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

by Peter Lynch

  At Crown, Cork, and Seal, I noticed that the president’s office had a scenic view of the can lines, the floors were faded linoleum, and the office furniture was shabbier than stuff I sat on in the Army. Now there’s a company with the right priorities—and you know what’s happened to the stock? It’s gone up 280-fold in the last thirty years. Rich earnings and a cheap headquarters is a great combination.

  So what do you make of Uniroyal, perched on a Connecticut hillside like all the fancy prep schools? I guessed it was a bad sign, and sure enough, the company went downhill. Other bad signs include fine antique furniture, trompe l’oeil drapes, and polished-walnut walls. I’ve seen it happen in many an office: when they bring the rubber trees indoors, it’s time to fear for the earnings.

  INVESTOR RELATIONS IN PERSON

  Visiting headquarters also gives you a chance to meet one or more of the front-office representatives. Another way to meet one is to attend the annual meetings, not so much for the formal sessions, but for the informal gatherings. Depending on how serious you want to get about this, the annual meeting is your best chance to develop useful contacts.

  It doesn’t always happen this way, but occasionally I sense something about a corporate representative that gives me a feeling about the company’s prospects. When I went to see Tandon, a company I dismissed in the first place on account of its being in the hot floppy-disk industry, I had an interesting encounter with the investor relations man. He was as polite, well-scrubbed, and well-spoken as any other investor relations person. However, when I looked him up in the Tandon proxy statement (among other things, proxy statements tell you how many shares are owned by the various corporate officers and directors, and how much those people are paid), I discovered that between his Tandon stock options and direct stock purchases, this man, who had not been with the company very long, was worth about $20 million.

  Somehow, that this average person was so well-off thanks to Tandon seemed too good to be true. The stock already had gone up eightfold into high p/e euphoria. Thinking about this for a minute, I realized that if Tandon doubled again, the investor relations man would be worth $40 million. For me to make money in the stock, he would have to get twice as rich as he was already, and already he was many times richer than I figured he should be. The whole setup just wasn’t realistic. There were other reasons I declined to invest, but the interview was the kicker. The stock dropped from $35¼ to $1⅜, adjusted for splits.

  I had identical reservations about the founder and principal shareholder in Televideo, whom I’d met at a group luncheon in Boston. Already he owned $100 million worth of shares in a company with a high p/e ratio, and in the very competitive computer peripherals industry. I thought to myself: If I make money in Televideo, this guy is going to be worth $200 million. That didn’t seem realistic, either. I declined to invest, and that stock went from $40½ in 1983 to $1 in 1987.

  I could never prove this scientifically, but if you can’t imagine how a company representative could ever get that rich, chances are you’re right.

  KICKING THE TIRES

  From the time Carolyn discovered L’eggs in the supermarket, and I discovered Taco Bell via the burrito, I’ve continued to believe that wandering through stores and tasting things is a fundamental investment strategy. It’s certainly no substitute for asking key questions, as the Bildner’s case proves. But when you’re developing a story, it’s reassuring to be able to check out the practical end of it.

  I’d already heard about Toys “R” Us from my friend Peter deRoetth, but one trip to the nearest local outlet convinced me that this company knew how to sell toys. If you asked customers if they liked the place, they all seemed to say that they planned to come back.

  Before I bought La Quinta, I spent those three nights in their motor inns. Before I bought Pic ’N’ Save, I stopped in at one of their stores in California and was impressed with the bargains. Pic ’N’ Save’s strategy was to take discontinued products out of the regular distribution channels and offer them at fire-sale prices.

  I could have gotten that information from investor relations, but it wasn’t the same as seeing the brand-name cologne for 79 cents a bottle, and the customers oohing and aahing over it. A financial analyst might have told me about the millions of dollars’ worth of Lassie Dog Food that Pic ’N’ Save bought from Campbell’s Soup after Campbell’s got out of the dog-food business, and that Pic ’N’ Save promptly resold for a huge profit. But watching the people line up with their carts full of dog food, you could see proof that the strategy was working.

  When I visited a Pep Boys outlet at a new location in California, a salesman there almost sold me a set of tires. I only wanted to look the place over, but he was so enthusiastic that I almost had four new tires shipped home with me on the airplane. He could have been an aberration, but I figured with personnel like that, Pep Boys could sell anything. Sure enough, they have.

  After Apple computer fell apart and the stock dropped from $60 to $15, I wondered if the company would ever recover from its difficulties, and whether I should consider it as a turnaround. Apple’s new Lisa, its entry into the lucrative business market, had been a total failure. But when my wife told me that she and the children needed a second Apple for the house, and when the Fidelity systems manager told me that Fidelity was buying 60 new Macintoshes for the office, then I just learned that (a) Apple still was popular in the home market, and (b) it was making new inroads in the business market. I bought a million shares and I haven’t regretted it.

  My faith in Chrysler was considerably strengthened after my conversation with Lee Iacocca, who made a very bullish case for an auto industry revival, for Chrysler’s successful cost-cutting, and for its improved lineup of cars. Outside the headquarters I noticed that the executive parking lot was half empty, another sign of progress. But my real enthusiasm developed in visiting a showroom and getting in and out of new Lasers, New Yorkers, and LeBaron convertibles.

