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invest in stocks not to preserve capital, but to make money. Then you take your
profits and invest in more stocks, and make even more money.Â
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efficient-market hypothesis
(that everything in the stock market is âknownâ and prices are always ârationalâ)
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âDonât gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it donât go up, donât buy it.â
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market-capitalization rule: Size is measured by multiplying the number of outstanding shares by the current stock price.
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Consistent winners raise their bet as their position strengthens, and they exit the game when the odds are against them
Consistent winners also resign themselves to the fact that theyâll occasionally be dealt three aces and bet the limit, only to lose to a hidden royal flush.
They realize the stock market is not pure science, and not like chess, where the superior position always wins.
If 7 out of 10 of my stocks perform as expected, then Iâm delighted.
If six out of ten of my stocks perform as expected, then Iâm thankful.Â
6 out of 10 is all it takes to produce an enviable record on Wall Street.
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⢠Donât overestimate the skill and wisdom of professionals.
⢠Take advantage of what you already know.
⢠Look for opportunities that havenât yet been discovered and certified by Wall
Streetâcompanies that are âoff the radar scope.â
⢠Invest in a house before you invest in a stock.
⢠Invest in companies, not in the stock market.
⢠Ignore short-term fluctuations.
⢠Large profits can be made in common stocks.
⢠Large losses can be made in common stocks.
⢠Predicting the economy is futile.
⢠Predicting the short-term direction of the stock market is futile.
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⢠The long-term returns from stocks are both relatively predictable and also far
superior to the long-term returns from bonds.
⢠Keeping up with a company in which you own stock is like playing an endless
stud-poker hand.
⢠Common stocks arenât for everyone, nor even for all phases of a personâs life.
⢠The average person is exposed to interesting local companies and products
years before the professionals.
⢠Having an edge will help you make money in stocks.
⢠In the stock market, one in the hand is worth ten in the bush.
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The best place to begin looking for the tenbagger is close to home
Canât think of any such opportunity in your own life? What if youâre retired, live ten miles from the nearest traffic light, grow your own food, and donât have a television set? Well, maybe one day you have to go to a doctor. The rural existence has given you ulcers, which is the perfect introduction to SmithKline Beckman.
people who buy stocks about which they are ignorant may get lucky and enjoy great rewards, it seems to me they are competing under unnecessary handicaps
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This gives an incredible head start in anticipating an improvement in earningsâand earnings, as youâll see, make stock prices go higher.
Youâre looking for a situation where the value of the assets per share exceeds the price per share of the stock. In such delightful instances you can truly buy a great deal of something for nothing. Iâve done it myself numerous times.
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I could go on for the rest of the book about the edge that being in a business
gives the average stockpicker. On top of that, thereâs the consumerâs edge thatâs
helpful in picking out the winners from the newer and smaller fast-growing
companies, especially in the retail trades. Whichever edge applies, the exciting
part is that you can develop your own stock detection system outside the normal
channels of Wall Street, where youâll always get the news late.
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Invest in things you know about. Neither of us should let an opportunity pass us by again.
Investing without research is like playing stud poker and never looking at the cards.
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place it into one of six general categories:
slow growers
stalwarts
fast growers
cyclicals
asset plays
and turnarounds.Â
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Usually these large and aging companies are expected to grow slightly faster than the gross national product.
Slow growers didnât start out that way.
They started out as fast growers and eventually pooped out, either because they had gone as far as they could, or else they got too tired to make the most of their chances.Â
Sooner or later every popular fast-growing industry becomes a slow-growing industry,Â
aluminum was a fast-growth industry. In the twenties the railroads were the great growth companies,Â
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Then cars became the fast-growth industry, and for a time it was steel, then chemicals, then electric utilities, then computers.
Another sure sign of a slow grower is that it pays a generous and regular dividend. companies pay generous dividends when they canât dream up new ways to use the money to expand the business.Â
You wonât find a lot of two to four percent slow growers in my portfolio, because if companies arenât going anywhere fast, neither will the price of their stocks.
If growth in earnings is what enriches a company, then whatâs the sense of wasting time on sluggards?
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When you traffic in stalwarts, youâre more or less in the foothills: 10 to 12 percent annual growth in earnings.
In fact, when anyone brags about doubling or tripling his money on a stalwart (or on any company, for that matter), your next question ought to be: âAnd how long did you own it?â In many instances the risk of ownership has not resulted in any advantage to the owner, who therefore took chances for nothing
always keep some stalwarts in portfolio because they offer pretty good protection during recessions and hard times.
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These are among my favorite investments: small, aggressive new enterprises that grow at 20 to 25 percent a year. If you choose wisely, this is the land of the 10-to 40-baggers, and even the 200-baggers. With a small portfolio, one or two of these can make a career.
A fast-growing company doesnât necessarily have to belong to a fast-growing industry.
All it needs is the room to expand within a slow-growing industry. Beer is a slow-growing industry
Thereâs plenty of risk in fast growers, especially in the younger companies that tend to be overzealous and underfinanced.
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Wall Street does not look kindly on fast growers that run out of stamina and turn into slow growers, and when that happens, the stocks are beaten down accordingly.Â
Once a fast grower gets too big, it faces the same dilemma as Gulliver in Lilliput. Thereâs simply no place for it to stretch out.
But for as long as they can keep it up, fast growers are the big winners in the stock market.
I look for the ones that have good balance sheets and are making substantial profits.
The trick is figuring out when theyâll stop growing, and how much to pay for the growth.
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A cyclical is a company whose sales and profits rise and fall in regular if not completely predictable fashion.Â
In a growth industry, business just keeps expanding, but in a cyclical industry it expands and contracts, then expands and contracts again.
