by Peter Lynch
I managed to repeat the error with Flowers, a bakery company, and then again with Lance, a crackers company. Because somebody told me that these were takeover candidates, I kept waiting for them to be taken over and finally got bored and disposed of my shares. After I sold, you can imagine what happened. The lesson this time was that I shouldn’t have cared if this profitable bakery company got taken over or not. In fact, I should have been delighted that it stayed independent.
I already reported that I almost didn’t buy La Quinta because an important insider had been selling shares. Not buying because an insider has started selling can be as big a mistake as selling because an outsider (Petrie) has stopped buying. In the La Quinta case I ignored the nonsense, and I’m glad I did.
I’m sure there are other examples of my having been faked out that I’ve conveniently forgotten. It’s normally harder to stick with a winning stock after the price goes up than it is to believe in it after the price goes down. These days if I feel there’s a danger of being faked out, I try to review the reasons why I bought in the first place.
THE DRUMBEAT EFFECT
This is one instance where the amateur investor is just as vulnerable to folly as the professional. We have fellow experts whispering into our ears; you have friends, relatives, brokers, and assorted financial factotums from the media.
Maybe you’ve received the “Congratulations: Don’t Be Greedy” announcement. That’s when the broker calls to say: “Congratulations, you’ve doubled your money on ToggleSwitch, but let’s not be greedy. Let’s sell ToggleSwitch and try KinderMind.” So you sell ToggleSwitch and it keeps going up, while KinderMind goes bankrupt, taking all of your profits with it. Meanwhile the broker gets a commission from both sides of the transaction, so every “Congratulations” message represents a double payday.
Beyond the broker, every single dumb idea you hear about stocks gets into your brain the same way that “Warner is overextended” got into mine. These days, dumb ideas are at a deafening roar.
Every time you turn on the television there’s somebody declaring that bank stocks are in and airline stocks are out, that utilities have seen their best days and savings-and-loans are doomed. If you flip around the radio dial and happen to hear the offhand remark that an overheated Japanese economy will destroy the world, you’ll remember that snippet the next time the market drops 10 percent, and maybe it will scare you into selling your Sony and your Honda, and even your Colgate-Palmolive, which isn’t cyclical or Japanese.
When astrologers are interviewed alongside economists from Merrill Lynch, and both say contradictory things and yet sound equally convincing, no wonder we’re all confused.
Lately we’ve had to contend with the drumbeat effect. A particularly ominous message is repeated over and over until it’s impossible to get away from it. A couple of years ago there was a drumbeat around the M-1 money supply. When I was in the Army, M-1 was a rifle and I understood it. Suddenly M-1 was this critical digit on which the entire future of Wall Street depended, and I couldn’t tell you what it was. Remember One Hour Martinizing? Nobody can tell you what that is, either, and millions of dry-cleaning patrons have never asked. Maybe M-1 actually stands for Martinizing One, and some guy on the Council of Economic Advisors used to run a dry-cleaning business. Anyway, for months there was something in the news about the M-1’s growing too fast, and people worried that it would sink our economy and threaten the world. What better reason to sell stocks than that “the M-1 is rising”—even if you weren’t sure what the M-1 was.
Then suddenly we heard nothing further about the dreaded rise in the M-1 money supply, and our attention was diverted to the discount rate that the Fed charges member banks. How many people know what this is? You can count me out once again. How many people know what the Fed does? William Miller, once Fed chairman, said that 23 percent of the U.S. population thought the Federal Reserve was an Indian reservation, 26 percent thought it was a wildlife preserve, and 51 percent thought it was a brand of whiskey.
Yet every Friday afternoon (it used to be Thursday afternoon until too many people jostled into the Fed building to get the number in advance of the Friday stock market opening) half the professional investing population was mesmerized by the news of the latest money supply figures, and stock prices were wafted up and down because of it. How many investors got faked out of good stocks because they heard that a higher money supply growth rate would sink the stock market?
More recently we’ve been warned (in no particular order) that a rise in oil prices is a terrible thing and a fall in oil prices is a terrible thing; that a strong dollar is a bad omen and a weak dollar is a bad omen; that a drop in the money supply is cause for alarm and an increase in the money supply is cause for alarm. A preoccupation with money supply figures has been supplanted with intense fears over budget and trade deficits, and thousands more must have been drummed out of their stocks because of each.
WHEN TO REALLY SELL
If the market can’t tell you when to sell, then what can? No single formula could possibly apply. “Sell before the interest rates go up” or “sell before the next recession” would be advice worth following, if only we knew when these things would happen, but of course we don’t, and so these mottos become platitudes as well.
Over the years I’ve learned to think about when to sell the same way I think about when to buy. I pay no attention to external economic conditions, except in the few obvious instances when I’m sure that a specific business will be affected in a specific way. When oil prices go down, it obviously has an effect on oil-service companies, but not on ethical drug companies. In 1986–87, I sold my Jaguar, Honda, Subaru, and Volvo holdings because I was convinced that the falling dollar would hurt the earnings of foreign automakers that sell a high percentage of their cars in the U.S. But in nine cases out of ten, I sell if company 380 has a better story than company 212, and especially when the latter story begins to sound unlikely.
