by Peter Lynch
There’s a long-standing debate between two factions of investment advisors, with the Gerald Loeb faction declaring, “Put all your eggs in one basket,” and the Andrew Tobias faction retorting, “Don’t put all your eggs in one basket. It may have a hole in it.”
If the one basket I owned was Wal-Mart stock, I’d have been delighted to put all my eggs into it. On the other hand, I wouldn’t have been too happy to risk everything on a basket of Continental Illinois. Even if I was handed five baskets—one apiece from Shoney’s, The Limited, Pep Boys, Taco Bell, and Service Corporation International—I’d swear it was a fine idea to divide my eggs between them, but if this diversification included Avon Products or Johns-Manville, then I’d be yearning for a single, solid basket of Dunkin’ Donuts. The point is not to rely on any fixed number of stocks but rather to investigate how good they are, on a case-by-case basis.
In my view it’s best to own as many stocks as there are situations in which: (a) you’ve got an edge; and (b) you’ve uncovered an exciting prospect that passes all the tests of research. Maybe that’s a single stock, or maybe it’s a dozen stocks. Maybe you’ve decided to specialize in turnarounds or asset plays and you buy several of those; or perhaps you happen to know something special about a single turnaround or a single asset play. There’s no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors.
That said, it isn’t safe to own just one stock, because in spite of your best efforts, the one you choose might be the victim of unforeseen circumstances. In small portfolios I’d be comfortable owning between three and ten stocks. There are several possible benefits:
(1) If you are looking for tenbaggers, the more stocks you own the more likely that one of them will become a tenbagger. Among several fast growers that exhibit promising characteristics, the one that actually goes the furthest may be a surprise.
Stop & Shop was a big gainer that I never thought would give me more than a 30–40 percent profit. It was a mediocre company whose stock was declining, and I started buying it in 1979 partly because I liked the dividend yield. Then the story got better and better, both at the supermarkets and at the Bradlee’s discount store division. The stock, which I started buying at $4, ended up at $44 when the company was taken private in 1988. Marriott is another example of a business whose stock market success I couldn’t have predicted. I knew the company was a winner because I had stayed at its hotels countless times, but it never dawned on me how far the stock could go. I wish I had bought a few thousand shares instead of settling for a few thousand of those little bars of soap.
By the way, in spite of all the takeover rumors that fill the newspapers these days, I can’t think of a single example of a company that I bought in expectation of a takeover that was actually taken over. Usually what happens is that some company I own for its fundamental virtues gets taken over—and that, too, is a complete surprise.
Since there’s no way to anticipate when pleasant surprises of various kinds might occur, you increase your odds of benefiting from one by owning several stocks.
(2) The more stocks you own, the more flexibility you have to rotate funds between them. This is an important part of my strategy.
Some people ascribe my success to my having specialized in growth stocks. But that’s only partly accurate. I never put more than 30–40 percent of my fund’s assets into growth stocks. The rest I spread out among the other categories described in this book. Normally I keep about 10–20 percent or so in the stalwarts, another 10–20 percent or so in the cyclicals, and the rest in the turnarounds. Although I own 1,400 stocks in all, half of my fund’s assets are invested in 100 stocks, and two-thirds in 200 stocks. One percent of the money is spread out among 500 secondary opportunities I’m monitoring periodically, with the possibility of tuning in later. I’m constantly looking for values in all areas, and if I find more opportunities in turnarounds than in fast-growth companies, then I’ll end up owning a higher percentage of turnarounds. If something happens to one of the secondaries to bolster my confidence, then I’ll promote it to a primary selection.
SPREADING IT AROUND
Spreading your money among several categories of stocks is another way to minimize downside risk, as discussed in Chapter 3. Assuming that you’ve done all the proper research and have bought companies that are fairly priced, then you’ve already minimized the risk to an important degree, but beyond that, it’s worth considering the following:
Slow growers are low-risk, low-gain because they’re not expected to do much and the stocks are usually priced accordingly. Stalwarts are low-risk, moderate gain. If you own Coca-Cola and everything goes right next year, you could make 50 percent; and if everything goes wrong, you could lose 20 percent. Asset plays are low-risk and high-gain if you’re sure of the value of the assets. If you are wrong on an asset play, you probably won’t lose much, and if you are right, you could make a double, a triple, or perhaps a five-bagger.
