by Peter Lynch
If you failed to buy Home Depot at a low price, and then bought Scotty’s, the “next Home Depot,” then you probably made another mistake, because Home Depot is up twenty-five-fold since it came public, and Scotty’s is up only 25–30 percent, underperforming the general market over the same period.
The same thing happened if you missed Piedmont and bought People Express, or you missed the Price Club and bought the Warehouse Club. In most cases it’s better to buy the original good company at a high price than it is to jump on the “next one” at a bargain price.
THE STOCK’S GONE UP, SO I MUST BE RIGHT, OR... THE STOCK’S GONE DOWN SO I MUST BE WRONG
If I had to choose a great single fallacy of investing, it’s believing that when a stock’s price goes up, then you’ve made a good investment. People often take comfort when their recent purchase of something at $5 a share goes up to $6, as if that proves the wisdom of the purchase. Nothing could be further from the truth. Of course, if you sell quickly at the higher price, then you’ve made a fine profit, but most people don’t sell in these favorable circumstances. Instead they convince themselves that the higher price proves that the investment is worthwhile, and they hold on to the stock until the lower price convinces them the investment is no good. If it’s a choice, they hold on to the stock that’s risen from $10 to $12, and they get rid of the one that’s dropped from $10 to $8, while telling themselves that they have “kept the winner and dumped the loser.”
That’s just what might have happened back in 1981, when Zapata, an oil stock at the height of the energy boom, must have seemed far more pleasant to own than Ethyl Corp., a so-called “dog that got run over” because of the EPA ban on its main product—lead additives for gasoline. However, the “better” stock of these two went from $35 to $2, and you couldn’t have bailed that one out with the Big Dipper. Meanwhile Ethyl was getting great results from its specialty chemicals division, improved performance overseas, and rapid consistent growth from its insurance operation. Ethyl stock went from $2 to $32.
So when people say, “Look, in two months it’s up 20 percent, so I really picked a winner,” or “Terrible, in two months it’s down 20 percent, so I really picked a loser,” they’re confusing prices with prospects. Unless they are short-term traders who are looking for 20-percent gains, the short-term fanfare means absolutely nothing.
A stock’s going up or down after you buy it only tells you that there was somebody who was willing to pay more—or less—for the identical merchandise.
19
Options, Futures, and Shorts
Investment gimmicks have become so popular that the old motto “Buy a share in America” ought to be changed to “Buy an option on America.” “Invest in the future of America” now means “take a flier at the New York Futures Exchange.”
I’ve never bought a future nor an option in my entire investing career, and I can’t imagine buying one now. It’s hard enough to make money in regular stocks without getting distracted by these side bets, which I’m told are nearly impossible to win unless you’re a professional trader.
That’s not to say that futures don’t serve a useful purpose in the commodity business, where a farmer can lock in a price for wheat or corn at harvest and know he can sell for that amount when the crops are delivered; and a buyer of wheat or corn can do the same. But stocks are not commodities, and there is no relationship between producer and consumer that makes such price insurance necessary to the functioning of a stock market.
Reports out of Chicago and New York, the twin capitals of futures and options, suggest that between 80 and 95 percent of the amateur players lose. Those odds are worse than the worst odds at the casino or at the racetrack, and yet the fiction persists that these are “sensible investment alternatives.” If this is sensible investing, then the Titanic was a tight ship.
There’s no point describing how futures and options really work, because (1) it requires long and tedious exposition, after which you’d still be confused, (2) knowing more about them might get you interested in buying some, and (3) I don’t understand futures and options myself.
Actually I do know a few things about options. I know that the large potential return is attractive to many small investors who are dissatisfied with getting rich slow. Instead, they opt for getting poor quick. That’s because an option is a contract that’s only good for a month or two, and unlike most stocks, it regularly expires worthless—after which the options player must buy another option, only to lose 100 percent of his or her money once again. A string of these, and you’re in deep kimchee.
And consider the situation when you’re absolutely sure that something wonderful is about to happen to Sure Thing, Inc., and the good news will send the stock price higher. Maybe you’ve discovered a Tagamet, a cancer cure, a surge in earnings, or one of the many other positive fundamental signs you’ve learned to look for. You’ve found the perfect company, the nearest thing to a royal flush you’ll ever encounter.
You check your assets, and there’s only $3,000 in your savings account. The rest is invested in mutual funds that The Person Who Understands the Serious Business of Money won’t let you touch. You comb the house looking for heirlooms to take to the pawn shop, but the mink coat is riddled with moth holes. The silver flatware is a possibility, but since you’re having a dinner party over the weekend, the spouse is certain to notice it’s missing. Perhaps you could sell the cat, but it doesn’t have a pedigree. The wooden sloop leaks, and nobody would pay for rusty golf clubs with bad grips.
So the $3,000 is all you can come up with to invest in Sure Thing. It will only get you 150 shares at $20 a share. Just as you’ve resigned yourself to settling for that, you remember having heard about the remarkable leverage of options. You talk to your broker, who confirms that the April $20 call option in Sure Thing, now selling for $1, may be worth $15 if the stock goes to $35. A $3,000 investment here would give you a $45,000 payoff.
