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

by Peter Lynch

  Safety-Kleen hasn’t rested on the spoils of greasy auto parts. It has since branched out into restaurant grease traps and other sorts of messes. What analyst would want to write about this, and what portfolio manager would want to have Safety-Kleen on his buy list? There aren’t many, which is precisely what’s endearing about Safety-Kleen. Like Automatic Data Processing, this company has had an unbroken run of increased earnings. Profits have gone up every quarter, and so has the stock.

  Or how about Envirodyne? This one was pointed out to me a few years ago by Thomas Sweeney, then Fidelity’s forest products analyst and now the manager of Fidelity Capital Appreciation Fund. Envirodyne passes the odd name test: it sounds like something you could bounce off the ozone layer, when actually it has to do with lunch. One of its subsidiaries, Clear Shield, makes plastic forks and straws, the perfect business that any idiot could run, but in reality it has topflight management with a large personal stake in the company.

  Envirodyne is number two in plastic cutlery and number three in plastic straws, and being the lowest-cost producer gives it a big advantage in the industry.

  In 1985, Envirodyne started negotiating to buy Viskase, a leading producer of intestinal byproducts, particularly the casings surrounding hot dogs and sausages. They got Viskase from Union Carbide at a bargain price. Then in 1986 they bought Filmco, the leading producer of the PVC film that’s used to wrap leftover food items. Plastic forks, hot-dog casings, plastic wrap—pretty soon they’ll take over the family picnic.

  Largely as a result of these acquisitions, the earnings increased from 34 cents a share in 1985 to $2 a share in 1987—and should top $2.50 in 1988. The company has used its substantial cash flow to pay down its debt on the various acquisitions. I bought it for $3 a share in September, 1985. At the high in 1988 it sold for $36⅞.

  (4) IT’S A SPINOFF

  Spinoffs of divisions or parts of companies into separate, freestanding entities—such as Safety-Kleen out of Chicago Rawhide or Toys “R” Us out of Interstate Department Stores—often result in astoundingly lucrative investments. Dart & Kraft, which merged years ago, eventually separated so that Kraft could become a pure food company again. Dart (which owns Tupperware) was spun off as Premark International and has been a great investment on its own. So has Kraft, which was bought out by Philip Morris in 1988.

  Large parent companies do not want to spin off divisions and then see those spinoffs get into trouble, because that would bring embarrassing publicity that would reflect back on the parents. Therefore, the spinoffs normally have strong balance sheets and are well-prepared to succeed as independent entities. And once these companies are granted their independence, the new management, free to run its own show, can cut costs and take creative measures that improve the near-term and long-term earnings.

  Here is a list of some recent spinoffs that have done well, and a couple that haven’t done so well:

  The literature sent to shareholders explaining the spinoff is usually hastily prepared, blasé, and understated, which makes it even better than the regular annual reports. Spinoff companies are often misunderstood and get little attention from Wall Street. Investors often are sent shares in the newly created company as a bonus or a dividend for owning the parent company, and institutions, especially, tend to dismiss these shares as pocket change or found money. These are favorable omens for the spinoff stocks.

  This is a fertile area for the amateur shareholder, especially in the recent frenzy of mergers and acquisitions. Companies that are targets of hostile takeovers frequently fight off raiders by selling or spinning off divisions that then become publicly traded issues on their own. When a company is taken over, the parts are often sold off for cash, and they, too, become separate entities in which to invest. If you hear about a spinoff, or if you’re sent a few fractions of shares in some newly created company, begin an immediate investigation into buying more. A month or two after the spinoff is completed, you can check to see if there is heavy insider buying among the new officers and directors. This will confirm that they, too, believe in the company’s prospects.

  The greatest spinoffs of all were the “Baby Bell” companies that were created in the breakup of ATT: Ameritech, Bell Atlantic, Bell South, Nynex, Pacific Telesis, Southwestern Bell, and US West. While the parent has been an uninspiring performer, the average gain from stock in the seven newly created companies was 114 percent from November, 1983, to October, 1988. Add in the dividends and the total return is more like 170 percent. This beats the market twice around, and it beats the majority of all known mutual funds, including the one run by yours truly.