Cyclicals may be low-risk and high-gain or high-risk and low-gain, depending on how adept you are at anticipating cycles. If you are right, you can get your tenbaggers here, and if you are wrong, you can lose 80–90 percent.
Meanwhile, additional tenbaggers are likely to come from fast growers or from turnarounds—both high-risk, high-gain categories. The higher the potential upside, the greater the potential downside, and if a fast grower falters or the troubled old turnaround has a relapse, the downside can be losing all your money. At the time I bought Chrysler, if everything went right, I thought I could make 400 percent, and if everything went wrong, I could lose 100 percent. This is something you had to recognize going in. As it turned out, I was pleasantly surprised and made fifteenfold on it.
There’s no pat way to quantify these risks and rewards, but in designing your portfolio you might throw in a couple of stalwarts just to moderate the thrills and chills of owning four fast growers and four turnarounds. Again, the key is knowledgeable buying. You don’t want to buy an overvalued stalwart and thus add to the very risk you’re trying to moderate. Remember that during several years in the 1970s, even the wonderful Bristol-Myers was a risky pick. The stock went nowhere because investors had bid it up to 30 times earnings and it was only a 15 percent grower. It took Bristol-Myers a decade of consistent growth to catch up to the inflated price. If you bought it at that price, which was twice its growth rate, you took unnecessary chances.
It’s a real tragedy when you buy a stock that’s overpriced, the company is a big success, and still you don’t make any money. That’s what happened with Electronic Data Systems, the stock that had the 500 p/e ratio in 1969. Earnings grew dramatically over the next 15 years, up about twentyfold. The stock price (adjusted for splits) fell from $40 all the way down to $3 in 1974 and then rebounded, and in 1984 the company was bought out by General Motors for $44, or about what the stock sold for ten years earlier.
Finally, your portfolio design may change as you get older. Younger investors with a lifetime of wage-earning ahead of them can afford to take more chances on tenbaggers than can older investors who must live off the income from their investments. Younger investors have more years in which they can experiment and make mistakes before they find the great stocks that make investing careers. The circumstances vary so widely from person to person that any further analysis of this point will have to come from you.
WATERING THE WEEDS
In the next chapter I’ll explain what I know about when to sell a stock, but here I want to discuss selling as it relates to portfolio management. I’m constantly rechecking stocks and rechecking stories, adding and subtracting to my investments as things change. But I don’t go into cash—except to have enough of it around to cover anticipated redemptions. Going into cash would be getting out of the market. My idea is to stay in the market forever, and to rotate stocks depending on the fundamental situations. I think if you decide that a certain amount you’ve invested in the stock market will always b
e invested in the stock market, you’ll save yourself a lot of mistimed moves and general agony.
Some people automatically sell the “winners”—stocks that go up—and hold on to their “losers”—stocks that go down—which is about as sensible as pulling out the flowers and watering the weeds. Others automatically sell their losers and hold on to their winners, which doesn’t work out much better. Both strategies fail because they’re tied to the current movement of the stock price as an indicator of the company’s fundamental value. (It wasn’t that Taco Bell the company was in bad shape when the price was beaten down in 1972—only Taco Bell the stock. Taco Bell the company was doing well.) As we’ve seen, the current stock price tells us absolutely nothing about the future prospects of a company, and it occasionally moves in the opposite direction of the fundamentals.
A better strategy, it seems to me, is to rotate in and out of stocks depending on what has happened to the price as it relates to the story. For instance, if a stalwart has gone up 40 percent—which is all I expected to get out of it—and nothing wonderful has happened with the company to make me think there are pleasant surprises ahead, I sell the stock and replace it with another stalwart I find attractive that hasn’t gone up. In the same situation, if you didn’t want to sell all of it, you could sell some of it.
