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

by Peter Lynch

  Trends and gradual changes stick in my mind. The period of conglomeration in the mid to late 1960s resulted in many major companies diworseifying, falling apart, and then not recovering for another fifteen years. Many have never come back, and others, such as Gulf and Western, ITT, and Ogden, have reemerged as turnarounds.

  There was a great love affair with high-quality blue chips in the 1970s. These were known as the “nifty fifty” or “the one decision” stocks that you could buy and hold forever. This brief serendipity of overrated and overpriced issues was followed by the devastating market decline of 1973–74 (the Dow hit 1050 in 1973 and had regressed all the way back to 578 in December, 1974) with blue chips falling 50 to 90 percent.

  The popular romance with small technology companies in mid-1982 to mid-1983 led to another collapse (60–98 percent) of the similarly beloved issues that could do no wrong. Small may be beautiful, but it’s not necessarily profitable.

  The rise of the Japanese market from 1966 to 1988 has taken the Nikkei Dow Jones up seventeenfold as our Dow Jones has only doubled. The total market value of all Japanese stocks actually passed that of U.S. stocks in April, 1987, and the gap has widened since. The Japanese have their own way of thinking about stocks, and I don’t understand it yet. Every time I go over there to study the situation, I conclude that all the stocks are grossly overpriced, but they keep going higher, anyway.

  Nowadays the change in trading hours makes it harder to pay attention to fundamentals and keep your eye off the Quotron. For eighty years until 1952 the New York Stock Exchange opened at 10 A.M. and closed at 3 P.M., giving the newspapers time to print up the results for the afternoon editions so investors could check their stocks on the ride home. In 1952, Saturday trading was eliminated, but the daily closing hour was advanced to 3:30, and in 1985, the opening hour was moved to 9:30, and now the market closes at 4:00. Personally, I’d prefer a much shorter market. It would give us all more time to devote to analyzing companies, or even to visiting museums, both of which are more useful than watching stock prices go up and down.

  Institutions have emerged from their minor role in the 1960s to dominate the stock market in the 1980s.

  The legal status of major brokerage firms has changed from partnerships, where the individuals’ personal wealth was on the line, to corporations, where the individual liability is limited. Theoretically this was supposed to strengthen the brokerage firms, since as corporations they could raise capital by selling stock to the public. I’m convinced it has been a net negative.

  The rise of the over-the-counter exchange has brought thousands of secondary issues that were once traded by the obscure “pink sheet” method—where you never knew if you were getting a fair price—into a reliable and efficient computerized marketplace.

  The nation is preoccupied with up-to-the-minute financial news, which twenty years ago was scarcely mentioned on television. The incredible success of Wall $treet Week, with Louis Rukeyser, from its debut on November 20, 1970, has proven that a financial news show can actually be popular. It was Rukeyser’s achievement that inspired the regular networks to expand their financial coverage, and that in turn led to the establishment of the Financial News Network, which has brought the ticker tape into millions of American homes. Amateur investors can now check their holdings all day. All that separates Houndstooth from the professional trader is a 15-minute tape delay.

  The boom and then bust in tax shelters: farm land, oil wells, oil rigs, barges, low-rent housing syndicates, graveyards, movie productions, shopping centers, sports teams, computer leasing, and almost anything else that can be bought, financed, or rented.

  The emergence of merger and acquisition groups, and other buyout groups, that are willing and able to finance $20-billion purchases. Between the domestic buyout groups (Kohlberg, Kravis, and Roberts; Kelso; Coniston Partners; Odyssey Partners; and Wesray), the European firms and buyout groups (Hanson Trust, Imperial Chemical, Electrolux, Unilever, Nestlé, etc.), and the individual corporate raiders with sizable bankrolls (David Murdock, Donald Trump, Sam Hyman, Paul Bilzerian, the Bass brothers, the Reichmanns, the Hafts, Rupert Murdoch, Boone Pickens, Carl Icahn, Asher Edelman, et al.) any company, large or small, is up for grabs.