  Over the years Chrysler had developed the reputation as the old fogy’s car, but from what I saw, it was obvious they were putting more pizzazz into the recent models—especially the convertible. (That one they made by cutting the tops off the regular LeBaron hardtops.)

  Somehow I overlooked the minivan, which soon became the most successful vehicle Chrysler ever made, and the L’eggs of the 1980s. But at least I could sense that the company was doing something right. Lately Chrysler has stretched the minivan and added a bigger engine, which is what the customers wanted, and Chrysler minivans alone now represent three percent of the cars and trucks sold in the U.S. I may buy one for myself as soon as my eleven-year-old AMC Concord totally rusts out.

  It’s amazing how much analysis of the auto industry you can do in the parking lots of ski lodges, shopping centers, bowling alleys, or churches. Every time I see a Chrysler minivan or a Ford Taurus (Ford is still one of my biggest holdings) parked with a driver in it, I saunter over and ask “How do you like it?” and “How long have you owned it?” and “Would you recommend it?” So far, the answers are one hundred percent positive, which bodes well for Ford and Chrysler. Carolyn, meanwhile, is busy inside the stores, doing analysis on The Limited, Pier 1 Imports, and McDonald’s new salads.

  The more homogeneous the country gets, the more likely that what’s popular in one shopping center will also be popular in all the other shopping centers. Think of all the brand names and products whose success or failure you’ve correctly predicted.

  Why then didn’t I buy OshKosh B’Gosh when our children have grown up in those wonderful OshKosh bib overalls? Why did I talk myself out of investing in Reebok because one of my wife’s friends complained that the shoes hurt her feet? Imagine missing a five-bagger because the neighbor gave a pair of sneakers a bad review. Nothing is ever easy in this business.

  READING THE REPORTS

  It’s no surprise why so many annual reports end up in the garbage can. The text on the glossy pages is the understandable part, and that’s generally useless,
and the numbers in the back are incomprehensible, and that’s supposed to be important. But there’s a way to get something out of an annual report in a few minutes, which is all the time I spend with one.

  Consider the 1987 annual report of Ford. It has a nice cover shot of the back end of a Lincoln Continental, photographed by Tom Wojnowski, and inside there’s a flattering tribute to Henry Ford II and a photograph of him standing in front of a portrait of his grandfather, Henry I. There’s a friendly message to stockholders, a treatise on corporate culture, and mention of the fact that Ford sponsored an exhibition of the works of Beatrix Potter, creator of Peter Rabbit.

  I flip past all that and turn directly to the Consolidated Balance Sheet printed on the cheaper paper on of the report (see charts). (That’s a rule with annuals and perhaps with publications in general—the cheaper the paper the more valuable the information.) The balance sheet lists the assets and then the liabilities. That’s critical to me.

  In the top column marked Current Assets, I notice that the company has $5.672 billion in cash and cash items, plus $4.424 billion in marketable securities. Adding these two items together, I get the company’s current overall-cash position, which I round off to $10.1 billion. Comparing the 1987 cash to the 1986 cash in the right-hand column, I see that Ford is socking away more and more cash. This is a sure sign of prosperity.

  Then I go to the other half of the balance sheet, down to the entry that says “long-term debt.” Here I see that the 1987 long-term debt is $1.75 billion, considerably reduced from last year’s long-term debt. Debt reduction is another sign of prosperity. When cash increases relative to debt, it’s an improving balance sheet. When it’s the other way around, it’s a deteriorating balance sheet.

  Subtracting the long-term debt from the cash, I arrive at $8.35 billion, Ford’s “net cash” position. The cash and cash assets alone exceed the debt by $8.35 billion. When cash exceeds debt it’s very favorable. No matter what happens, Ford isn’t about to go out of business.

  (You may have noticed Ford’s short-term debt of $1.8 billion. I ignore short-term debt in my calculations. The purists can fret all they want about this, but why complicate matters unnecessarily? I simply assume that the company’s other assets [inventories and so forth] are valuable enough to cover the short-term debt, and I leave it at that.)

  As often as not, it turns out that long-term debt exceeds cash, the cash has been shrinking and debt has been growing, and the company is in weak financial shape. Weak or strong is what you want to know in this short exercise.

  Next, I move on to the 10-Year Financial Summary, located on , to get a look at the ten-year picture. I discover that there are 511 million shares outstanding. I can also see that the number has been reduced in each of the past two years. This means that Ford has been buying back its own shares, another positive step.

  Dividing the $8.35 billion in cash and cash assets by the 511 million shares outstanding, I conclude that there’s $16.30 in net cash to go along with every share of Ford. Why this is important will be apparent in the next chapter.

  After that, I turn to...already this is getting complicated. If you don’t want to proceed with this exercise, and you’d rather read about Henry Ford, then ask your broker whether Ford is buying back shares, whether cash exceeds long-term debt, and how much cash there is per share!

