by Peter Lynch
The Globe has a niche, and the Times Mirror Company has several, including the Los Angeles Times, Newsday, the Hartford Courant, and the Baltimore Sun. Gannett owns 90 daily newspapers, and most of them are the only major dailies in town. Investors who discovered the advantages of exclusive newspaper and cable franchises in the early 1970s were rewarded with a number of tenbaggers as the cable stocks and media stocks got popular on Wall Street.
Any reporter, ad executive, or editor who worked at the Washington Post could have seen the profits and the earnings and understood the value of the niche. A newspaper company is a great business for a variety of reasons as well.
Drug companies and chemical companies have niches—products that no one else is allowed to make. It took years for SmithKline to get the patent for Tagamet. Once a patent is approved, all the rival companies with their billions in research dollars can’t invade the territory. They have to invent a different drug, prove it is different, and then go through three years of clinical trials before the government will let them sell it. They have to prove that it doesn’t kill rats, and most drugs, it seems, do kill rats.
Or perhaps rats aren’t as healthy as they used to be. Come to think of it, I once made money on a rat stock—Charles River Breeding Labs. There’s a business that turns people off.
Chemical companies have niches in pesticides and herbicides. It’s not any easier to get a poison approved than it is to get a cure approved. Once you have a patent and the federal go-ahead on a pesticide or a herbicide, you’ve got a money machine. Monsanto has several today.
Brand names such as Robitussin or Tylenol, Coca-Cola or Marlboro, are almost as good as niches. It costs a fortune to develop public confidence in a soft drink or a cough medicine. The whole process takes years.
(10) PEOPLE HAVE TO KEEP BUYING IT
I’d rather invest in a company that makes drugs, soft drinks, razor blades, or cigarettes than in a company that makes toys. In the toy industry somebody can make a wonderful doll that every child has to have, but every child gets only one each. Eight months later that product is taken off the shelves to make room for the newest doll the children have to have—manufactured by somebody else.
Why take chances on fickle purchases when there’s so much steady business around?
(11) IT’S A USER OF TECHNOLOGY
Instead of investing in computer companies that struggle to survive in an endless price war, why not invest in a company that benefits from the price war—such as Automatic Data Processing? As computers get cheaper, Automatic Data can do its job cheaper and thus increase its own profits. Or instead of investing in a company that makes automatic scanners, why not invest in the supermarkets that install the scanners? If a scanner helps a supermarket company cut costs just three percent, that alone might double the company’s earnings.
(12) THE INSIDERS ARE BUYERS
There’s no better tip-off to the probable success of a stock than that people in the company are putting their own money into it. In general, corporate insiders are net sellers, and they normally sell 2.3 shares to every one share that they buy. After the 1,000-point drop from August to October, 1987, it was reassuring to discover that there were four shares bought to every one share sold by insiders across the board. At least they hadn’t lost their faith.
When insiders are buying like crazy, you can be certain that, at a minimum, the company will not go bankrupt in the next six months. When insiders are buying, I’d bet there aren’t three companies in history that have gone bankrupt near term.
Long term, there’s another important benefit. When management owns stock, then rewarding the shareholders becomes a first priority, whereas when management simply collects a paycheck, then increasing salaries becomes a first priority. Since bigger companies tend to pay bigger salaries to executives, there’s a natural tendency for corporate wage-earners to expand the business at any cost, often to the detriment of shareholders. This happens less often when management is heavily invested in shares.
Although it’s a nice gesture for the CEO or the corporate president with the million-dollar salary to buy a few thousand shares of the company stock, it’s more significant when employees at the lower echelons add to their positions. If you see someone with a $45,000 annual salary buying $10,000 worth of stock, you can be sure it’s a meaningful vote of confidence. That’s why I’d rather find seven vice presidents buying 1,000 shares apiece than the president buying 5,000.
If the stock price drops after the insiders have bought, so that you have a chance to buy it cheaper than they did, so much the better for you.
It’s simple to keep track of insider purchases. Every time an officer or a director buys or sells shares, he or she has to declare it on Form 4 and send the form to the Securities and Exchange Commission advising them of the fact. Several newsletter services, including Vicker’s Weekly Insider Report and The Insiders, keep track of these filings. Barron’s, The Wall Street Journal, and Investor’s Daily also carry the information. Many local business newspapers report on insider trading on local companies—I know the Boston Business Journal has such a column. Your broker may also be able to provide the information, or you may find that your local library subscribes to the newsletters. There’s also a tabulation of insider buying and selling in the Value Line publication.
(Insider selling usually means nothing, and it’s silly to react to it. If a stock had gone from $3 to $12 and nine officers were selling, I’d take notice, particularly if they were selling a majority of their shares. But in normal situations insider selling is not an automatic sign of trouble within a company. There are many reasons that officers might sell. They may need the money to pay their children’s tuition or to buy a new house or to satisfy a debt. They may have decided to diversify into other stocks. But there’s only one reason that insiders buy: They think the stock price is undervalued and will eventually go up.)
