by Peter Lynch
Any student of the p/e ratio could have seen that this was lunacy, and I wish one of them had told me. In 1973–74 the market had its most brutal correction since the 1930s.
FUTURE EARNINGS
Future earnings—there’s the rub. How do you predict those? The best you can get from current earnings is an educated guess whether a stock is fairly priced. If you do this much, you’ll never buy a Polaroid or an Avon at a 40 p/e, nor will you overpay for Bristol-Myers, Coca-Cola, or McDonald’s. However, what you’d really like to know is what’s going to happen to earnings in the next month, the next year, or the next decade.
Earnings, after all, are supposed to grow, and every stock price carries with it a built-in growth assumption.
Battalions of analysts and statisticians are launched against the questions of future growth and future earnings, and you can pick up the nearest financial magazine to see for yourself how often they get the wrong answer (the word most frequently seen with “earnings” is “surprise”). I’m not about to suggest that you can begin to predict earnings, or growth in earnings, successfully on your own.
Once you got into this game seriously, you’d be boggled by the examples of stocks that go down even though the earnings are up, because professional analysts and their institutional clients expected the earnings to be higher, or stocks that go up even though earnings are down, because that same cheering section expected the earnings to be lower. These are short-term anomalies, but nonetheless frustrating to the shareholder who notices them.
If you can’t predict future earnings, at least you can find out how a company plans to increase its earnings. Then you can check periodically to see if the plans are working out.
There are five basic ways a company can increase earnings*: reduce costs; raise prices; expand into new markets; sell more of its product in the old markets; or revitalize, close, or otherwise dispose of a losing operation. These are the factors to investigate as you develop the story. If you have an edge, this is where it’s going to be most helpful.
11
The Two-Minute Drill
Already you’ve found out whether you’re dealing with a slow grower, a stalwart, a fast grower, a turnaround, an asset play, or a cyclical. The p/e ratio has given you a rough idea of whether the stock, as currently priced, is undervalued or overvalued relative to its immediate prospects. The next step is to learn as much as possible about what the company is doing to bring about the added prosperity, the growth spurt, or whatever happy event is expected to occur. This is known as the “story.”
With the possible exception of the asset play (where you can sit back and wait for the value of the real estate or the oil reserves or the TV stations to be recognized by others), something dynamic has to happen to keep the earnings moving along. The more certain you are about what that something is, the better you’ll be able to follow the script.
The analyst’s reports on the company you get from your broker, and the short essays in the Value Line give you the professional version of the story, but if you’ve got an edge in the company or in the industry, you’ll be able to develop your own script in useful detail.
Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. The two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot. Once you’re able to tell the story of a stock to your family, your friends, or the dog (and I don’t mean “a guy on the bus says Caesars World is a takeover”), and so that even a child could understand it, then you have a proper grasp of the situation.
Here are some of the topics that might be addressed in the monologue:
If it’s a slow-growing company you’re thinking about, then presumably you’re in it for the dividend, (Why else own this kind of stock?) Therefore, the important elements of the script would be: “This company has increased earnings every year for the last ten, it offers an attractive yield; it’s never reduced or suspended a dividend, and in fact it’s raised the dividend during good times and bad, including the last three recessions. It’s a telephone utility, and the new cellular operations may add a substantial kicker to the growth rate.”
If it’s a cyclical company you’re thinking about, then your script revolves around business conditions, inventories, and prices. “There has been a three-year business slump in the auto industry, but this year things have turned around. I know that because car sales are up across the board for the first time in recent memory. I notice that GM’s new models are selling well, and in the last eighteen months the company has closed five inefficient plants, cut twenty percent off labor costs, and earnings are about to turn sharply higher.”
If it’s an asset play, then what are the assets, how much are they worth? “The stock sells for $8, but the videocassette division alone is worth $4 a share and the real estate is worth $7. That’s a bargain in itself, and I’m getting the rest of the company for a minus $3. Insiders are buying, and the company has steady earnings, and there’s no debt to speak of.”
If it’s a turnaround, then has the company gone about improving its fortunes, and is the plan working so far? “General Mills has made great progress in curing its diworseification. It’s gone from eleven basic businesses to two. By selling off Eddie Bauer, Talbot’s, Kenner, and Parker Brothers and getting top dollar for these excellent companies, General Mills has returned to doing what it does best: restaurants and packaged foods. The company has been buying back millions of its shares. The seafood subsidiary, Gortons, has grown from 7 percent of the seafood market to 25 percent. They are coming out with low-cal yogurt, no-cholesterol Bisquick, and microwave brownies. Earnings are up sharply.”
If it’s a stalwart, then the key issues are the p/e ratio, whether the stock already has had a dramatic run-up in price in recent months, and what, if anything, is happening to accelerate the growth rate. You might say to yourself: “Coca-Cola is selling at the low end of its p/e range. The stock hasn’t gone anywhere for two years. The company has improved itself in several ways. It sold half its interest in Columbia Pictures to the public. Diet drinks have sped up the growth rate dramatically. Last year the Japanese drank 36 percent more Cokes than they did the year before, and the Spanish upped their consumption by 26 percent. That’s phenomenal progress. Foreign sales are excellent in general. Through a separate stock offering, Coca-Cola Enterprises, the company has bought out many of its independent regional distributors. Now the company has better control over distribution and domestic sales. Because of these factors, Coca-Cola may do better than people think.”