  Let’s be realistic. I’m not about to lead you on a wild-goose chase through the trails of the accounts. There are important numbers that will help you follow companies, and if you get them from the annual reports, fine. If you don’t get them from the annual reports, you can get them from S&P reports, from your broker, or from Value Line.

  Value Line is easier to read than a balance sheet, so if you’ve never looked at any of this, start there. It tells you about cash and debt, summarizes the long-term record so you can see what happened during the last recession, whether earnings are on the upswing, whether dividends have always been paid, etc. Finally, it rates companies for financial strength on a simple scale of 1 to 5, giving you a rough idea of a company’s ability to withstand adversity. (There’s also a rating system for the “timeliness” of stocks, but I don’t pay attention to that.)

  I’m putting aside the annual report for now. Let’s instead consider the important numbers one by one on their own and not struggle further with finding them here.

  13

  Some Famous Numbers

  Here, and not in any particular order of importance, are the various numbers worth noticing:

  PERCENT OF SALES

  When I’m interested in a company because of a particular product—such as L’eggs, Pampers, Bufferin, or Lexan plastic—the first thing I want to know is what that product means to the company in question. What percent of sales does it represent? L’eggs sent Hanes stock soaring because Hanes was a relatively small company. Pampers was more profitable than L’eggs, but it didn’t mean as much to the huge Procter and Gamble.

  Let’s say you’ve gotten excited about Lexan plastic, and you find out that General Electric makes Lexan. Next, you discover from your broker (or from the annual report if you can follow it) that the plastics division is part of the materials division, and that entire division contributes only 6.8 percent to GE’s total revenues. So what if Lexan is the next Pampers—it’s not going to mean much to the shareholders of GE. You look at this and ask yourself who else makes Lexan, or you forget about Lexan.

  THE PRICE/EARNINGS RATIO

  We’ve gone on about this already, but here’s a useful refinement: The p/e ratio of any company that’s fairly priced will equal its growth rate. I’m talking about growth rate of earnings here. How do you find that out? Ask your broker what’s the growth rate, as compared to the p/e ratio.

  If the p/e of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year (also known as a “12-percent grower”) and a p/e ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown.

  In general, a p/e ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative. We use this measure all the time in analyzing stocks for the mutual funds.

  If your broker can’t give you a company’s growth rate, you can figure it out for yourself by taking the annual earnings from Value Line or an S&P report and calculating the percent increase in earnings from one year to the next. That way, you’ll end up with another measure of whether a stock is or is not too pricey. As to the all-important future growth rate, your guess is as good as mine.

  A slightly more complicated formula enables us to compare growth rates to earnings, while also taking the dividends into account. Find the long-term growth rate (say, Company X’s is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the p/e ratio (Company X’s is 10). 12 plus 3 divided by 10 is 1.5.

  Less than a 1 is poor, and 1.5 is okay, but what you’re really looking for is a 2 or better. A company with a 15 percent growth rate, a 3 percent dividend, and a p/e of 6 would have a fabulous 3.

  THE CASH POSITION

  We just went over Ford’s $8.35 billion in cash net of long-term debt. When a company is sitting on billions in cash, it’s definitely something you want to know about. Here’s why:

  Ford’s stock had moved from $4 a share in 1982 to $38 a share in early 1988 (adjusted for splits). Along the way I’d bought my 5 million shares. At $38 a share I’d already made a huge profit in Ford, and the Wall Street chorus had been sounding off for almost two years about Ford’s being overvalued. Numerous advisors said that this cyclical auto company had had its last hurrah and the next move was down. I almost cashed in the stock on several occasions.

  But by glancing at the annual report I’d noticed that Ford had accumula
ted the $16.30 a share in cash beyond debt—as mentioned in the previous chapter. For every share of Ford I owned, there was this $16.30 bonus sitting there on paper like some delightful hidden rebate.

  The $16.30 bonus changed everything. It meant that I was buying the auto company not for $38 a share, the stock price at the time, but for $21.70 a share ($38 minus the $16.30 in cash). Analysts were expecting Ford to earn $7 a share from its auto operations, which at the $38 price gave it a p/e of 5.4, but at the $21.70 price it had a p/e of 3.1.

  A p/e of 3.1 is a tantalizing number, cycles or no cycles. Maybe I wouldn’t have been impressed if Ford were a lousy company or if people were turned off by its latest cars. But Ford is a great company, and people loved the latest Ford cars and trucks.

  The cash factor helped convince me to hold on to Ford, and it rose more than 40 percent after I made the decision not to sell.

  I also knew (and you could have found out on of the annual report—still in the readable glossy section) that Ford’s financial services group—Ford Credit, First Nationwide, U. S. Leasing, and others—earned $1.66 per share on their own in 1987. For Ford Credit, which alone contributed $1.33 per share, it was “its 13th consecutive year of earnings growth.”

  Assigning a hypothetical p/e ratio of 10 to the earnings of Ford’s financial businesses (finance companies commonly have p/e ratios of 10) I estimated the value of these subsidiaries to be 10 times the $1.66, or $16.60 per share.