By successfully rotating in and out of several stalwarts for modest gains, you can get the same result as you would with a single big winner: six 30-percent moves compounded equals a fourbagger plus, and six 25-percent moves compounded is nearly a fourbagger.
The fast growers I keep as long as the earnings are growing and the expansion is continuing, and no impediments have come up. Every few months I check the story just as if I were hearing it for the first time. If between two fast growers I find that the price of one has increased 50 percent and the story begins to sound dubious, I’ll rotate out of that one and add to my position in the second fast grower whose price has declined or stayed the same, and where the story is sounding better.
Ditto for cyclicals and turnarounds. Get out of situations in which the fundamentals are worse and the price has increased, and into situations in which the fundamentals are better and the price is down.
A price drop in a good stock is only a tragedy if you sell at that price and never buy more. To me, a price drop is an opportunity to load up on bargains from among your worst performers and your laggards that show promise.
If you can’t convince yourself “When I’m down 25 percent, I’m a buyer” and banish forever the fatal thought “When I’m down 25 percent, I’m a seller,” then you’ll never make a decent profit in stocks.
For reasons that should by now be obvious, I’ve always detested “stop orders,” those automatic bailouts at a predetermined price, usually 10 percent below the price at which a stock is purchased. True, when you put in a “stop order” you’ve limited your losses to 10 percent, but with the volatility in today’s market, a stock almost always hits the stop. It’s uncanny how stop orders seem to guarantee that the stock will drop 10 percent, the shares are sold, and instead of protecting against a loss, the investor has turned losing into a foregone conclusion. You would have lost Taco Bell ten times over with stop orders!
Show me a portfolio with 10 percent stops, and I’ll show you a portfolio that’s destined to lose exactly that amount. When you put in a stop, you’re admitting that you’re going to sell the stock for less than it’s worth today.
It’s equally uncanny how stocks seem to shoot straight up after the stop is hit, and the would-be cautious investor has been sold out. There’s simply no way to rely on stops as protection on the downside, nor on artificial objectives as goals on the upside. If I’d believed in “Sell when it’s a double,” I would never have benefited from a single big winner, and I wouldn’t have been given the opportunity to write a book. Stick around to see what happens—as long as the original story continues to make sense, or gets better—and you’ll be amazed at the results in several years.
17
The Best Time to Buy and Sell
After all that’s been said, I don’t want to sound like a market timer and tell you that there’s a certain best time to buy stocks. The best time to buy stocks will always be the day you’ve convinced yourself you’ve found solid merchandise at a good price—the same as at the department store. However, there are two particular periods when great bargains are likely to be found.
The first is during the peculiar annual ritual of end-of-the-year tax selling. It’s no accident that the most severe drops have occurred between October and December. It’s the holiday period, after all, and brokers need spending money like the rest of us, so there’s extra incentive for them to call and ask what you might want to sell to get the tax loss. For some reason investors are delighted to get the tax loss, as if it’s a wonderful opportunity or a gift of some kind—I can’t think of another situation in which failure makes people so happy.
Institutional investors also like to jettison the losers at the end of the year so their portfolios are cleaned up for the upcoming evaluations. All this compound selling drives stock prices down, and especially in the lower-priced issues, because once the $6-per-share threshold is reached, stocks do not count as collateral for people who buy on credit in margin accounts. Margin players sell their cheap stocks, and so do the institutions, who cannot own them without violating one stricture or another. This selling begets more selling and drives perfectly good issues to crazy levels.
If you have a list of companies that you’d like to own if only the stock price were reduced, the end of the year is a likely time to find the deals you’ve been waiting for.
