have rushed out to buy the stock? Not if you’d begun to develop the story. Then, in about five minutes, you would have noticed that Procter and Gamble is a huge company and that Pampers sales contribute only a small part of the earnings. Pampers made some difference to Procter and Gamble, but it wasn’t nearly as consequential as what L’eggs did for a smaller outfit such as Hanes.

  If you’re considering a stock on the strength of some specific product that a company makes, the first thing to find out is: What effect will the success of the product have on the company’s bottom line? Back in February of 1988, I recall, investors got very enthused about Retin-A, a skin cream made by Johnson & Johnson. Since 1971 this cream had been sold as an acne medicine, but a recent doctors’ study suggested it might also fight skin blots and blemishes caused by the sun. The newspapers loved this story, and headline writers called it the anti-aging cream, and the “wrinkle-fighter.” You would have thought that Johnson & Johnson had discovered the Fountain of Youth.

  So what happens? Johnson & Johnson stock jumps $8 a share in two days (January 21–22, 1988), which adds $1.4 billion in extra market value to the company. In all this hoopla the buyers must have forgotten to notice that the previous year’s sales of Retin-A brought in only $30 million a year to Johnson & Johnson, and the company still faced further FDA review on the new claims.

  In another case, which happened about the same time, investors did better homework. A new medical study reported that an aspirin every other day might reduce the risk of men’s getting heart attacks. The study used the Bufferin brand of aspirin made by Bristol-Myers, but Bristol-Myers stock hardly budged, moving up just 50 cents per share to $42⅞. A lot of people must have realized that domestic Bufferin sales last year were $75 million, less than 1.5 percent of Bristol-Myers’s total revenues of $5.3 billion.

  A somewhat better aspirin play was Sterling Drug, maker of Bayer aspirin, before it was bought out by Eastman Kodak. Sterling’s aspirin sales were 6.5 percent of its total revenues, but close to 15 percent of the company’s profits—aspirin was Sterling’s most profitable product.

  BIG COMPANIES, SMALL MOVES

  The size of a company has a great deal to do with what you can expect to get out of the stock. How big is this company in which you’ve taken an interest? Specific products aside, big companies don’t have big stock moves. In certain markets they perform well, but you’ll get your biggest moves in smaller companies. You don’t buy stock in a giant such as Coca-Cola expecting to quadruple your money in two years. If you buy Coca-Cola at the right price, you might triple your money in six years, but you’re not going to hit the jackpot in two.

  There’s nothing wrong with Procter and Gamble or Coca-Cola, and recently both have been excellent performers. But you just have to know these are big companies so you won’t have false hopes or unrealistic expectations.

  Sometimes a series of misfortunes will drive a big company into desperate straits, and, as it recovers, the stock will make a big move. Chrysler had a big move, as did Ford and Bethlehem Steel. When Burlington Northern got depressed, the stock dropped from $12 to $6 and then climbed back to $70. But these are extraordinary situations that fall into the category of turnarounds. In the normal course of business, multibillion-dollar enterprises such as Chrysler or Burlington Northern, DuPont or Dow Chemical, Procter and Gamble or Coca-Cola, simply cannot grow fast enough to become tenbaggers.

  For a General Electric to double or triple in size in the foreseeable future is mathematically impossible. GE already has gotten so big that it represents nearly one percent of the entire U.S. gross national product. Every time you spend a dollar, GE gets almost a penny of it. Think of that. In all the trillions spent annually by American consumers, nearly a penny of every dollar goes to goods or s
ervices (light bulbs, appliances, insurance, the National Broadcasting Corporation [NBC], etc.) provided by GE.

  Here is a company that has done everything right—made sensible acquisitions; cut costs; developed successful new products; rid itself of bumbling subsidiaries; avoided getting suckered into the computer business (after selling its mistake to Honeywell)—and still the stock inches along. That’s not GE’s fault. The stock can’t help but inch along since it’s attached to such a huge enterprise.

  GE has 900 million shares outstanding, and a total market value of $39 billion. The annual profit, more than $3 billion, is enough to qualify as a Fortune 500 company on its own. There is simply no way that GE could accelerate its growth very much without taking over the world. And since fast growth propels stock prices, it’s no surprise that GE moves slowly as La Quinta soars.

  Everything else being equal, you’ll do better with the smaller companies. In the last decade you’d have made more money on Pic ’N’ Save than on Sears, although both are retail chains. Now that Waste Management is a multibillion-dollar conglomerate, it will probably lag behind the speedy new entries in the waste-removal field. In the recent comeback of the steel industry, shareholders in the smaller Nucor have fared better than shareholders in U.S. Steel (now USX). In the earlier comeback of the drug industry, the smaller SmithKline Beckman outperformed the larger American Home Products.

  THE SIX CATEGORIES

  Once I’ve established the size of the company relative to others in a particular industry, next I place it into one of six general categories: slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds. There are almost as many ways to classify stocks as there are stockbrokers—but I’ve found that these six categories cover all of the useful distinctions that any investor has to make.

 

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