  The popularity of the leveraged buyout, or LBO, through which entire companies or divisions are “taken private”—purchased by outsiders or by current management with money that’s borrowed from banks or raised via junk bonds.

  The phenomenal popularity of these junk bonds, as first invented by Drexel Burnham Lambert and now copied everywhere.

  The advent of futures and options trading, especially of the stock indexes, enabling “program traders” to buy or sell bushels of stocks in the regular stock markets and then reverse their positions in the so-called futures markets, throwing around billions of dollars for tiny incremental profits.

  And throughout all this tumult, SS Kresge, a moribund five-and-dime company, develops the K mart formula and the stock goes up forty-fold in ten years; Masco develops its one-handle faucet and goes up 1,000-fold, becoming the greatest stock in forty years—and who would have guessed it from a faucet company? The successful fast growers turn into tenbaggers, the whisper stocks go bankrupt, and investors receive their “Baby Bell” shares from the breakup of ATT and double their money in four years.

  If you ask me what’s been the most important development in the stock market, the breakup of ATT ranks near the top (this affected 2.96 million shareholders), and the Wobble of October probably wouldn’t rank in my top three.

  Some things I’ve been hearing lately:

  I’ve been hearing that the small investor has no chance in this dangerous environment and ought to get out. “Would you build your house over an earthquake?” one cautious advisor asks. But the earthquake isn’t under the house, it’s under the real estate office.

  Small investors are capable of handling all sorts of markets, as long as they own good merchandise. If anyone should worry, it’s some of the oxymorons. After all, the losses of last October were only losses to people who took the losses. That wasn’t the long-term investor. It was the margin player, the risk arbitrageur, the options player, and the portfolio manager whose computer signaled “sell” who took the losses. Like a cat who sees himself in a mirror, the sellers spooked themselves.

  I’ve been hearing that the era of professional management has brought new sophistication, prudence, and intelligence to the stock market. There are 50,000 stockpickers who dominate the show, and like the 50,000 Frenchmen, they can’t possibly be wrong.

  From where I sit, I’d say that the 50,000 stockpickers are usually right, but only for the last 20 percent of a typical stock move. It’s that last 20 percent that Wall Street studies for, clamors for, and then lines up for—all the while with a sharp eye on the exits. The idea is to make a quick gain and then stampede out the door.

  Small investors don’t have to fight this mob. They can calmly walk in the entrance when there’s a crowd at the exit, and walk out the exit when there’s a crowd at the entrance. Here’s a short list of stocks that were the favorites of large institutions in mid-1987 but sold at sharply lower prices ten months later, in spite of higher earnings, exciting prospects, and good cash flows. The companies hadn’t changed, but the institutions had lost interest: Automatic Data Processing, Coca-Cola, Dunkin’ Donuts, General Electric, Genuine Parts, Philip Morris, Primerica, Rite Aid, Squibb, and Waste Management.

  I’ve been hearing that the 200-million share day is a great improvement over the 100-million share day, and there’s great advantage in a liquid market.

  But not if you’re drowning in it—and we are. Last year 87 percent of all the shares listed on the NYSE changed owners at least once. In the early 1960s a six-to seven-million-share trading day was normal, and the turnover rate in stocks was 12 percent a year. In the 1970s a forty-to sixty-million-share day was normal, and in the 1980s it became 100–120 million shares. Now if we don’t have 150-million-share days, p
eople think something is wrong. I know I do my part to contribute to the cause, because I buy and sell every day. But my biggest winners continue to be stocks I’ve held for three and even four years.

  The rapid and wholesale turnover has been accelerated by the popular index funds, which buy and sell billions of shares without regard to the individual characteristics of the companies involved, and also by the “switch funds,” which enable investors to pull out of stocks and into cash, or out of cash and into stocks, without delay or penalty.

