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

by Peter Lynch

  Other sell signs:

  • Although the shares sell at a discount to real market value, management has announced it will issue 10 percent more shares to help finance a diversification program.

  • The division that was expected to be sold for $20 million only brings $12 million in the actual sale.

  • The reduction in the corporate tax rate considerably reduces the value of the company’s tax-loss carryforward.

  • Institutional ownership has risen from 25 percent five years ago to 60 percent today—with several Boston fund groups being major purchasers.

  18

  The Twelve Silliest (and Most Dangerous)

  Things People Say About

  Stock Prices

  I’m constantly amazed at popular explanations of why stocks behave the way they do, which are volunteered by amateurs and professionals alike. We’ve made great advances in eliminating ignorance and superstition in medicine and in weather reports, we laugh at our ancestors for blaming bad harvests on corn gods, and we wonder, “How could a smart man like Pythagoras think that evil spirits hide in rumpled bedsheets?” However, we’re perfectly willing to believe that who wins the Super Bowl might have something to do with stock prices.

  Moving back and forth from graduate school to my summer job at Fidelity, I first realized that even the most intelligent professors on the subject are as wrong about stocks as Pythagoras was about beds. Since then I’ve heard a continuous stream of theories, each as misguided as the last, which have filtered down to the general public. The myths and misconceptions are numerous, but I’ve written a few of them down: These are the Twelve Silliest Things People Say About Stock Prices, which I present in the hope that you can dismiss them from your mind. Some probably will sound familiar.

  IF IT’S GONE DOWN THIS MUCH ALREADY, IT CAN’T GO MUCH LOWER

  That’s a good one. I’d bet the owners of Polaroid shares were repeating this very phrase just after the stock had fallen a third of the way along its long drop from a high of $143½. Polaroid had been a solid company with a blue-chip reputation, so when the earnings collapsed and the sales collapsed, as we’ve already reported, a lot of people didn’t pay attention to how overpriced Polaroid really was. Instead they continued to reassure themselves that if “it’s gone down this much already, it can’t go much lower,” and probably also threw in “good companies always come back,” “you have to be patient in the stock market,” and “there’s no sense getting scared out of a good thing.”

  These phrases were no doubt heard again and again around investor households, and in the bank portfolio departments, as Polaroid stock sank to $100, then to $90, and then $80. As the stock broke below $75, the “can’t go much lower” faction must have grown into a small mob, and at $50 you could have heard the phrase repeated by every other Polaroid owner who held on.

  Newer owners were buying Polaroid all the way down on the theory that it couldn’t go much lower, and many of them must have regretted that decision, because in fact Polaroid did go much lower. This great stock fell from $143½ to $14⅛ in less than a year, and only then did “it can’t go much lower” turn out to be true. So much for the it-can’t-go-lower theory.

  There’s simply no rule that tells you how low a stock can go in principle. I learned this lesson for myself in 1971, when I was an eager but somewhat inexperienced analyst at Fidelity. Kaiser Industries had already dropped from $25 to $13. On my recommendation Fidelity bought five million shares—one of the biggest blocks ever traded in the history of the American Stock Exchange—when the stock hit $11. I confidently asserted that there was no way the stock could go below $10.

  When it reached $8, I called my mother and told her to go out and buy it, since it was absolutely inconceivable that Kaiser would drop below $7.50. Fortunately my mother didn’t listen to me. I watched with horror as Kaiser faded from $7 to $6 to $4 in 1973—where it finally proved that it couldn’t go much lower.

  The portfolio managers at Fidelity held on to their five million shares, on the theory that if Kaiser had been a good buy at $11, it was undoubtedly a bargain at $4. Since I was the analyst who recommended it, I kept having to reassure them that it had a good balance sheet. In fact, it cheered us all up to discover that with only 25 million shares outstanding, at the $4 price the entire company was selling for $100 million. That same money would have bought you four Boeing 747s back then. Today, you’d get one plane with no engines.

