This is the second book I read Peter Lynch, which is one of my favorite investors. Check out the first one here.
One of the reasons or perhaps the biggest reason I like to learn from Peter is because he has a way of communicating his common sense in an understandable way. Simplifying complex things and making them obvious.
I’ll share my highlights from the book and add context when needed.
I own stocks where results depend on ancient fundamentals: a successful company enters new markets, its earnings rise, and the share price follows along. Or a flawed company turns itself around. The typical big winner in the Lynch portfolio (I continue to pick my share of losers, too!) generally takes three to ten years or more to play out.
To my mind, the stock price is the least useful information you can track, and it’s the most widely tracked.
To me, this barrage of price tags sends the wrong message. If my favorite Internet company sells for $30 a share, and yours sells for $10, then people who focus on price would say that mine is the superior company. This is a dangerous delusion. What Mr. Market pays for a stock today or next week doesn’t tell you which company has the best chance to succeed two to three years down the information superhighway. If you can follow only one bit of data, follow the earnings—assuming the company in question has earnings.
I mention Microsoft and Cisco to add contemporary examples to illustrate a major theme of this book. An amateur investor can pick tomorrow’s big winners by paying attention to new developments at the workplace, the mall, the auto showrooms, the restaurants, or anywhere a promising new enterprise makes its debut.
Liking a store, a product, or a restaurant is a good reason to get interested in a company and put it on your research list, but it’s not enough of a reason to own the stock! Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition, competitive position, plans for expansion, and so forth.
My clunkers remind me of an important point: You don’t need to make money on every stock you pick. In my experience, six out of ten winners in a portfolio can produce a satisfying result. Why is this? Your losses are limited to the amount you invest in each stock (it can’t go lower than zero), while your gains have no absolute limit. Invest $1,000 in a clunker and in the worst case, maybe you lose $1,000. Invest $1,000 in a high achiever, and you could make $10,000, $15,000, $20,000, and beyond over several years. All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out.
You don’t want to be forced to sell in a losing market to raise cash. When you’re a long-term investor, time is on your side.
As a very successful investor once said: “The bearish argument always sounds more intelligent.”
Anybody could have noticed Dell’s strong sales and the growing popularity of its product. People who bought shares early were rewarded with an amazing 889-bagger: $10,000 invested in Dell from the outset generated an $8.9 million fortune.
This is investing, where the smart money isn’t so smart, and the dumb money isn’t really as dumb as it thinks. Dumb money is only dumb when it listens to the smart money.
What Peter means is that professional investors often get into a herd-thinking of their own, and by definition don’t act on some real opportunities if those aren’t popular among Wall Street.
To make this spectacular showing, you only had to find one big winner out of eleven. The more right you are about any one stock, the more wrong you can be on all the others and still triumph as an investor.
If a product becomes a best-seller without brand-name recognition, imagine how it will sell once the brand is publicized.
Moreover, the nice thing about investing in familiar companies such as L’eggs or Dunkin’ Donuts is that when you try on the stockings or sip the coffee, you’re already doing the kind of fundamental analysis that they pay Wall Street analysts to do. Visiting stores and testing products is one of the critical elements of the analyst’s job.
People seem more comfortable investing in something about which they are entirely ignorant. There seems to be an unwritten rule on Wall Street: If you don’t understand it, then put your life savings into it.
Finding the promising company is only the first step. The next step is doing the research.
Recently I listened to the Peter Lynch episode of the We study Billionaires podcast. Something they mentioned was that Peter is often miss-quoted on recommending to buy stocks if you discover and like a local business. But that’s only the first step Peter recommends to do, the second, equally important step is to do the fundamental research!
It is personal preparation, as much as knowledge and research, that distinguishes the successful stockpicker from the chronic loser. Ultimately it is not the stock market nor even the companies themselves that determine an investor’s fate. It is the investor.
Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage. If stockpicking could be quantified, you could rent time on the nearest Cray computer and make a fortune. But it doesn’t work that way.
Peter explains how “Quant alpha” can be arbitraged away which is what we see so much in today’s markets.
After that interlude at Fidelity, I returned to Wharton for my second year of graduate school more skeptical than ever about the value of academic stock-market theory. It seemed to me that most of what I learned at Wharton, which was supposed to help you succeed in the investment business, could only help you fail. I studied statistics, advanced calculus, and quantitative analysis. Quantitative analysis taught me that the things I saw happening at Fidelity couldn’t really be happening.