  Once liberated, the seven regional companies were able to increase earnings, cut costs, and enjoy higher profits. They got all the local and regional telephone business, the yellow pages, along with 50 cents for every $1 of long-distance business generated by ATT. It was a great niche. They had already gone through an earlier period of heavy spending on modern equipment, so they didn’t have to dilute shareholders’ equity by selling extra stock. And human nature being what it is, the seven Baby Bells set up a healthy competition amongst themselves, and also between themselves and their proud parent, Ma Bell. Ma, meanwhile, was losing its stranglehold on its highly profitable leased equipment business, and facing new competitors such as Sprint and MCI, and sustaining heavy losses in its computer operations.

  Investors who owned the old ATT stock had eighteen months to decide what to do. They could sell ATT and be done with the whole complicated mess, they could keep ATT plus the shares and fractions of shares in the new Baby Bells that they received, or they could sell the parent and keep the Baby Bells. If they did their homework, they sold ATT, kept the Baby Bells, and added to their position with as many more shares as they could afford.

  Pounds of material were sent out to the 2.96 million ATT shareholders explaining the Baby Bells’ plans. The new companies laid out exactly what they were going to do. A million employees of ATT and countless suppliers could have seen what was going on. So much for the amateur’s edge being restricted to a lucky few. For that matter, anyone who had a phone knew that there were big changes going on. I participated in the rally, but only in a modest way—I never dreamed that conservative companies such as these could do so well so quickly.

  (5) THE INSTITUTIONS DON’T OWN IT, AND THE ANALYSTS DON’T FOLLOW IT

  If you find a stock with little or no institutional ownership, you’ve found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner. When I talk to a company that tells me the last analyst showed up three years ago, I can hardly contain my enthusiasm. It frequently happens with banks, savings-and-loans, and insurance companies, since there are thousands of these and Wall Street only keeps up with fifty to one hundred.

  I’m equally enthusiastic about once-popular stocks the professionals have abandoned, as many abandoned Chrysler at the bottom and Exxon at the bottom, just before both began to rebound.

  Data on institutional ownership are available from the following sources: Vicker’s Institutional Holdings Guide, Nelson’s Directory of Investment Research, and the Spectrum Surveys, a publication of CDA Investment Technologies. Although these publications are not always easy to find, you can get similar information from the Value Line Investment Survey and from the S&P stock sheets, also called tear sheets. Both are routinely provided by regular stockbrokers.

  (6) THE RUMORS ABOUND: IT’S INVOLVED WITH TOXIC WASTE AND/OR THE MAFIA

  It’s hard to think of a more perfect industry than waste management. If there’s anything that disturbs people more than animal casings, grease and dirty oil, it’s sewage and toxic waste dumps. That’s why I got very excited one day when the solid waste executives showed up in my office. They had come to town for a solid waste convention complete with booths and slides—imagine how attractive that must have been. Anyway, instead of the usual blue cotton button-down shirts that I see day after day,
they were wearing polo shirts that said “Solid Waste.” Who would put on shirts like that, unless it was the Solid Waste bowling team? These are the kind of executives you dream about.

  As you already know if you were fortunate enough to have bought some, Waste Management, Inc. is up about a hundredfold.

  Waste Management is a better prospect even than Safety-Kleen because it has two unthinkables going for it: toxic waste itself, and also the Mafia. Everyone who fantasizes that the Mafia runs all the Italian restaurants, the newsstands, the dry cleaners, the construction sites, and the olive presses also probably thinks that the Mafia controls the garbage business. This fantastic assertion was a great advantage to the earliest buyers of shares in Waste Management, which as usual were underpriced relative to the actual opportunity.

  Maybe the rumors of the Mafia in waste management kept away the same investors who worried about the Mafia in hotel/casino management. Remember the dreaded casino stocks that are now on everybody’s buy list? Respectable investors weren’t supposed to touch them because the casinos allegedly were all Mafia. Then the earnings exploded and the profits exploded, and the Mafia faded into the background. When Holiday Inn and Hilton got into the casino business, it suddenly was all right to own casino stocks.