  The stock market had driven Kaiser so low that this powerful company, with its real estate, aluminum, steel, cement, shipbuilding, aggregates, fiberglass, engineering, and broadcasting businesses—not to mention jeeps—was selling for the price of four airplanes. The company had very little debt. Even if it were liquidated for the assets, we calculated that it was worth $40 a share. Nowadays a raider would have swooped in and taken it over.

  Soon enough Kaiser Industries did rebound to $30 a share, but not before the drop to $4 had cured me of any further urge to announce, “It can’t possibly go any lower than this.”

  YOU CAN ALWAYS TELL WHEN A STOCK’S HIT BOTTOM

  Bottom fishing is a popular investor pastime, but it’s usually the fisherman who gets hooked. Trying to catch the bottom on a falling stock is like trying to catch a falling knife. It’s normally a good idea to wait until the knife hits the ground and sticks, then vibrates for a while and settles down before you try to grab it. Grabbing a rapidly falling stock results in painful surprises, because inevitably you grab it in the wrong place.

  If you get interested in buying a turnaround, it ought to be for a more sensible reason than the stock’s gone down so far it looks like up to you. Maybe you realize that business is picking up, and you check the balance sheet and you see that the company has $11 per share in cash and the stock is selling for $14.

  But even so, you aren’t going to be able to pick the bottom on the price. What usually happens is that a stock sort of vibrates itself out before it starts up again. Generally this process takes two or three years, but sometimes even longer.

  IF IT’S GONE THIS HIGH ALREADY, HOW CAN IT POSSIBLY GO HIGHER?

  Right you are, unless of course you are talking about a Philip Morris or a Subaru. That Philip Morris is one of the greatest stocks of all time is obvious from the chart on . I’ve already mentioned how Subaru could have made us all millionaires, if we’d bought the stock instead of the car.

  If you bought Philip Morris in the 1950s for the equivalent of 75 cents a share, then you might have been tempted to sell it for $2.50 a share in 1961, on the theory that this stock couldn’t go much higher. Eleven years later, with the stock selling at seven times the 1961 price and 23 times the 1950s price, you might once again have concluded that Philip Morris couldn’t go higher. But if you sold it then, you would have missed the next sevenbagger on top of the last 23-bagger.

  Whoever managed to ride Philip Morris all the way would have seen their 75-cent shares blossom into $124.50 shares, and a $1,000 investment end up as a $166,000 result. And that doesn’t even include the $23,000 in dividends you picked up along the way.

  If I’d bothered to ask myself, “How can this stock possibly go higher,” I would never have bought Subaru after it already had gone up twentyfold. But I checked the fundamentals, realized that Subaru was still cheap, bought the stock, and made sevenfold after that.

  The point is, there’s no arbitrary limit to how high a stock can go, and if the story is still good, the earnings continue to improve, and the fundamentals haven’t changed, “can’t go much higher” is a terrible reason to snub a stock. Shame on all those experts who advise clients to sell automatically after they double their money. You’ll never get a tenbagger doing that.

  Stocks such as Philip Morris, Shoney’s, Masco, McDonald’s, and Stop & Shop have broken the “can’t go much higher” barriers year after year.

  Frankly, I’ve never been able to predict which stocks will go up tenfold, or which will go up fivefold. I try to stick with them as long as
the story’s intact, hoping to be pleasantly surprised. The success of a company isn’t the surprise, but what the shares bring often is. I remember buying Stop & Shop as a conservative, dividend-paying stock, and then the fundamentals kept improving and I realized I had a fast grower on my hands.

  IT’S ONLY $3 A SHARE: WHAT CAN I LOSE?

  How many times have you heard people say this? Maybe you’ve said it yourself. You come across some stock that sells for $3 a share, and already you’re thinking, “It’s a lot safer than buying a $50 stock.”

  I put in twenty years in the business before it finally dawned on me that whether a stock costs $50 a share or $1 a share, if it goes to zero you still lose everything. If it goes to 50 cents a share, the results are slightly different. The investor who bought in at $50 a share loses 99 percent of his investment, and the investor who bought in at $3 loses 83 percent, but what’s the consolation in that?