Here Peter makes fun of the modern portfolio theory. I highly recommend reading something on this topic from Warren Buffet’s biography here. You won’t regret it.
It also was obvious that Wharton professors who believed in quantum analysis and random walk weren’t doing nearly as well as my new colleagues at Fidelity, so between theory and practice, I cast my lot with the practitioners.
As for Will Rogers, he may have given the best bit of advice ever uttered about stocks: “Don’t gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”
In spite of crashes, depressions, wars, recessions, ten different presidential administrations, and numerous changes in skirt lengths, stocks in general have paid off fifteen times as well as corporate bonds, and well over thirty times better than Treasury bills! There’s a logical explanation for this. In stocks you’ve got the company’s growth on your side. You’re a partner in a prosperous and expanding business.
I’m always amused when people describe their investments as “conservative speculations” or else claim that they are “prudently speculating.” Usually that means they hope they’re investing but they’re worried that they’re gambling.
(1) Do I own a house?
(2) Do I need the money? and
(3) Do I have the personal qualities that will bring me success in stocks?
Whether stocks make good or bad investments depends more on your responses to these three questions than on anything you’ll read in The Wall Street Journal.
Only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.
This is so important! It’s my biggest advice to friends who are interested in investing.
If you’re the kind of buyer who can’t resist getting in at $50, buying more at $60 (“See, I was right, that sucker is going up”), and then selling out in despair at $40 (“I guess I was wrong. That sucker’s going down”) then no shelf of how-to books is going to help you.
The true contrarian is not the investor who takes the opposite side of a popular hot issue (i.e., shorting a stock that everyone else is buying). The true contrarian waits for things to cool down and buys stocks that nobody cares about, and especially those that make Wall Street yawn.
The market ought to be irrelevant. If I could convince you of this one thing, I’d feel this book had done its job. And if you don’t believe me, believe Warren Buffett. “As far as I’m concerned,” Buffett has written, “the stock market doesn’t exist. It is there only as a reference to see if anybody is offering to do anything foolish.”
I have to say, through my own experience through investing in DeFi, and after reading The most important thing Illuminated by Howard Marks, I’m convinced timing market cycles can be very beneficial. But don’t put worry into timing the market, just pick good companies!
Perhaps a winning investment seems so unlikely in the first place that people can best imagine it happening as far away as possible, somewhere off in the Great Beyond, just as we all imagine that perfect behavior takes place in heaven and not on earth.
If you’re considering a stock on the strength of some specific product that a company makes, the first thing to find out is: What effect will the success of the product have on the company’s bottom line?
For instance, if that product only forms part of 5% of that company’s revenue, don’t buy it only for that product.
You won’t find a lot of two to four percent growers in my portfolio, because if companies aren’t going anywhere fast, neither will the price of their stocks. If growth in earnings is what enriches a company, then what’s the sense of wasting time on sluggards?
Stalwarts are stocks that I generally buy for a 30 to 50 percent gain, then sell and repeat the process with similar issues that haven’t yet appreciated. I always keep some stalwarts in my portfolio because they offer pretty good protection during recessions and hard times.
So while the smaller fast growers risk extinction, the larger fast growers risk a rapid devaluation when they begin to falter.
Timing is everything in cyclicals, and you have to be able to detect the early signs that business is falling off or picking up.
Putting stocks in categories is the first step in developing the story. Now at least you know what kind of story it’s supposed to be. The next step is filling in the details that will help you guess how the story is going to turn out.
Peter likes to create a story for every company he invests in. From time to time he re-checks the story and adjusts his strategy accordingly.
If a company with terrific earnings and a strong balance sheet also does dull things, it gives you a lot of time to purchase the stock at a discount. Then when it becomes trendy and overpriced, you can sell your shares to the trend-followers.
Buy low sell high
Long term, there’s another important benefit. When management owns stock, then rewarding the shareholders becomes a first priority, whereas when management simply collects a paycheck, then increasing salaries becomes a first priority. Since bigger companies tend to pay bigger salaries to executives, there’s a natural tendency for corporate wage-earners to expand the business at any cost, often to the detriment of shareholders. This happens less often when management is heavily invested in shares.
The importance of people to have “skin in the game”.
When stock is bought in by the company, it is taken out of circulation, therefore shrinking the number of outstanding shares. This can have a magical effect on earnings per share, which in turn has a magical effect on the stock price. If a company buys back half its shares and its overall earnings stay the same, the earnings per share have just doubled. Few companies could get that kind of result by cutting costs or selling more widgets.