If it is a fast grower, then where and how can it continue to grow fast? “La Quinta is a motel chain that started out in Texas. It was very profitable there. The company successfully duplicated its successful formula in Arkansas and Louisiana. Last year it added 20 percent more motel units than the year before. Earnings have increased every quarter. The company plans rapid future expansion. The debt is not excessive. Motels are a low-growth industry, and very competitive, but La Quinta has found something of a niche. It has a long way to go before it has saturated the market.”
Those are some basic themes for the story, and you can fill in as much detail as you want. The more you know the better. I often devote several hours to developing a script, though that’s not always necessary. Let me give you two examples, one a situation that I checked out properly, and the other where there was something I forgot to ask. The first was La Quinta, which has been a fifteenbagger, and the second was Bildner’s, a fifteenbagger in reverse.
CHECKING OUT LA QUINTA
At one point I’d decided the motel industry was due for a cyclical turnaround. I’d already invested in United Inns, the largest franchiser of Holiday Inns, and I was keeping my ears open for other opportunities. During a telephone interview with a vice president at United Inns, I asked which company was Holiday
Inn’s most successful competitor.
Asking about the competition is one of my favorite techniques for finding promising new stocks. Muckamucks speak negatively about the competition ninety-five percent of the time, and it doesn’t mean much. But when an executive of one company admits he’s impressed by another company, you can bet that company is doing something right. Nothing could be more bullish than begrudging admiration from a rival.
“La Quinta Motor Inns,” the vice president of United Inns enthused. “They’re doing a great job. They’re killing us in Houston and in Dallas.” He sounded very impressed, and so was I.
That’s the first I’d ever heard of La Quinta, but as soon as I got off the phone with this exciting new tip, I got back on the phone with Walter Biegler at La Quinta headquarters in San Antonio to find out what the story was. Mr. Biegler told me that in two days he’d be coming to Boston for a business conference at Harvard, at which time he’d be glad to tell me the story in person.
Between the United Inns man’s dropping the hint and five minutes later the La Quinta man’s mentioning that he just happened to be traveling to Boston, the whole thing sounded like a set-up job to sucker me into buying millions of shares. But as soon as I heard Biegler’s presentation, I knew it wasn’t a set-up job, and the best way to have gotten suckered would have been not to have bought this wonderful stock.
The concept was simple. La Quinta offered rooms of Holiday Inn quality, but at a lower price. The room was the same size as a Holiday Inn room, the bed was just as firm (there are bed consultants to the motel industry who figure these things out), the bathrooms were just as nice, the pool was just as nice, yet the rates were 30 percent less. How was that possible? I wanted to know. Biegler went on to explain.
La Quinta had eliminated the wedding area, the conference rooms, the large reception area, the kitchen area, and the restaurant—all excess space that contributed nothing to the profits but added substantially to the costs. La Quinta’s idea was to install a Denny’s or some similar 24-hour place next door to every one of its motels. La Quinta didn’t even have to own the Denny’s. Somebody else could worry about the food. Holiday Inn isn’t famous for its cuisine, so it’s not as if La Quinta was giving up a major selling point. Right here, La Quinta avoided a big capital investment and sidestepped some big trouble. It turns out that most hotels and motels lose money on their restaurants, and the restaurants cause 95 percent of the complaints.
I always try to learn something new from every investment conversation I have. From Mr. Biegler I learned that hotel and motel customers routinely pay one one-thousandth of the value of a room for each night’s lodging. If the Plaza Hotel in New York is worth $400,000 a room, you’re probably going to pay $400 a night to stay there, and if the No-Tell Motel is built for $20,000 a room, then you’ll be paying $20 a night. Because it cost 30 percent less to build a La Quinta than it did to build a Holiday Inn, I could see how La Quinta could rent out rooms at a 30-percent discount and still make the same profit as a Holiday Inn.
Where was the niche? I wanted to know. There were hundreds of motel rooms at every fork in the road already. Mr. Biegler said they had a specific target: the small businessman who didn’t care for the budget motel, and if he had the choice, he’d rather pay less for the equivalent luxury of a Holiday Inn. La Quinta was there to provide the equivalent luxury, and at locations that were often more convenient to traveling businessmen.
Holiday Inn, which wanted to be all things to all travelers, frequently built its units just off the access ramps of major turnpikes. La Quinta built its units near the business districts, government offices, hospitals, and industrial complexes where its customers were most likely to do business. And because these were business travelers and not vacationers, a higher percentage of them booked their rooms in advance, giving La Quinta the advantage of a steadier and more predictable clientele.