So you buy the options, and every day you open the paper, anxiously awaiting the moment the stock begins to rise. By mid-March there’s still no movement, and the options you bought for $3,000 already have lost half their value. You’re tempted to sell and get some of your money back, but you hold on because there’s still a month to go before they expire worthless. A month later, that is exactly what happens.
Insult is added to injury when a few weeks after you’ve been out of the option, Sure Thing makes its move. Not only have you lost all your money, you’ve done it while being right about the stock. That’s the biggest tragedy of all. You did your homework, and instead of being rewarded for it, you’ve been wiped out. It’s an absolute waste of time, money, and talent when this happens.
Another nasty thing about options is that they are very expensive. They may not seem expensive, until you realize that you have to buy four or five sets of them to cover stock for a year. You’re literally buying time here, and the more time you buy, the higher the premium you have to pay for it. There’s a generous broker’s commission attached to every purchase to boot. Options are the broker’s gravy train. A broker with only a handful of active options clients can make a wonderful living.
The worst thing of all is that buying an option has nothing to do with owning a share of a company. When a company grows and prospers, all the shareholders benefit, but options are a zero-sum game. For every dollar that’s won in the market there’s a dollar that’s lost, and a tiny minority does all the winning.
When you buy a share of stock, even a very risky stock, you are contributing something to the growth of the country. That’s what stocks are for. In previous generations, when it was considered dangerous to speculate in stocks of small companies, at least the “speculators” were providing the capital to enable the IBMs and the McDonald’ses and the Wal-Marts to get started. In the multibillion-dollar futures and options market, not a bit of the money is put to any constructive use. It doesn’t finance anything, except the cars, planes, and houses purchased by the brokers and th
e handful of winners. What we’re witnessing here is a giant transfer payment from the unwary to the wary.
There’s a lot of talk these days about the use of futures and options as portfolio insurance to protect our investments in stocks. Many of my fellow professionals have led the way down this slippery slope, as usual. Institutions have bought billions in portfolio insurance, to cover themselves in case of a crash. It turns out that they thought they were well-covered during the last crash, but the portfolio insurance worked against them. Part of the insurance program required them to automatically sell off stocks at the same time they were buying more futures, and the massive automatic selling drove the market lower, triggering more buying of futures and more selling. Among the plausible causes of the October collapse, portfolio insurance is a principal culprit, but many institutions are still buying the insurance.
Some individual investors have taken up this bad idea on their own. (Does it ever pay to imitate the experts?) They buy “put” options (which increase in value as the market goes down) to protect themselves in a decline. But “put” options, too, expire worthless, and you have to keep buying them if you want to be continually protected. You can waste 5–10 percent of your entire investment stake every year to protect yourself from a 5–10 percent decline.
Like the alcoholic enticed back into the gin bottle by the innocent tasting of beer, the stockpicker who invests in options as insurance often cannot help himself, and soon enough he’s buying options for their own sake, and from there it’s on to hedges, combinations, and straddles. He forgets that stocks ever interested him in the first place. Instead of researching companies, he spends all his waking hours reading market-timer digests and worrying about head-and-shoulder patterns or zigzag reversals. Worse, he loses all his money.
Warren Buffett thinks that stock futures and options ought to be outlawed, and I agree with him.
SHORTING A STOCK
You’ve no doubt heard of this ancient and strange practice, which enables you to profit from a stock that’s going down. (Some people get interested in this idea by looking at their portfolios and realizing that if they’d been short instead of long all these years, they’d be rich.)
Shorting is the same thing as borrowing something from the neighbors (in this case, you don’t know their names) and then selling the item and pocketing the money. Sooner or later you go out and buy the identical item and return it to the neighbors, and nobody is the wiser. It’s not exactly stealing, but it’s not exactly neighborly, either. It’s more like borrowing with criminal intent.
What the shorter hopes to do is to sell the borrowed item at a very high price, but the replacement item at a very low price, and keep the difference. You could do it with lawn mowers and garden hoses, I suppose, but it works best with stocks—especially stocks that are inflated in price to begin with. For instance, if you figured out that Polaroid was overpriced at $140 a share, you could have shorted 1,000 shares for an immediate $140,000 credit to your account. Then you could have waited for the price to drop to $14, jumped in and bought back the same 1,000 shares for $14,000, and gone home $126,000 richer.
The person from whom you borrowed the shares originally will never have known the difference. These transactions are all done on paper and handled by stockbrokers. It’s as easy to go short as it is to go long.
Before we get too excited about this, there are some serious drawbacks to going short. During all the time you borrow the shares, the rightful owner gets all the dividends and other benefits, so you’re out some money there. Also, you can’t actually spend the proceeds you get from shorting a stock until you’ve paid the shares back and closed out the transaction. In the Polaroid example, you couldn’t simply take the $140,000 and run off to France for a long vacation. You are required to maintain a sufficient balance in your brokerage account to cover the value of the shorted stock. As the price of Polaroid dropped, you could have taken some of the money out, but what if the price of Polaroid had gone up? Then you would have had to add more money to cover your position.