  (7) THERE’S SOMETHING DEPRESSING ABOUT IT

  In this category my favorite all-time pick is Service Corporation International (SCI), which also has a boring name. I got this pick from George Vanderheiden, the onetime Fidelity electronics analyst who’s done a great job running the Fidelity Destiny Fund.

  Now, if there’s anything Wall Street would rather ignore besides toxic waste, it’s mortality. And SCI does burials.

  For several years this Houston-based enterprise has been going around the country buying up local funeral homes from the mom-and-pop owners, just as Gannett did with the small-town newspapers. SCI has become a sort of McBurial. It has picked up the active funeral parlors that bury a dozen or more people a week, ignoring the smaller one-or two-burial parlors.

  At last count the company owned 461 funeral parlors, 121 cemeteries, 76 flower shops, 21 funeral product-and-supply manufacturing centers, and 3 casket distribution centers, so they’re vertically integrated. They broke into the big-time when they buried Howard Hughes.

  They also pioneered the pre-need policy, a layaway plan that’s been very popular. It enables you to pay off your funeral service and your casket right now while you can still afford it, so your family won’t have to pay for it later. Even if the cost has tripled by the time you require a funeral service, you’re locked in at the old prices. This is a great deal for the family of the deceased, and an even greater deal for the company.

  SCI gets the money from its pre-need sales right away, and the cash just keeps on compounding. If they sell $50 million worth of these policies each year, it will add up to billions by the time they’ve had all the funerals. Lately they’ve gone beyond their own operations to offer the pre-need policies to other funeral homes. Over the past five years the sales of prearranged funerals have been climbing at 40 percent a year.

  Once in a while a positive story is topped off by an extraordinary kicker, an unexpected valuable card that turns up. In SCI’s case it happened when the company struck a very lucrative bargain with another company (American General) that wanted to buy the real estate under one of SCI’s Houston locations. In return for the rights to this land, American General, which owned 20 percent of SCI’s stock, gave all their stock back to SCI. Not only did SCI retrieve 20 percent of its shares at no cost, but it was allowed to continue to operate the funeral home at the old location for two years, until it could open a new home at a different site in Houston.

  The best thing about this company is that it was shunned by most professional investors for years. Despite an incredible record, the SCI executives had to go out on cavalcades to beg people to listen to their story. That meant that amateurs in the know could buy stock in a proven winner with a record of solid growth in earnings, and at much lower prices than they’d have to pay for a hot stock in a popular industry. Here was the perfect opportunity—everything was working, you could see it happening, the earnings kept increasing, there was rapid growth with almost no debt—and Wall Street turned the other way.

  Only in 1986 did SCI develop a big following among the institutions, who now own over 50 percent of the shares, and more analysts started covering the company. Predictably the stock was a twentybagger before SCI got Wall Street’s full attention, but since then it has greatly underperformed the market. In addition to the burdens of high institutional ownership and broad coverage by brokers, the company has been hurt in the last few years by entering the casket business through two acquisitions that have not contributed to profits. Also, the price of buying quality funeral homes and cemeteries has risen sharply, and the growth in pre-need insurance has been less than expected.

  (8) IT’S A NO-GROWTH INDUSTRY

  Many people prefer to invest in a high-growth industry, where there’s a lot of sound and fury. Not me. I prefer to invest in a low-growth industry like plastic knives and forks, but only if I can’t find a no-growth industry like funerals. That’s where the biggest winners are developed.

  There’s nothing thrilling about a thrilling high-growth industry, except watching the stocks go down. Carpets in the 1950s, electronics in the 1960s, computers in the 1980s, were all exciting high-growth industries, in which numerous major and minor companies unerringly failed to prosper for long. That’s because for every single product in a hot industry, there are a thousand MIT graduates trying to figure out how to make it cheaper in Taiwan. As soon as a computer company designs the best word-processor in the world, ten other competitors are spending $100 million to design a better one, and it will be on the market in eight months. This doesn’t happen with bottle caps, coupon-clipping services, oil-drum retrieval, or motel chains.