  Soon enough we’ll have a 100 percent annual turnover in stocks. If it’s Tuesday, then I must own General Motors! How do these poor companies keep up with where to send the annual reports? A new book called What’s Wrong with Wall Street reports that we spend $25 to $30 billion annually to maintain the various exchanges and pay the commissions and fees for trading stocks, futures, and options. That means we spend as much money on passing old shares back and forth as we raise for new issues. After all, the raising of money for new ventures is the reason we have stocks in the first place. And when the trading is finished, come every December, the big portfolios of 50,000 stockpickers look about the same as they did the previous January.

  The large investors who’ve caught this trading habit are fast becoming the short-term churning suckers that neighborhood brokers used to love. Some have called it the “rent-a-stock market.” Now it’s the amateurs who are prudent and the professionals who are flighty. The public is the comforting and stabilizing factor.

  The flightiness of trust departments, the Wall Street establishment, and the Boston financial district may be an opportunity for you. You can wait for out-of-favor stocks to hit the crazy low prices, then buy them.

  I’ve been hearing that the October 19th drop, which happened on a Monday, was only one of several historic declines that have taken place on Mondays, and researchers have spent entire careers studying the Monday effect. They were even talking about the Monday effect back when I went to Wharton.

  After looking this up, I’ve discovered that there seems to be something to it: from 1953 through 1984 the stock market gained 919.6 points overall, but lost 1,565 points on Mondays. In 1973 the market was ahead 169 points overall, but down 149 on Mondays; in 1974, down 235 overall and 149 on Mondays; in 1984, ahead 149 overall and down 47 on Mondays; in 1987, down 483 on Mondays and up 42 overall.

  If there is a Monday effect, I think I know why. Investors can’t talk to companies for two days over the weekend. All of the usual sources of fundamental news are shut down, giving people sixty hours to worry about the yen sell-off, the yen bid-up, the flooding in the Nile River, the damage to the Brazilian coffee crop, the progress of the killer bees, or other horrors and cataclysms reported in the Sunday papers. The weekend is also when people have time to read the gloomy long-term forecasts of economists who write guest columns on the op-ed pages.

  Unless you’re careful to sleep late and ignore the general business news, so many fears and suspicions can build up on weekends that by Monday morning you’re ready to sell all your stocks. That, it seems to me, is the principal cause of the Monday effect. (By late Monday you’ve had a chance to call a company or two and find out that they haven’t gone out of business, which is why stocks rebound the rest of the week.)

  I’ve been hearing that the 1987–88 market is a rerun of the 1929–30 market and we’re about to enter another great depression. So far, the 1987–88 market has behaved quite similarly to the 1929–30 market, but so what? If we have another depression, it won’t be because the stock market crashed, any more than the earlier depression happened because the stock market crashed. In those days, only one percent of Americans owned stocks.

  The earlier depression was caused by an economic slowdown in a country in which 66 percent of the work force was in manufacturing, 22 percent was in farming, and there was no social security, unemployment compensation, pension plans, welfare and medicare payments, guaranteed student loans, or government-insured bank accounts. Today, manufacturing represents only 27 percent of the work force, agriculture accounts for a mere 3 percent, and the service sector, which was 12 percent in 1930, has grown steadily through recession and boom and now accounts for 70 percent of the U.S. work force. Unlike the thirties, today a large percentage of people own their own homes; many own them free and clear or have watched their equity grow substantially as property values have soared. Today, the average household has two wage earners instead of one, and that provides an economic cushion that didn’t exist sixty years ago. If we have a depression, it won’t be like the last one!

  On weekends and weekdays I’ve been hearing that the country is falling apart. Our money used to be as good as gold, and now it’s as cheap as dirt. We can’t win wars anymore. We can’t even win gold medals in ice dashes. Our brains are being drained abroad. We’re losing jobs to the Koreans. We’re losing cars to the Japanese. We’re losing basketball to the Russians. We’re losing oil to the Saudis. We’re losing face to Iran.