Nobody else had captured this part of the market, the middle ground between the Hilton hotels above and the budget inn below. Also, there was no way that some newer competitor could sneak up on La Quinta without Wall Street’s knowing about it. That’s one reason I prefer hotel and restaurant stocks to technology stocks—the minute you invest in an exciting new technology, a more exciting and newer technology is brought out of somebody else’s lab. But the prototypes of would-be hotel and restaurant chains have to show up someplace—you simply can’t build 100 of them overnight, and if they are in a different part of the country, they wouldn’t affect you anyway.
What about the costs? When small and new companies undertake expensive projects like hotel construction, the burden of debt can weigh them down for years. Biegler reassured me on this point as well. He said that La Quinta had kept costs low by building 120-room inns instead of 250-room inns, by supervising the construction in-house, and by following a cookie-cutter blueprint. Furthermore, a 120-room operation could be managed by a live-in retired couple, which saved on overhead. And most impressive, La Quinta had struck a deal with major insurance companies who were providing all the financing at favorable terms, in exchange for a small share in the profits.
As partners in La Quinta’s success or failure, insurance companies weren’t likely to make loan demands that would drive the company into bankruptcy if a shortfall ever occurred. In fact, this access to insurance-company money is what enabled La Quinta to grow rapidly in a capital-intensive business without incurring the dreaded bank debt (see Chapter 13).
Soon enough, I was satisfied that Biegler and his employers had thought of everything. La Quinta was a great story, and not one of those would-be, could-be, might-be, soon-to-be tales. If they aren’t already doing it, then don’t invest in it.
La Quinta had already been operating for four or five years at the time Biegler visited my office. The original La Quinta had been duplicated several times and in several different locations. The company was growing at an astounding 50 percent a year, and the stock was selling at ten times earnings, which made it an incredible bargain. I knew how many new units La Quinta was proposing to build, so I could keep track of progress in the future.
To top it all off, I was delighted to discover that only three brokerage firms covered La Quinta in 1978, and that less than 20 percent of the stock was held by the big institutions. The only thing wrong with La Quinta that I could see was it wasn’t boring enough.
I followed up on this conversation by spending three nights in three different La Quintas while I was on the road talking to other companies. I bounced on the beds, stuck my toe into the shallow end of the swimming pools (I never learned to swim), tugged at the curtains, squeezed the towels, and satisfied myself that La Quinta was the equal of Holiday Inn.
The La Quinta story checked out in every detail, and even then I almost talked myself out of buying any shares. That the stock had doubled in the previous year wasn’t bothersome—the p/e ratio relative to the growth rate still made it a bargain. What bothered me was that one of the important insiders had sold his shares at half the price I was staring at in the newspaper. (I found out later that this insider, a member of the founding family of La Quinta, was simply diversifying his portfolio.)
Fortunately I reminded myself that insider selling is a terrible reason to dislike a stock, and then I bought as much La Quinta as possible for Magellan fund. I made elevenfold on it over a ten-year period before it suffered a downturn due to declining fortunes in the energy-producing states. Recently the company has become an exciting combination of asset play and turnaround.
BILDNER’S, ALAS
The mistake I didn’t make with La Quinta I made with J. Bildner and Sons. My having invested in Bildner’s is a perfect example of what happens when you get so caught up in the euphoria of an enterprise that you ask all the questions except a most important one, and that turns out to be the fatal flaw.
Bildner’s is a specialty food store located right across the street from my office on Devonshire in Boston. There was also a Bildner’s out in the town where I
live—although it’s gone now. Among other things, Bildner’s sells gourmet sandwiches and prepared hot foods, a sort of happy compromise between a convenience store and a three-star restaurant. I’m well-acquainted with their sandwiches, since I’ve been eating them for lunch for several years. That was my edge on Bildner’s: I had firsthand information that they had the best bread and the best sandwiches in Boston.
The story was that Bildner’s was planning to expand into other cities and was going public to raise the money. It sounded good to me. The company had carved out a perfect niche—the millions of white-collar types who had no tolerance for microwave sandwiches in plastic wrappers, and yet who also refused to cook.
Bildner’s takeout already was the salvation of working couples who were too tired to set up the Cuisinart and yet who wanted to serve something that looked as if it could have been prepared in a Cuisinart for dinner. Before they went home to the suburbs, they could stop at Bildner’s and buy the kind of designer meal they would have cooked themselves, if they were still cooking: something with French beans, béarnaise sauce, and/or almonds.
I’d fully researched the operation by wandering into the store across the street. One of the original Bildner’s, it was clean, efficient, and full of satisfied customers, a regular yuppie 7-Eleven. I also discovered it was a fabulous money-maker. When I heard that Bildner’s was planning to sell stock and use the proceeds to open more stores, I was understandably excited.
From the prospectus of the stock offering, I learned that the company was not going to burden itself with excessive bank debt. This was a plus. It was going to lease space for its new stores, as opposed to buying the real estate. This, too, was a plus. Without further investigation I bought Bildner’s at the initial offering price of $13 in September, 1986.