The second is during the collapses, drops, burps, hiccups, and freefalls that occur in the stock market every few years. If you can summon the courage and presence of mind to buy during these scary episodes when your stomach says “sell,” you’ll find opportunities that you wouldn’t have thought you’d ever see again. Professionals are often too busy or too constrained to act quickly in market breaks, but look at the solid companies with excellent earnings growth that you could have picked up in the latest ones:
THE 1987 BREAK
In the sell-off of October, 1987, you had a chance to buy many of the companies I’ve been mentioning throughout this book. The 1,000-point drop between summer and fall took everything with it, but in the real world all the companies listed below were healthy, profitable, and never missed a beat. Many of them recovered in quick fashion, and I took advantage whenever I could. I missed Dreyfus the first time around, but not this time (fool me once, shame on you; fool me twice, shame on me). Dreyfus was beaten down to $16 and the company had $15 in cash after debt, so what was the risk? In addition to the cash, Dreyfus actually profited from the crisis, as many investors switched out of stocks and into money-market funds that Dreyfus manages.
WHEN TO SELL
Even the most thoughtful and steadfast investor is susceptible to the influence of skeptics who yell “Sell” before it’s time to sell. I ought to know. I’ve been talked out of a few tenbaggers myself.
Soon after I started managing Magellan in May of 1977, I was attracted to Warner Communications. Warner was a promising turnaround from a conglomerate that had diworseified. Confident of the fundamentals, I invested three percent of my fund in Warner at $26.
A few days later I got a call from a technical analyst who follows Warner. I don’t pay much attention to that science of wiggles, but just to be polite I asked him what he thought. Without hesitation he announced that the stock was “extremely extended.” I’ve never forgotten those words. One of the biggest troubles with stock market advice is that good or bad it sticks in your brain. You can’t get it out of there, and someday, sometime, you may find yourself reacting to it.
Six months or so had passed, and Warner had risen from $26 to $32. Already I was beginning to worry. “If Warner was extremely extended at $26,” I argued to myself, “then it must be hyperextended at $32.” I checked the
fundamentals, and nothing there had changed enough to diminish my enthusiasm, so I held on. Then the stock hit $38. For no conscious reason I began a major sell program. I must have decided that whatever was extended at $26 and hyperextended at $32 has surely been stretched into three prefixes at $38.
Of course after I sold, the stock continued its ascent to $50, $60, $70, and over $180. Even after it suffered the consequences of the Atari fiasco, and the price declined by 60 percent in 1983–84, it was still twice my exit price of $38. I hope I’ve learned my lesson here.
Another time I made a premature exit from Toys “R” Us, that nifty fast grower that I’ve already bragged about. By 1978, when Toys “R” Us was liberated from Interstate Department Stores (a woeful dog) in that company’s bankruptcy action (creditors were paid off in new Toys “R” Us shares), this was already a proven and profitable enterprise, expanding into one mall after another. It had passed the tests of success in one location, and then of duplication. I did my homework, visited the stores, and took a big position at an adjusted price of $1 per share. By 1985, when Toys “R” Us hit $25, it was a 25-bagger for some. Unfortunately, those some didn’t include me, because I sold too soon. I sold too soon because somewhere along the line I’d read that a smart investor named Milton Petrie, one of the deans of retailing, had bought 20 percent of Toys “R” Us and that his buying was making the stock go up. The logical conclusion, I thought, was that when Petrie stopped buying, the stock would go down. Petrie stopped buying at $5.
I got in at $1 and out at $5 for a five-bagger, so how can I complain? We’ve all been taught the same adages: “Take profits when you can,” and “A sure gain is always better than a possible loss.” But when you’ve found the right stock and bought it, all the evidence tells you it’s going higher, and everything is working in your direction, then it’s a shame if you sell. A fivefold gain turns $10,000 into $50,000, but the next five folds turn $10,000 into $250,000. Investing in a 25-bagger is not a regular occurrence even among fund managers, and for the individual it may happen only once or twice in a lifetime. When you’ve got one, you might as well enjoy the full benefit. The clients of Peter deRoetth, who first told me about Toys “R” Us, did just that. He stuck with it all the way in his fund.