  I hear every day that major companies are going out of business. Certainly some of them are. But what about the thousands of smaller companies that are coming into business and providing millions of new jobs? As I make my usual rounds of various headquarters, I’m amazed to discover that many companies are still going strong. Some are actually earning money. If we’ve lost all sense of enterprise and will to work, then who are those people who seem to be stuck in rush hour?

  I’ve even seen evidence that hundreds of these same companies have cut costs and learned to make things more efficiently. It appears to me that many of them are better off than they were in the late 1960s, when investors were more optimistic. CEOs are brighter and more heavily pressured to perform. Managers and workers understand that they have to compete.

  I hear every day that AIDS will do us in, the drought will do us in, inflation will do us in, recession will do us in, the budget deficit will do us in, the trade deficit will do us in, and the weak dollar will do us in. Whoops. Make that the strong dollar will do us in. They tell me real estate prices are going to collapse. Last month people started worrying about that. This month they’re worrying about the ozone layer. If you believe the old investment adage that the stock market climbs a “wall of worry,” take note that the worry wall is fairly good-sized now and growing every day.

  I’d developed a whole counterargument to the common argument that the trade deficit will do us in. It turns out that England had a big trade deficit for seventy years, and England was thriving around it. But there’s no point bringing this up. By the time I thought of it, people had forgotten about the trade deficit and had started to worry about the next trade surplus.

  Why does the emperor of Wall Street always have to have no clothes? We’re so anxious to catch that act that every time he parades around in full regalia we think we’re seeing a nude.

  I’ve been hearing that investors ought to be delighted when companies in which they’ve invested are bought out by corporate raiders, or taken private by management, sometimes doubling the stock price overnight.

  When a raider comes in to buy out a solid and prosperous enterprise, it’s the shareholders who get robbed. Maybe it looks like a good deal to the shareholders today, but they’re giving away their stake in the future growth. Investors were only too happy to tender their shares in Taco Bell when Pepsi-Cola bought in the shares for $40 apiece. But this fast grower continued to grow fast, and on the strength of the earnings an independent Taco Bell might be worth $150 a share by now. Let’s say a depressed company is on its way back up from $10, and some deep pocket offers to take it private for $20. It seems terrific when it happens. But the rest of the rise to $100 is cut off to all but the private entrepreneur.

  More than a few potential tenbaggers have been taken out of play by recent mergers and acquisitions.

  I’ve been hearing that we’re rapidly becoming a nation of useless debt-mongering, cappuccino-drinking, vacation-taking, croissant-eaters. Sadly, it’s true that America h
as one of the lowest savings rates in the developed world. Part of the blame goes to the government, which continues to punish savings by taxing capital gains and dividends, while rewarding debt with tax deductions on interest payments. The Individual Retirement Account was one of the most beneficial inventions of the last decade—finally Americans were encouraged to save something free of tax—so what does the government do? It cancels the deduction for all but the modest wage earner.

  Frequent follies notwithstanding, I continue to be optimistic about America, Americans, and investing in general. When you invest in stocks, you have to have a basic faith in human nature, in capitalism, in the country at large, and in future prosperity in general. So far, nothing’s been strong enough to shake me out of it.

  I’m told that the Japanese started out making little party favors and paper umbrellas to decorate Hawaiian cocktails, while we started out making cars and TVs; and now they make the cars and the TVs, and we make the party favors and the little umbrellas to decorate Hawaiian cocktails. If so, there’s got to be a fast-growing company that makes party favors somewhere in the U.S. that ought to be looked into. It could be the next Stop & Shop.

  If you take anything with you at all from this last section, I hope you’ll remember the following:

  • Sometime in the next month, year, or three years, the market will decline sharply.

  • Market declines are great opportunities to buy stocks in companies you like. Corrections—Wall Street’s definition of going down a lot—push outstanding companies to bargain prices.

  • Trying to predict the direction of the market over one year, or even two years, is impossible.