  The point is that a lousy cheap stock is just as risky as a lousy expensive stock if it goes down. If you’d invested $1,000 in a $43 stock or a $3 stock and each fell to zero, you’d have lost exactly the same amount. No matter where you buy in, the ultimate downside of picking the wrong stock is always the identical 100 percent.

  Yet I’m certain there are buyers who can’t resist a bargain at $3 and say to themselves: “What can I lose?”

  It’s interesting to note that the professional short sellers, who profit on stocks that go down in price, usually take their positions nearer to the bottom than to the top. The short sellers like to wait until a company is so obviously foundering that bankruptcy is a certainty. It doesn’t bother them to get involved at $8 or $6 a share instead of at $60, because if the stock goes to zilch, they’ll make exactly the same profit in either instance.

  And guess who they’re selling to when the stock’s at $8 or $6? All those hapless investors who are telling themselves, “How can I lose?”

  EVENTUALLY THEY ALWAYS COME BACK

  So will the Visigoths and the Picts, and Genghis Khan will ride again. People said RCA would come back, and after 65 years it never did. This was a world-famous successful company. Johns-Manville is another world-famous company that hasn’t come back, and with all the asbestos lawsuits filed against it, the possibilities are too open-ended to measure. By printing hundreds of millions of new shares, the company has also diluted its earnings, just as Navistar did.

  If I could only remember the names, I could give you a much longer list of smaller and lesser-known public companies whose blips have disappeared from the Quotrons forever. Perhaps you’ve invested in a few of these yourself—I wouldn’t want to think I was the only one. When you consider the thousands of bankrupt companies, plus the solvent companies that never regain their former prosperity, plus the companies that get bought out at prices that are far below the all-time highs, you can begin to see the weakness in the “they always come back” argument.

  Health Maintenance Organizations, floppy disks, double knits, digital watches, and mobile home stocks haven’t come back so far.

  IT’S ALWAYS DARKEST BEFORE THE DAWN

  There’s a very human tendency to believe that things that have gotten a little bad can’t get any worse. In 1981 there were 4,520 active oil-drilling rigs in the U.S., and by 1984 the number had fallen to 2,200. At that point many people bought oil-service stocks, believing that the worst was over. But two years after that, there were only 686 active rigs, and today there are still fewer than 1,000.

  People who invest on the basis of freight-car deliveries were amazed when business dropped from a peak of 95,650 units delivered in 1979, to a low of 44,800 in 1981. This was the lowest total in 17 years, and nobody imagined it could get much worse, until it dropped to 17,582 units in 1982, and then to 5,700 in 1983. This was a whopping 90 percent decline in a once-vibrant industry.

  Sometimes it’s always darkest before the dawn, but then again, other times it’s always darkest before pitch black.

  WHEN IT REBOUNDS TO $10, I’LL SELL

  In my experience no downtrodden stock ever returns to the level at which you’ve decided you’d sell. In fact, the minute you say, “If it gets back to $10, I’ll sell,” you’ve probably doomed the stock to several years of teetering around just below $9.75 before it keels over to $4, on its way to falling flat on its face at $1. This whole painful process may take a decade, and all the while you’re tolerating an investment you don’t even like, and only because some inner voice tells you to get $10 for it.

  Whenever I’m tempted to fall for this one, I remind myself that unless I’m confident enough in the company to buy more shares, I ought to be selling immediately.

  WHAT ME WORRY? CONSERVATIVE STOCKS DON’T FLUCTUATE MUCH

  Two generations of conservative investors grew up on the idea that you couldn’t go wrong with utility stocks. You could just put these worry-free issues in the safety-deposit box and cash the dividend checks. Then suddenly there were nuclear problems and rate-base problems, and stocks such as Consolidated Edison lost 80 percent of their value. Then, just as suddenly, Con Edison gained back more than it had lost.

  With the economic and regulatory troubles caused by expensive nuclear plants, the so-called stable utility sector has become just as volatile and treacherous as the savings-and-loan industry or the computer stocks. There are now electric companies that were or can be tenbaggers up and tenbaggers down. You can win big or lose big, depending on how lucky or careful you are at choosing the right utility.