There’s a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them. I’d rather see a vigorous buyback of shares, which is the purest synergy of all.
Here Peter explains that well earning companies tend to spend money with little caution. I’d be better to return that money to shareholders.
What all these longshots had in common besides the fact that you lost money on them was that the great story had no substance. That’s the essence of a whisper stock.
Whisper stocks are those you hear people talking about at the barber’s.
What I try to remind myself (and obviously I’m not always successful) is that if the prospects are so phenomenal, then this will be a fine investment next year and the year after that. Why not put off buying the stock until later, when the company has established a record? Wait for the earnings. You can get tenbaggers in companies that have already proven themselves. When in doubt, tune in later.
Analyzing a company’s stock on the basis of earnings and assets is no different from analyzing a local laundromat, drugstore, or apartment building that you might want to buy. Although it’s easy to forget sometimes, a share of stock is not a lottery ticket. It’s part ownership of a business.
The storefront lawyer isn’t likely to become a tenbagger overnight unless he wins a big divorce case, but the guy who scrapes barnacles off boats and writes novels might be the next Hemingway. (Read the books before you invest!) That’s why investors seek out promising fast growers and bid the stocks up, even when the companies are earning nothing at present—or when the earnings are paltry as compared to the price per share.
(A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies—such as Shoney’s, The Limited, or Marriott—when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well. [It sure would have worked with Avon!] I’m not necessarily advocating this practice, but I can think of worse strategies.)
The p/e ratio can be thought of as the number of years it will take the company to earn back the amount of your initial investment— assuming, of course, that the company’s earnings stay constant.
If you buy shares in a company selling at two times earnings (a p/e of 2), you will earn back your initial investment in two years, but in a company selling at 40 times earnings (a p/e of 40) it would take forty years to accomplish the same thing. Cher might be a great-grandmother by then. With all the low p/e opportunities around, why then would anybody buy a stock with a high p/e? Because they’re looking for Harrison Ford at the lumber yard. Corporate earnings do not stay constant any more than human earnings do.
A company with a high p/e must have incredible earnings growth to justify the high price that’s been put on the stock.
The stock market as a whole has its own collective p/e ratio, which is a good indicator of whether the market at large is overvalued or undervalued.
If you can’t predict future earnings, at least you can find out how a company plans to increase its earnings. Then you can check periodically to see if the plans are working out. There are five basic ways a company can increase earnings*: reduce costs; raise prices; expand into new markets; sell more of its product in the old markets; or revitalize, close, or otherwise dispose of a losing operation. These are the factors to investigate as you develop the story. If you have an edge, this is where it’s going to be most helpful.
Asking about the competition is one of my favorite techniques for finding promising new stocks.
When cash increases relative to debt, it’s an improving balance sheet. When it’s the other way around, it’s a deteriorating balance sheet.
In general, a p/e ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative. We use this measure all the time in analyzing stocks for the mutual funds.
More than anything else, it’s debt that determines which companies will survive and which will go bankrupt in a crisis. Young companies with heavy debts are always at risk.
I’ve seen this happen enough times to begin to believe in the bladder theory of corporate finance, as propounded by Hugh Liedtke of Pennzoil: The more cash that builds up in the treasury, the greater the pressure to piss it away.
The flaw is that the stated book value often bears little relationship to the actual worth of the company. It often understates or overstates reality by a large margin.
Overvalued assets on the left side of the balance sheet are especially treacherous when there’s a lot of debt on the right.
But if cash flow is ever mentioned as a reason you’re supposed to buy a stock, make sure that it’s free cash flow that they’re talking about. Free cash flow is what’s left over after the normal capital spending is taken out.
If you know your cyclical, you have an advantage in figuring out the cycles. (For instance, everyone knows there are cycles in the auto industry. Eventually there are going to be three or four up years to follow three or four down years. There always are. Cars get older and they have to be replaced.
Portfolio design
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.
There’s no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors.
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.
If something happens to one of the secondaries to bolster my confidence, then I’ll promote it to a primary selection.
Whenever Peter notices that a company he didn’t put much attention to previously improves, he gives it more weight in his portfolio.
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.
Compounding
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.
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.
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.
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.
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.
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.
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.
What Peter talks about is called FOMO (Fear of missing out) in the Crypto world.
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 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.
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.
Selling an outstanding fast grower because its stock seems slightly overpriced is a losing technique.
Don’t become so attached to a winner that complacency sets in and you stop monitoring the story.
When stocks are out of line with reality and better alternatives exist, sell them and switch into something else.