As it turns out, if you know why you bought a stock in the first place, you’ll automatically have a better idea of when to say good-bye to it. Let’s review some of the sell signs, category by category.
WHEN TO SELL A SLOW GROWER
I can’t really help you with this one, because I don’t own many slow growers in the first place. The ones I do buy, I sell when there’s been a 30–50 percent appreciation or when the fundamentals have deteriorated, even if the stock has declined in price. Here are some other signs:
• The company has lost market share for two consecutive years and is hiring another advertising agency.
• No new products are being developed, spending on research and development is curtailed, and the company appears to be resting on its laurels.
• Two recent acquisitions of unrelated businesses look like diworseifications, and the company announces it is looking for further acquisitions “at the leading edge of technology.”
• The company has paid so much for its acquisitions that the balance sheet has deteriorated from no debt and millions in cash to no cash and millions in debt. There are no surplus funds to buy back stock, even if the price falls sharply.
• Even at a lower stock price the dividend yield will not be high enough to attract much interest from investors.
WHEN TO SELL A STALWART
These are the stocks that I frequently replace with others in the category. There’s no point expecting a quick tenbagger in a stalwart, and if the stock price gets above the earnings line, or if the p/e strays too far beyond the normal range, you might think about selling it and waiting to buy it back later at a lower price—or buying something else, as I do.
Other sell signs:
• New products introduced in the last two years have had mixed results, and others still in the testing stage are a year away from the marketplace.
• The stock has a p/e of 15, while similar-quality companies in the industry have p/e’s of 11–12.
• No officers or directors have bought shares in the las
t year.
• A major division that contributes 25 percent of earnings is vulnerable to an economic slump that’s taking place (in housing starts, oil drilling, etc.).
• The company’s growth rate has been slowing down, and though it’s been maintaining profits by cutting costs, future cost-cutting opportunities are limited.
WHEN TO SELL A CYCLICAL
The best time to sell is toward the end of the cycle, but who knows when that is? Who even knows what cycles they’re talking about? Sometimes the knowledgeable vanguard begins to sell cyclicals a year before there’s a single sign of a company’s decline. The stock price starts to fall for apparently no earthly reason.
To play this game successfully you have to understand the strange rules. That’s what makes cyclicals so tricky. In the defense business, which behaves like a cyclical, the price of General Dynamics once fell 50 percent on higher earnings. Farsighted cycle-watchers were selling in advance to avoid the rush.
Other than at the end of the cycle, the best time to sell a cyclical is when something has actually started to go wrong. Costs have started to rise. Existing plants are operating at full capacity, and the company begins to spend money to add to capacity. Whatever inspired you to buy XYZ between the last bust and latest boom ought to clue you in that the latest boom is over.
One obvious sell signal is that inventories are building up and the company can’t get rid of them, which means lower prices and lower profits down the road. I always pay attention to rising inventories. When the parking lot is full of ingots, it’s certainly time to sell the cyclical. In fact, you may be a little late.
Falling commodity prices is another harbinger. Usually prices of oil, steel, etc., will turn down several months before the troubles show up in the earnings. Another useful sign is when the future price of a commodity is lower than the current, or spot, price. If you had enough of an edge to know when to buy the cyclical in the first place, then you’ll notice the price changes.
Competition businesses are also a bad sign for cyclicals. The outsider will have to win customers by cutting prices, which forces everyone else to cut prices and leads to lower earnings for all the producers. As long as there’s strong demand for nickel and nobody to challenge Inco, Inco will do fine, but as soon as demand slackens or rival nickel producers begin to sell nickel, Inco’s got problems.
Other signs:
• Two key union contracts expire in the next twelve months, and labor leaders are asking for a full restoration of the wages and benefits they gave up in the last contract.
• Final demand for the product is slowing down.
• The company has doubled its capital spending budget to build a fancy new plant, as opposed to modernizing the old plants at low cost.
• The company has tried to cut costs but still can’t compete with foreign producers.
WHEN TO SELL A FAST GROWER
Here, the trick is not to lose the potential tenbagger. On the other hand, if the company falls apart and the earnings shrink, then so will the p/e multiple that investors have bid up on the stock. This is a very expensive double whammy for the loyal shareholders.
The main thing to watch for is the end of the second phase of rapid growth, as explained earlier.
If The Gap has stopped building new stores, and the old stores are beginning to look shabby, and your children complain that The Gap doesn’t carry acid-washed denim apparel, which is the current rage, then it’s probably time to think about selling. If forty Wall Street analysts are giving the stock their highest recommendation, 60 percent of the shares are held by institutions, and three national magazines have fawned over the CEO, then it’s definitely time to think about selling.
All the characteristics of the Stock You’d Avoid (see Chapter 9) are characteristics of the Stock You’d Want to Sell.