  Investors who didn’t catch on to this new situation right away must have suffered terrible financial and psychological punishment. Their so-called prudent investments in Public Service of Indiana or Gulf States Utilities or Public Service of New Hampshire turned out to be as risky as if they’d taken fliers in unknown start-up biogenetic firms—or actually riskier since they weren’t aware of the dangers.

  Companies are dynamic, and prospects change. There simply isn’t a stock you can own that you can afford to ignore.

  IT’S TAKING TOO LONG FOR ANYTHING TO EVER HAPPEN

  Here’s something else that’s certain to occur: If you give up on a stock because you’re tired of waiting for something wonderful to happen, then something wonderful will begin to happen the day after you get rid of it. I call this the postdivestiture flourish.

  Merck tested everybody’s patience (see chart). This stock went nowhere from 1972 to 1981, even though earnings grew steadily at an average of 14 percent a year. Then what happened? It shot up fourfold in the next five years. Who knows how many unhappy investors got out of Merck because they were tired of waiting, or because they yearned for more “action.” If they had kept up to date on the story, they wouldn’t have sold.

  The stock of Angelica Corporation, manufacturers of career apparel, hardly budged a nickel from 1974 to 1979. American Greetings was dead for eight years; GAF Corporation for eleven; Brunswick for the entire 1970s; SmithKline (before Tagamet) for half the 1960s and half the 1970s; Harcourt Brace through Nixon, Carter, and the first Reagan administration; and Lukens didn’t move for fourteen years.

  I stuck with Merck because I’m accustomed to hanging around with a stock when the price is going nowhere. Most of the money I make is in the third or fourth year that I’ve owned something—only with Merck it took a little longer. If all’s right with the company, and whatever attracted me in the first place hasn’t changed, then I’m confident that sooner or later my patience will be rewarded.

  This going nowhere for several years, which I call the “EKG of a rock,” is actually a favorable omen. Whenever I see the EKG of a rock on the chart of a stock to which I’m already attracted, I take it as a strong hint that the next major move may be up.

  It takes remarkable patience to hold on to a stock in a company that excites you, but which everybody else seems to ignore. You begin to think everybody else is right and you are wrong. But where the fundamentals are promising, patience is often rewarded—Lukens stock went up sixfold in the fifteenth year,
American Greetings was a sixbagger in six years, Angelica a sevenbagger in four, Brunswick a sixbagger in five, and SmithKline a threebagger in two.

  LOOK AT ALL THE MONEY I’VE LOST: I DIDN’T BUY IT!

  We’d all be much richer today if we’d put all our money into Crown, Cork, and Seal at 50 cents a share (split-adjusted)! But now that you know this, open your wallet and check your latest bank statement. You’ll notice the money’s still there. In fact, you aren’t a cent poorer than you were a second ago, when you found out about the great fortune you missed in Crown, Cork, and Seal.

  This may sound like a ridiculous thing to mention, but I know that some of my fellow investors torture themselves every day by perusing the “ten biggest winners on the New York Stock Exchange” and imagining how much money they’ve lost by not having owned them. The same thing happens with baseball cards, jewelry, furniture, and houses.

  Regarding somebody else’s gains as your own personal losses is not a productive attitude for investing in the stock market. In fact, it can only lead to total madness. The more stocks you learn about, the more winners you realize that you’ve missed, and soon enough you’re blaming yourself for losses in the billions and trillions. If you get out of stocks entirely and the market goes up 100 points in a day, you’ll be waking up and muttering: “I’ve just suffered a $110 billion setback.”

  The worst part about this kind of thinking is that it leads people to try to play catch up by buying stocks they shouldn’t buy, if only to protect themselves from losing more than they’ve already “lost.” This usually results in real losses.

  I MISSED THAT ONE, I’LL CATCH THE NEXT ONE

  The trouble is, the “next” one rarely works, as we’ve already shown. If you missed Toys “R” Us, a great company that continued to go up, and then bought Greenman Brothers, a mediocre company that went down, then you’ve compounded your error. Actually you’ve taken a mistake that cost you nothing (remember, you didn’t lose anything by not buying Toys “R” Us) and turned it into a mistake that cost you plenty.