How to Use What You Already Know to Make Money in the Market
For those Time Starved Professionals, I have compiled the list of points which I feel are relevant to the man in the street. Although this book is about navigating the financial markets, it is easy to read as Lynch wrote this with the intention for the everyday people to read. His aim is to show us that understanding the markets is not rocket science, arm yourself with knowledge and be patient. This book aimed at long term investors. If you are here looking for fast gains and strategy play, then this book is not for you.
1. Don't over-estimate the skill and wisdom of professionals
2. Take advantage of what you already know
3. Look for opportunities that haven't been yet discovered and certified by Wall Street - companies that are "off the radar scope"
4. Invest in a house before you invest in a stock
5. Invest in companies, not the stock market
6. Ignore short term fluctuations
7. Predicting the economy is futile
8. Predicting the short term direction of the stock market is futile
9. The Long term returns from stocks are both relatively predictable and also far superior to the long term returns from bonds
10. In the stock market, one in the hand is worth ten in the bush
Stalking the Tenbagger
The Six Categories of a Stock
(i) Slow growing companies grow more or less in line with the nation's GDP, about 3% a year
Fast growing companies grow as much as 20 to 30% a year or more
Growth can be classified as -
(ii) Slow Growers - start out as fast growers and eventually pooped out. The chart of a slow grower resembles the topographical map of Delaware, which has no hills
Another sure sign of a slow grower is that it pays a generous and regular dividend.
(iii) Medium Growers - 10% to 12% annual growth in earnings
(iv) Fast Growers - doesn't necessarily belong to a fast growing industry. All it needs is the room to expand within a slow growing industry.
Look for the ones with a good balance sheet and making substantial profits. The trick is figuring out when they will stop growing, and how much to pay for the growth.
(v) The Cyclical - Autos and Airlines, Tire companies, Steel companies, Chemical companies. Defence companies.
(vi) The Asset Plays - the asset may be as simple as a pile of cash. Sometimes it's real estate.
The Perfect Stock
- it sounds dull, or even ridiculous
- it does something dull
- it does something disagreeable
- it is a spin off
- the institutions don't own it, the analysts don't follow it
- the rumours abound: it's involved with toxic waste and or the mafia
- there is something depressing about it
- it is a no growth industry
- it has got a niche
- people have to keep buying it
- it is a user of technology
- the insiders are buyers
- the company is buying back shares
Stocks to Avoid
- the hottest stock in the hottest industry
- the "next something" i.e a company being touted as the next ____
- avoid companies that do diversification. i.e spending money on foolish acquisitions.
- beware the middleman - e.g suppliers that are dependent on big clients
- beware the stock with the exciting company name
Earnings
- a quick way to tell if the stock is overpriced is to compare the price line to the earnings line
P/E Ratio - avoid stocks with excessively high P/E ratios
Future Earnings - you can't predict the future earnings, you can find out how the company plans to increase its earnings. Then you can check periodically to see if the plans are working out.
There are 5 ways a company can increase its earnings
- reduce costs, raise prices
- expand into new markets
- sell more of its products in the old markets
- revitalise, close or dispose of a losing operation
The 2 minute Drill
- Look at P/E ratio to see if its fairly priced
- learn what the company is doing to bring about the added prosperity, the growth spurt, or whatever happy event is expected to occur.
- What is the Company's Story
- if its a slow growing company, then presumably you are in for the dividend
e.g. this company has increased earnings every year for the last ten, it offers an attractive yield, its never reduced or suspended a dividend, and in fact its raised the dividend during good times and bad, including the last 3 recessions. its a telephone utility, and the new cellular operations may add a substantial kicker to the growth rate.
- if its a cyclical company, then the story revolves around business conditions, inventories and prices.
- if its an Asset Play, then what are the assets, how much are they worth?
e.g the stock sells for $8, but the video division alone is worth $4 a share and the real estate is worth $7. that is a bargain, and I am getting the rest of the company for (-)$3. Insiders are buying, the company has steady earnings, and there is no debt to speak of.