The scary part about shorting stock is that even if you’re convinced that the company’s in lousy shape, other investors might not realize it and might even send the stock price higher. Though Polaroid had already reached a ridiculous plateau, what if it had doubled once more to an even more ridiculous $300 a share? If you were short then, you were very nervous. The prospect of spending $300,000 to replace a $140,000 item that you’ve borrowed can be disturbing. If you don’t have the extra hundred thousand or so to put into your account to hold your position, you may be forced to liquidate at a huge loss.
None of us is immune to the panic that we feel when a normal stock drops in price, but that panic is restrained somewhat by our understanding that the normal stock cannot go lower than zero. If you’ve shorted something that’s going up, you begin to realize that there’s nothing to stop it from going to infinity, because there’s no ceiling on a stock price. Infinity is where a shorted stock always appears to be heading.
Among all the folk tales of successful short sellers are the horror stories of shorters who watched helplessly as their favorite lousy stocks soared higher and higher, against all reason and logic, forcing them into the poorhouse. One such unfortunate was Robert Wilson, a smart man and a good investor, who a decade or so ago shorted Resorts International. He was right, eventually—most shorters are right, eventually—didn’t John Maynard Keynes say in the long run “we all are dead”? In the meantime, however, the stock advanced from 70 cents to $70, a modest 100-bagger, leaving Mr. Wilson with a modest $20 or $30 million loss.
This tale is useful to remember if you’re contemplating shorting something. Before you short a stock, you have to have more than a conviction that the company is falling apart. You have to have the patience, the courage, and the resources to hold on if the stock price doesn’t go down—or worse, goes up. Stocks that are supposed to go down but don’t remind me of the cartoon characters who walk off cliffs into thin air. As long as they don’t recognize their predicament, they can just hang out there forever.
20
50,000 Frenchmen Can Be Wrong
Thinking back over my tenure as a stockpicker, I remember several major news events and their effects on the prices of stocks, beginning with President Kennedy’s election in 1960. Even at the tender age of sixteen, I’d heard that a Democratic presidency was always bad for stocks, so I was surprised that the day after the election, November 9, 1960, the market rose slightly.
During the Cuban missile crisis and our naval blockade of the Russian ships—the one and only time America has faced the immediate prospect of nuclear war—I feared for myself, my family, and my country. Yet the stock market fell less than 3 percent that day. Seven months later, when President Kennedy berated U.S. Steel and forced the industry to roll back prices, I feared for nothing, yet the market had one of its largest declines in history—7 percent. I was mystified that the potential of nuclear holocaust was less terrifying to Wall Street than the president’s meddling in business.
On November 22, 1963, I was about to take an exam at Boston College when the news that President Kennedy had been shot spread across the campus. Along with my classmates I went to St. Mary’s Hall to pray. The next day I saw in the newspaper that the stock market had fallen less than 3 percent, though trading was halted once the news of the assassination became official. Three days later the market recovered its losses of November 22, and then some.
In April, 1968, after President Johnson announced that he wouldn’t seek a second term, that he would halt the bombing raids in Southeast Asia, and that he favored peace talks, the market rose 2½ percent.
Throughout the 1970s I was totally involved in stocks and dedicated to my job at Fidelity. During that period the great events, and the market reactions to them, were as follows: President Nixon imposes price controls (market up 3 percent); President Nixon resigns (market down 1 percent) (Nixon once remarked that if he weren’t the president he’d be
buying stocks, and a Wall Street wag retorted that if Nixon weren’t president, he’d be buying stocks, too); President Ford’s Whip Inflation Now buttons are introduced (market up 4.6 percent); IBM wins a big antitrust case (market up 3.3 percent), Yom Kippur War breaks out (market up slightly). The decade of the 1970s was the poorest for stocks of any of the five since the 1930s, and yet the major-percentage one-day changes were all up—on the days just mentioned.
The event of most lasting consequence was OPEC’s oil embargo, October 19, 1973 (another lucky October 19!), which helped take the market down 16 percent in three months and 39 percent in twelve months. It’s interesting to note that the market did not respond to the significance of the embargo, actually rising 4 points that day and climbing an additional 14 points in the five following sessions before starting its dramatic decline. This demonstrates that the market, like individual stocks, can move in the opposite direction of the fundamentals over the short term, which, in the case of the embargo, involved rising gasoline prices, long gas lines, escalating inflation, and sharply higher interest rates.
The 1980s has had more days of exceptional gains and losses than were seen in all the other decades combined. In the big picture, most of them are meaningless. I’d rank the 508-point drop in October, 1987, far below the meeting of economic ministers on September 22, 1985, for its importance to long-term investors. It was at this so-called G7 conference that the major industrial nations agreed to coordinate economic policy and to allow the value of the dollar to decline. After that decision was announced, the general market rose 38 percent over six months. It had a more dramatic impact on specific companies that benefited from the lower dollar, and whose stocks doubled and tripled in price in the following two years. As on October 19, 1987, I was in Europe at the time of both the Yom Kippur War and the G7 conference, but at least on those occasions I was out visiting companies instead of losing golf balls.