(13) THE COMPANY IS BUYING BACK SHARES
Buying back shares is the simplest and best way a company can reward its investors. If a company has faith in its own future, then why shouldn’t it invest in itself, just as the shareholders do? The announcement of massive share buybacks by company after company broke on October 20, 1987 the fall of many stocks, and stabilized the market at the height of its panic. Long term, these buybacks can’t help but reward investors.
When stock is bought in by the company, it is taken out of circulation, therefore shrinking the number of outstanding shares. This can have a magical effect on earnings per share, which in turn has a magical effect on the stock price. If a company buys back half its shares and its overall earnings stay the same, the earnings per share have just doubled. Few companies could get that kind of result by cutting costs or selling more widgets.
Exxon has been buying in shares because it’s cheaper than drilling for oil. It might cost Exxon $6 a barrel to find new oil, but if each of its shares represents $3 a barrel in oil assets, then retiring shares has the same effect as discovering $3 oil on the floor of the New York Stock Exchange.
This sensible practice was almost unheard of until quite recently. Back in the 1960s, International Dairy Queen was one of the pioneers in share buybacks, but there were few others who followed suit. At the delightful Crown, Cork, and Seal they’ve bought back shares every year for the last twenty. They never pay a dividend, and they never make unprofitable acquisitions, but by shrinking shares they’ve gotten the maximum impact from the earnings. If this keeps up, someday there will be a thousand shares of Crown, Cork, and Seal—worth $10 million apiece.
At Teledyne, chairman Henry E. Singleton periodically offers to buy in the stock at a much higher price than is bid on the stock exchange. When Teledyne was selling for $5, he might have paid $7, and when the stock was at $10, then he was paying $14, and so on. All along he’s given shareholders a chance to get out at a fancy premium. This practical demonstration of Teledyne’s belief in itself is more convincing than the adjectives in the annual report.
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nbsp; The common alternatives to buying back shares are (1) raising the dividend, (2) developing new products, (3) starting new operations, and (4) making acquisitions. Gillette tried to do all four, with emphasis on the final three. Gillette has a spectacularly profitable razor business, which it gradually reduced in relative size as it acquired less profitable operations. If the company had regularly bought back its shares and raised its dividend instead of diverting its capital to cosmetics, toiletries, ballpoint pens, cigarette lighters, curlers, blenders, office products, toothbrushes, hair care, digital watches, and lots of other diversions, the stock might well be worth over $100 instead of the current $35. In the last five years, Gillette has gotten back on track by eliminating losing operations and emphasizing its core shaving business, where it dominates the market.
The reverse of buying back shares is adding more shares, also called diluting. International Harvester, now Navistar, sold millions of additional shares to raise cash to help it survive a financial crisis brought about by the collapse of the farm-equipment business (see chart). Chrysler, remember, did just the opposite—buying back stock and stock warrants and shrinking the number of outstanding shares as the business improved (see chart). Navistar is once again a profitable company, but because of the extraordinary dilution, the earnings have a minimal impact, and shareholders have yet to benefit from the recovery to any significant degree.
THE GREATEST COMPANY OF ALL
If I could dream up a single glorious enterprise that combines all of the worst elements of Waste Management, Pep Boys, Safety-Kleen, rock pits, and bottle caps, it would have to be Cajun Cleansers. Cajun Cleansers is engaged in the boring business of removing mildew stains from furniture, rare books, and draperies that are victims of subtropical humidity. It’s a recent spinoff from Louisiana BayouFeedback.
Its headquarters are located in the bayous of Louisiana, and to get there you have to change planes twice, then hire a pickup truck to take you from the airport. Not one analyst from New York or Boston ever visited Cajun Cleansers, nor has any institution bought a solitary share.
Mention Cajun Cleansers at a cocktail party and soon you’ll be talking to yourself. It sounds ridiculous to everyone within earshot.
While expanding quickly through the bayous and the Ozarks, Cajun Cleansers has had incredible sales. These sales will soon accelerate because the company just received a patent on a new gel that removes all sorts of stains from clothes, furniture, carpets, bathroom tiles, and even aluminum siding. The patent gives Cajun the niche it’s been looking for.
The company is also planning to offer lifetime prestain insurance to millions of Americans, who can pay in advance for a guaranteed removal of all the future stain accidents they ever cause. A fortune in off-balance-sheet revenue will soon be pouring in.
No popular magazines except the ones that think Elvis is alive have mentioned Cajun and its new patent. The stock opened at $8 in a public offering seven years ago and soon rose to $10. At that price the important corporate directors bought as many shares as they could afford.
I hear about Cajun from a distant relative who swears it’s the only way to get mildew off leather jackets left too long in dank closets. I do some research and discover that Cajun has had a 20 percent growth rate in earnings for the past four years, it’s never had a down quarter, there’s no debt on the balance sheet, and it did well in the last recession. I visit the company and find out that any trained crustacean could oversee the making of the gel.