- if it is a turn around, then has the company gone about improving its fortunes, and is the plan working so far.
- if its a fast grower, then where and how can it continue to grow fast
Reading the Reports
(i) Overall Cash Position
Current assets + Cash + Cash items + Marketable Securities
(ii) Long term debt
- debt reduction is another sign of prosperity - when cash increase relative to debt, its an improving Balance Sheet
Cash - Long Term Debt = Net Cash Position => higher, better
(iii) Company buys back its own shares
- (cash + cash assets) / shares outstanding => higher better
Some Famous Numbers
1. Percent of sales
- let's say there is a popular product from the company that you are interested in.
Look at the Percent of Sales it accounts for the Total Sales.
If it contributes only a relatively small % to Total Sales, then its useless as it does not mean much to the the total worth.
2. The Price/ Earnings Ratio
- P/E ratio of any company that is fairly priced will equal its growth rate
- Take Average P/E ratio of a large group of companies to see the Market P/E ratio to see if what you are buying is relatively cheap
- if P/E ratio < Growth Rate --> good deal
- Formula to determine if Company is fairly priced, taking Dividends into account
- (Long term growth rate + Dividend Yield) / P/E ratio
if ratio is less than 1 --> poor
if ratio > 2 --> good
3. The Cash Position
4. The Debt Factor
- a normal corporate B/S has 75% Debt and 25% Equity
- 2 types of Debt: Bank Debt & Funded Debt
Bank Debt (or Commercial paper)
- the worst kind, due on demand
- doesn't have to come from a bank
- Bad because it is due very soon, or sometimes due on call, i.e lender can ask for his money back at the first sign of trouble.
Funded Debt (usually takes the form of Corporate Bonds with long maturities)
- the best kind, can never be called in no matter how bleak the situation, as long as the borrower continues to pay the interest
- Corporate bonds may be upgraded or downgraded by the rating agencies depending on the financial health of the company, but whatever happens the bondholders cannot demand immediate repayment of principal
5. Dividends
- electric utilities and telephone utilities are the major dividend players
- if the company is going to be able to pay it during recessions and bad times
- best is if the company has 20 to 30 years record of regularly raising dividend
6. Book Value
- the stated book value often bears little relationship to the actual worth of the company
- unwritten rule: the closer you get to the finished product, the less predictable the resale value
- e.g price of cotton vs price of cotton shirt
- the actual book value will be the bankruptcy proceeds (the amt the asset can sell for during bankruptcy)
7. More Hidden Assets
- companies that own natural resources e.g land, timber, oil, precious metal carry those assets on their book at a fraction of the true value
- brand names e.g Coca Cola, Patented Drugs, cable franchise, TV and radio stations have tremendous value that is not reflected on the books
- Goodwill - company has to write down the value of goodwill to zero over the years, when in reality the value of the franchise will rise over the years
- Patented Drugs - 17 years patent. if the owner can improve the drug slightly, then he gets to keep the patent for another 17 years
- when one company own shares of a separate company ie. you may invest in another company indirectly for a cheaper price
- Find the foreign owner - e.g parent company is based in Europe which is not under radar by analysts VS subsidiary in US which is higher priced
8. Cash Flow
- all companies take in cash, but some have to spend more than others to get it
- better to invest in companies that don't depend on capital spending
- look at Free Cash Flow - leftover after the capital spending
9. Inventories
- look under the "Management Discussion of Earnings" - check if inventories are piling up --> bad sign
- in the auto industry, an inventory buildup isn't so disturbing because a new car is always worth something versus a new shirt whose price can drop really low
10. Pension Plans
- check if the company doesn't have an overwhelming pension obligation that it cannot meet
- check specifically: Pension Fund Asset > Vested Benefit Liabilities
11. Growth Rate
- Earnings
- find a business that can get away with raising prices year after years without losing customers
12. The Bottom Line
- Profit after taxes
- retailers have lower profit margins than manufacturers
e.g supermarket around 3% pretax earnings VS drug manufacturer at 25% pretax
Rechecking the Story
- check the company every few months
The Final Checklist
1. Stocks in General
- the P/E ratio - is it high or low for the particular company and for similar companies in the same industry
- the % of institutional ownership. The lower the better.
- Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs.
- The record of earnings growth to date and whether the earnings are sporadic or consistent. (The only category where earnings may not be important is in the asset play)
- Whether the company has a strong B/S or weak B/S (debt to equity ratio) and how it's rated for financial strength
- The cash position. With $16 in net cash, the stock is unlikely to drop below $16 per share.
2. Slow Growers
- Since you buy for the Dividends, you want to check to see if the dividends have always been paid, and whether they are routinely raised.
- When possible, find out what % of the earnings are being paid out as dividends. If it's a low %, then the company has a cushion in hard times. It can earn less money and still retain the dividend. If it's a high %, then the dividend is riskier.
3. Stalwarts
- These are big companies that aren't likely to go out of business. The key issue is price, and the P/E ratio will tell you if you are paying too much.
- Check for possible diworseifications that may reduce earnings in the future.
- Check the company's long term growth rate, and whether it has kept up the same momentum in recent years
- If you plan to hold the stock forever, see how the company has fared during previous recessions and market drops.
4. Cyclicals
- Keep a close watch on inventories, and the supply demand relationship. Watch for new entrants into the market, which is usually a dangerous development.
- Anticipate a shrinking P/E multiple over time as business recovers and investors look ahead to the end of the cycle, when the peak earnings are achieved.
- If you know your cyclical, you have an advantage in figuring out the cycles.
5. Fast Growers
- Investigate whether the product that's supposed to enrich the company is a major part of the company's business
- What the growth rate in earnings has been in recent years.
Around 20 to 25% range. Those faster than 25% are usually found in hot industries and you know what that means
- That the company has duplicated its success in more than one city or town, to prove that expansion will work
- that the company still has room to grow
- Whether the stock is selling at a P/E ratio at or near the growth rate
- whether the expansion is speeding up or slowing down. For stocks of companies such as Sensormatic Electronics, whose sales are primarily "one shot" deals, as opposed to razor blades, which customers have to keep buying - a slowdown in growth can be devastating.
- That few institutions own the stock and only a handful of analysts have ever heard of it.
6. Turnarounds
- Can the company survive a raid by its creditors?
- How much cash does the company have?
- How much debt?
- What is the debt structure, and how long can it operate in the red while working its problems without going bankrupt?
- If it's bankrupt already, then what's left for the shareholders?
- How is the company supposed to be turning around? Has it rid itself of unprofitable divisions?
- Are costs being cut?
7. Asset Plays
- What is the value of the assets? Are there any hidden assets?
- How much debt is there to detract from those assets? (Creditors are the first in line)
- Is the company taking on new debt, making the assets less valuable?
- Is there a raider in the wings to help shareholders reap the benefits of the assets?
Some Pointers....
1. Understand the nature of the companies you own and the specific reasons for holding the stock
2. By putting your stocks into categories you will have a better idea of what to expect from them
3. Big companies have small moves, small companies have big moves
4. Consider the size of a company if you expect it to profit from a specific product
5. Look for small companies that are already profitable and have proven that their concept can be replicated
6. Be suspicious of companies with growth rates of 50 to 100% a year
7. Avoid hot stocks in hot industries
8. Distrust diversification, which usually turn out to be diworseifications
9. Long shots almost never pay off
10. It's better to miss the first move in a stock and wait to see if a company's plans are working out
11. People get incredibly valuable fundamental information from their jobs that may not even reach the professionals for months or even years
12. Invest in simple companies that appear dull, mundane, out of favour, and haven't caught the fancy of wall street
13. Moderately fast growers (20 to 25%) in non growth industries are ideal investments
14. Look for companies with niches
15. When purchasing depressed stocks in troubled companies, seek out the ones with superior financial positions and avoid the ones with loads of bank debt
16. Companies that have no debt can't go bankrupt
17. Managerial ability may be important, but it's difficult to assess. Base your purchases on the company's prospects, not on the president's resume or speaking ability.