  SCI was helped by the fact that there’s almost no growth in the funeral industry. Growth in the burial business in this country limps along at one percent a year, too slow for the action-seekers who’ve gone into computers. But it’s a steady business with as reliable a customer base as you could ever find.

  In a no-growth industry, especially one that’s boring and upsets people, there’s no problem with competition. You don’t have to protect your flanks from potential rivals because nobody else is going to be interested. This gives you the leeway to continue to grow, to gain market share, as SCI has done with burials. SCI already owns 5 percent of the nation’s funeral homes, and there’s nothing stopping them from owning 10 percent or 15 percent. The graduating class of Wharton isn’t going to want to challenge SCI, and you can’t tell your friends in the investment banking firms that you’ve decided to specialize in picking up dirty oil from the gas stations.

  (9) IT’S GOT A NICHE

  I’d much rather own a local rock pit than own Twentieth Century-Fox, because a movie company competes with other movie companies, and the rock pit has a niche. Twentieth Century-Fox understood that when it bought up Pebble Beach, and the rock pit with it.

  Certainly, owning a rock pit is safer than owning a jewelry business. If you’re in the jewelry business, you’re competing with other jewelers from across town, across the state, and even abroad, since vacationers can buy jewelry anywhere and bring it home. But if you’ve got the only gravel pit in Brooklyn, you’ve got a virtual monopoly, plus the added protection of the unpopularity of rock pits.

  The insiders call this the “aggregate” business, but even the exalted name doesn’t alter the fact that rocks, sand, and gravel are as close to inherently worthless as you can get. That’s the paradox: mixed together, the stuff probably sells for $3 a ton. For the price of a glass of orange juice, you can purchase a half ton of aggregate, which, if you’ve got a truck, you can take home and dump on your lawn.

  What makes a rock pit valuable is that nobody else can compete with it. The nearest rival owner from two towns over isn’t going to haul
his rocks into your territory because the trucking bills would eat up all his profit. No matter how good the rocks are in Chicago, no Chicago rock-pit owner can ever invade your territory in Brooklyn or Detroit. Due to the weight of rocks, aggregates are an exclusive franchise. You don’t have to pay a dozen lawyers to protect it.

  There’s no way to overstate the value of exclusive franchises to a company or its shareholders. Inco is the world’s great producer of nickel today, and it will be the world’s great producer in fifty years. Once I was standing at the edge of the Bingham Pit copper mine in Utah, and looking down into that impressive cavern, it occurred to me that nobody in Japan or Korea can invent a Bingham pit.

  Once you’ve got an exclusive franchise in anything, you can raise prices. In the case of rock pits you can raise prices to just below the point that the owner of the next rock pit might begin to think about competing with you. He’s figuring his prices via the same method.

  To top it off, you get big tax breaks from depreciating your earth movers and rock crushers, plus you get a mineral depletion allowance, the same as Exxon and Atlantic Richfield get for their own oil and gas deposits. I can’t imagine anyone’s going bankrupt over a rock pit. So if you can’t run your own rock pit, the next best thing is buying shares in aggregate-producing companies such as Vulcan Materials, Calmat, Boston Sand & Gravel, Dravo, and Florida Rock. When larger companies such as Martin-Marietta, General Dynamics, or Ashland sell off various parts of their businesses, they always keep the rock pits.

  I always look for niches. The perfect company would have to have one. Warren Buffett started out by acquiring a textile mill in New Bedford, Massachusetts, which he quickly realized was not a niche business. He did poorly in textiles but went on to make billions for his shareholders by investing in niches. He was one of the first to see the value in newspapers and TV stations that dominated major markets, beginning with the Washington Post. Thinking along the same lines, I bought as much stock as I could in Affiliated Publications, which owns the local Boston Globe. Since the Globe gets over 90 percent of the print ad revenues in Boston, how could the Globe lose?