Unlike the cyclical where the p/e ratio gets smaller near the end, in a growth company the p/e usually gets bigger, and it may reach absurd and illogical dimensions. Remember Polaroid and Avon Products. P/e’s of 50 for companies of their size? Any astute fourth-grader could have figured it was time to sell those. Was Avon going to sell a billion bottles of perfume? How could it, when every other housewife in America was an Avon representative?
You could have sold Holiday Inn when it hit 40 times earnings and been confident that the party was over there, and you were right. When you saw a Holiday Inn franchise every twenty miles along every major U.S. highway, and then you traveled to Gibraltar and saw a Holiday Inn at the base of the rock, it had to be time to worry. Where else could they expand? Mars?
Other signs:
• Same store sales are down 3 percent in the last quarter.
• New store results are disappointing.
• Two top executives and several key employees leave to join a rival firm.
• The company recently returned from a “dog and pony” show, telling an extremely positive story to institutional investors in twelve cities in two weeks.
• The stock is selling at a p/e of 30, while the most optimistic projections of earnings growth are 15–20 percent for the next two years.
WHEN TO SELL A TURNAROUND
The best time to sell a turnaround is after it’s turned around. All the troubles are over and everybody knows it. The company has become the old self it was before it fell apart: growth company or cyclical or whatever. The shareholders aren’t embarrassed to own it again. If the turnaround has been successful, you have to reclassify the stock.
Chrysler was a turnaround play at $2 a share, at $5, and even at $10 (adjusted for splits), but not at $48 in mid-1987. By then the debt was paid and the rot was cleaned out, and Chrysler was back to being a solid, cyclical auto company. The stock may go higher, but it’s unlikely to see a tenfold rise. It has to be judged the same way that General Motors, Ford, or other prosperous companies are judged. If you like the autos, keep Chrysler. It’s doing well in all divisions, and the acquisition of American Motors gives it some extra long-term potential, along with some extra short-term problems. But if you specialize in turnarounds, sell Chrysler and look for something else.
General Public Utilities was a turnaround at $4 a share, at $8, and at $12, but after the second nuclear unit was returned to service, and other utilities agreed to help pay the costs of the Three Mile Island cleanup, GPU became a quality electric utility again. Nobody thinks GPU is going out of business anymore. The stock, now at $38, may hit $45, but it certainly isn’t going to hit $400.
Other signs:
• Debt, which has declined for five straight quarters, just rose by $25 million in the latest quarterly report.
• Inventories are rising at twice the rate of sales growth.
• The p/e is inflated relative to earnings prospects.
• The company’s strongest division sells 50 percent of its output to one leading customer, and that leading customer is suffering from a slowdown in its own sales.
WHEN TO SELL AN ASSET PLAY
Lately, the best idea is to wait for the raider. If there are really hidden assets there, Saul Steinberg, the Hafts, or the Reichmanns will figure it out. As long as the company isn’t going on a debt binge, thus reducing the value of the assets, then you’ll want to hold on.
Alexander and Baldwin owns 96,000 acres of Hawaiian real estate in addition to its exclusive shipping rights into the island plus other assets. A lot of people estimated that this $5 stock (adjusted for splits) was worth much more. They tried to be patient, but nothing happened for several years. Then a Mr. Harry Weinberg showed up and bought 5 percent, then 9 percent, and finally 15 percent of the shares. That inspired other investors to buy shares because Mr. Weinberg was buying, and the stock hit a high of $32 before it was marked down to $16 in the October, 1987, sell-off. Seven months later it was back up to $30.
The same thing happened at Storer Broadcasting, and then at Disney. Disney was a sleepy company that didn’t know its own worth until Mr. Steinberg came along to goad management in
to “enhancing shareholder values.” The company was making progress anyway. It’s done a brilliant job moving away from animated movies to appeal to a broader and more adult audience. It’s been successful with the Disney channel and the Japanese theme park, and the upcoming European theme park is promising. With its irreplaceable film library and its Florida and California real estate, Disney is an asset play, a turnaround, and a growth company all at once.
No longer do you have to wait until your children have children for hidden assets to be discovered. It used to be that you could sit on an undervalued situation your entire adult life and the stock wouldn’t budge a nickel. These days, the enhancement of shareholder values happens much quicker, thanks to the packs of well-heeled magnates roving around looking for every last example of an undervalued asset. (Boone Pickens came to our office a few years ago and told us exactly how a company such as Gulf Oil could hypothetically be taken over. I listened to his well-reasoned presentation, then promptly concluded that it couldn’t be done. I was convinced that Gulf Oil was too big to be taken over—right up to the day that Chevron did it. Now I’m ready to believe that anything could be taken over, including the larger continents.)
With so many raiders around, it’s harder for the amateur to find a good asset stock, but it’s a cinch to know when to sell. You don’t sell until the Bass brothers show up, and if it’s not the Bass brothers, then it’s certain to be Steinberg, Icahn, the Belzbergs, the Pritzkers, Irwin Jacobs, Sir James Goldsmith, Donald Trump, Boone Pickens, or maybe even Merv Griffin. After that, there could be a takeover, a bidding war, or a leveraged buyout to double, triple or quadruple the stock price.