18. A lot of money can be made when a troubled company turns around
19. Carefully consider the Price- earnings ratio. If the stock is grossly overpriced, even if everything else goes right, you won't make any money.
20. Find a story line to follow as a way of monitoring a company's progress.
21. Look for companies that consistently buy back their own shares.
22. Study the dividend record of a company over the years and also how its earnings have fared in past recessions.
23. Look for companies with little or no institutional ownership.
24. All else being equal, favour companies in which management has a significant personal investment over companies run by people that benefit only from their salaries.
25. Insider buying is a positive sign, especially when several individuals are buying at once.
26. Devote at least an hour a week to investment research. Adding up your dividends and figuring out your gains and losses doesn't count.
27. Be patient.
28. Buying stocks based on stated Book Value alone is dangerous and illusory. It's real value that counts.
29. When in doubt, tune in later.
30. Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.
The Long Term View
1. Don't forget to include all the costs of subscriptions to newsletters, commissions, investment seminars.
2. 9 to 10% per year is the generic long term return for stocks, the historic market average.
The Best time to Buy and Sell
Buy
1. End of the year tax selling
2. During collapses, drops, burps, hiccups and free-falls that occur in the stock market every few years
Sell
1. When to sell a Slow Grower
- sell when there is a 30- 50% appreciation or when the fundamentals have deteriorated.
- the company has lost market share for 2 consecutive years and is hiring another advertising agency.
- No new products are being developed, spending on R&D 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 B/S 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.
2. When to Sell a Stalwart
- if the stock price gets above the earnings line, or if the P/E strays too far beyond the normal range
- New products introduced in the last 2 years have had mixed results, and others still in the testing stage are a year away from the market place
- The stock has a P/E ratio of 15, while similar quality companies in the industry have a P/E of 11 - 12.
- No officers or directors have bought shares in the last year
- A major division that contributes 25% of earnings is vulnerable to an economic slump that's taking place (e.g housing, oil drilling)
- 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
3. When to Sell a Cyclical
- 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 the XYZ between the last bust and 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
- Falling commodity prices is another harbinger. Usually prices of oil, steel etc will turn down several months before troubles show up in earnings
- When the Future price of a commodity < Current Price ( or Spot Price), then the company's earnings will slow down months later
- Competition businesses are also a bad sign for cyclicals. The outsider will have to win customers by cutting prices, which forces everyone to cut prices and leads to lower earnings for all the producers.
- two key union contracts expire in the next twelve months, and labour 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 modernising the old plants at low cost
- The company has tried to cut costs but still can't compete with foreign producers
4. When to Sell a Fast Grower
- watch for the end of the second phase of rapid growth
- if 40 Wall Street analysts are giving the stock their highest recommendation, 60% of the shares are held by institutions, and 3 national magazines have fawned over the CEO, then it is definitely time to think about selling
- Same store sales are down 3% 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 industry show, and telling an extremely positive story to institutional investors in 12 cities in 2 weeks
- The stock is selling at a P/E of 30, while the most optimistic projections of earnings growth are 15-20% for the next 2 years
5. When to Sell a Turnaround
- If the turnaround has been successful, you have to reclassify the stock
- Debt, which has declined for five straight quarters, just rose by 25 million in the latest 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% of its output to one leading customer, and that leading customer is suffering from a slowdown in its own sales
6. When to Sell an Asset Play
- Although the shares sell at a discount to real market value, management has announced it will issue 10% more shares to help finance a diworseification program
- The division that was expected to be sold for $20 million only bring $12 million in the actual sale
- The reduction in the corporate tax rate considerably reduces the value of the company's tax loss carry forward (when expenses > revenues, negative taxable income, carry forward this lose, don't have to pay taxes on future capital gains). This is bad because the company has to pay more taxes in the future, meaning reduced profits.
- Institutional ownership has risen from 25% five years ago to 60% today - with several Boston Fund groups being major purchasers.
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