The day before I decide to buy Cajun Cleansers, the noted economist Henry Kaufman has predicted that interest rates are going up, and then the head of the Federal Reserve slips on the lane at a bowling alley and injures his back, both of which combine to send the market down 15 percent, and Cajun Cleansers with it. I get in at $7.50, which is $2.50 less than the directors paid.
That’s the situation at Cajun Cleansers. Don’t pinch me. I’m dreaming.
9
Stocks I’d Avoid
If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train—and succumbing to the social pressure, often buys.
Hot stocks can go up fast, usually out of sight of any of the known landmarks of value, but since there’s nothing but hope and thin air to support them, they fall just as quickly. If you aren’t clever at selling hot stocks (and the fact that you’ve bought them is a clue that you won’t be), you’ll soon see your profits turn into losses, because when the price falls, it’s not going to fall slowly, nor is it likely to stop at the level where you jumped on.
Look at the chart for Home Shopping Network, a recent hot stock in the hot teleshop industry, which in 16 months went from $3 to $47 back to $3½ (adjusted for splits). That was terrific for the people who said good-bye at $47, but what about the people who said hello at $47, when the stock was at its hottest? Where were the earnings, the profits, the future prospects? This investment had all the underlying security of a roulette spin.
The balance sheet was deteriorating rapidly (the company was taking on debt to buy television stations), there were problems with the telephones, and competitors had begun to appear. How many zirconium necklaces can people wear?
I already mentioned the various hot industries where sizzle led to fizzle. Mobile homes, digital watches, and health maintenance organizations were all hot industries where fervent expectations put a fog on the arithmetic. Just when the analysts predict double-digit growth rates forever, the industry goes into a decline.
If you had to live off the profits from investing in the hottest stocks in each successive hot industry, soon you’d be on welfare.
There couldn’t have been a hotter industry than carpets. As I was growing up, every housewife in America wanted wall-to-wall carpeting. Somebody invented a new tufting process that drastically reduced the amount of fiber that went into a rug, and somebody else automated the looms, and the prices dropped from $28 a yard to $4 a yard. The newly affordable rugs were laid down in schools, offices, airports, and in millions of tract houses in all the nation’s suburbs.
Wood floors were once cheaper than carpets, but now carpets were cheaper, so the upper classes switched from carpets to wood floors and the masses switched from wood floors to carpets. Carpet sales rose dramatically, and the five or six major producers were earning more money than they knew how to spend, and growing at an astonishing pace. That’s when the analysts started telling the stockbrokers that the carpet boom would last forever, and the brokers told their clients, and the clients bought the carpet stocks. At the same time, the five or six major producers were joined by two hundred new competitors, and they all fought for customers by dropping their prices, and nobody made another dime in the carpet business.
High growth and hot industries attract a very smart crowd that wants to get into the business. Entrepreneurs and venture capitalists stay awake nights trying to figure out how to get into the act as quickly as possible. If you have a can’t-fail idea but no way of protecting it with a patent or a niche, as soon as you succeed, you’ll be warding off the imitators. In business, imitation is the sincerest form of battery.
Remember what happened to disk drives? The experts said that this exciting industry would grow at 52 percent a year—and they were right, it did. But with thirty or thirty-five rival companies scrambling on the action, there were no profits.
Remember oil services? All you had to say was “oil” on a prospectus and people bought the stocks, even if the closest they ever got to oil services was having the gashop check under the hood.
In 1981, I attended a dinner at an energy conference in Colorado where Tom Brown was the featured speaker. Tom Brown was the principal owner and CEO of Tom Brown, Inc., a popular oil-service company that was selling for $50 a share at the time. Mr. Brown mentioned that an acquaintance of his had bragged about having shorted the stock (betting on it to go down), aft
er which Mr. Brown made the following psychological observation: “You must hate money to be shorting my stock. You’ll lose your car and your house and have to go naked to the Christmas party.” Mr. Brown got a laugh out of repeating this to us, but in the four years that followed the stock did fall from $50 to $1. The acquaintance who shorted the stock must have been delighted with the fortune he made. If anyone had to go naked to the Christmas party, it would have been the regular shareholders in the long position. They would have avoided this fate by ignoring the hottest stock in this hot industry, or at least by having done some homework. There was nothing to Tom Brown, Inc., but a bunch of useless rigs, some dubious oil and gas acreage, some impressive debts, and a bad balance sheet.
There’s never been a hotter stock than Xerox in the 1960s. Copying was a fabulous industry, and Xerox had control of the entire process. “To xerox” became a verb, which should have been a positive development. Many analysts thought so. They assumed that Xerox would keep growing to infinity when the stock was selling for $170 a share in 1972. But then the Japanese got into it, IBM got into it, and Eastman Kodak got into it. Soon there were twenty firms that made nice dry copies, as opposed to the original wet ones. Xerox got frightened and bought some unrelated businesses it didn’t know how to run, and the stock lost 84 percent of its value. Several competitors didn’t fare much better.
Copying has been a respectable industry for two decades and there’s never been a slowdown in demand, yet the copy machine companies can’t make a decent living.