The autos and the airlines, the tyre companies, steel companies, and chemical companies are all cyclicals. Even defense companies behave like cyclicals, since their profitsâ rise and fall depends on the policies of various administrations.
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Charts of the cyclicals look like the polygraphs of liars, or the maps of the Alps, as opposed to the maps of Delaware you get with the slow growers.
Coming out of a recession and into a vigorous economy, the cyclicals flourish, and their stock prices tend to rise much faster than the prices of the stalwarts. This is understandable, since people buy new cars and take more airplane trips in a vigorous economy, and thereâs greater demand for steel, chemicals, etc.
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You can lose more than fifty percent of your investment very quickly if you buy cyclicals in the wrong part of the cycle, and it may be years before youâll see another upswing.Â
Cyclicals are the most misunderstood of all the types of stocks.Â
The major cyclicals are large and well-known companies, they are naturally lumped together with the trusty stalwarts.Â
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Timing is everything in cyclicals, and you have to be able to detect the early
signs that business is falling off or picking up. If you work in some profession
thatâs connected to steel, aluminum, airlines, automobiles, etc., then youâve got
your edge, and nowhere is it more important than in this kind of investment.
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These arenât slow growers; these are no growers. These arenât cyclicals that rebound; these are potential fatalities.
Turnaround stocks make up lost ground very quickly.
The best thing about investing in successful turnarounds is that of all the categories of stocks, their ups and downs are least related to the general market.Â
There are several different types of turnarounds, and Iâve owned all of them at one time or another. Thereâs the bail-us-out-or-else kind of turnaround where the whole thing depended on a government loan guarantee.
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Thereâs the who-would-have-thunk-it kind of turnaround, such as Con Edison. Who would ever have believed you could lose this much money in a utility, as the stock price fell from $10 to $3 by 1974; and who would have believed you could make this much, as the price rebounded from $3 to $52 by 1987?
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Thereâs the little-problem-we-didnât-anticipate kind of turnaround, such as
Three Mile Island. This was a minor tragedy perceived to be worse than it was,
and in minor tragedy thereâs major opportunity. I made a lot of money in
General Public Utilities, the owner of Three Mile Island. Anybody could have.
You just had to be patient, keep up with the news, and read it with dispassion.Â
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I try to stay away from the tragedies where the outcome is unmeasurable, such
as the Bhopal disaster at the Union Carbide plant in India. This was a terrible
gas leak that resulted in thousands of deaths, and how much the families would
get out of Union Carbide in damages was an open question
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Thereâs the restructuring-to-maximize-shareholder-values kind of turnaround,
such as Penn Central. Wall Street seems to favor restructuring these days, and any director or CEO who mentions it is warmly applauded by shareholders.
Restructuring is a companyâs way of ridding itself of certain unprofitable subsidiaries it should never have acquired in the first place.
The earlier buying of these ill-fated subsidiaries, also warmly applauded, is called diversification. I call it diworseification.
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An asset play is any company thatâs sitting on something valuable that you know about, but that the Wall Street crowd has overlooked.
The asset play is where the local edge can be used to greatest advantage.
Asset opportunities are everywhere. Sure they require a working knowledge of the company that owns the assets, but once thatâs understood, all you need is patience.
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Companies donât stay in the same category forever. Over my years of watching stocks Iâve seen hundreds of them start out fitting one description and end up fitting another.
Fast growers can lead exciting lives, and then they burn out, just as humans can.
They canât maintain double-digit growth forever, and sooner or later they exhaust themselves and settle down into the comfortable single digits of sluggards and stalarts.
Cyclicals with serious financial problems collapse and then reemerge as turnarounds.Â
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Growth companies that canât stand prosperity foolishly diworseify and fall out of favor, which makes them into turnarouds
 McDonaldâs is a classic fast grower, but because of the thousands of outlets it either owns or is repurchasing from the franchisees, it could be a great future asset play in real estate.
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Are you looking for slow growth, fast growth, recession protection, a turnaround, a cyclical bounce, or assets?
Putting stocks in categories is the first step in developing the story.
Getting the story on a company is a lot easier if you understand the basic business.
The simpler it is, the better I like it. When somebody says, âAny idiot could run this joint,â thatâs a plus as far as Iâm concerned, because sooner or later any idiot probably is going to be running it.
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âAny idiot can run this businessâ is one characteristic of the perfect company,
the kind of stock I dream about. You never find the perfect company, but if you
can imagine it, then youâll know how to recognize favorable attributes,
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The perfect stock would be attached to the perfect company, and the perfect company has to be engaged in a perfectly simple business, and the perfectly simple business ought to have a perfectly boring name. The more boring it is, the better.
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I get even more excited when a company with a boring name also does something boring.Â
A company that does boring things is almost as good as a company that has a boring name, and both together is terrific.
 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.
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Better than boring alone is a stock thatâs boring and disgusting at the same time.
Something that makes people shrug, retch, or turn away in disgust is ideal.
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Spinoffs of divisions or parts of companies into separate, freestanding entities
Large parent companies do not want to spin off divisions and then see those spinoffs get into trouble, because that would bring embarrassing publicity that would reflect back on the parents.
Therefore, the spinoffs normally have strong balance sheets and are well-prepared to succeed as independent entities.
And once these companies are granted their independence, the new management, free to run its own show, can cut costs and take creative measures that improve the near-term and long-term earnings
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If you find a stock with little or no institutional ownership, youâve found a potential winner.
Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and youâve got a double winner.Â
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Itâs hard to think of a more perfect industry than waste management.
If thereâs anything that disturbs people more than animal casings, grease and dirty oil, itâs sewage and toxic waste dumps.Â
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 In this category my favorite all-time pick is Service Corporation International (SCI), which also has a boring name.
At last count the company owned 461 funeral parlors, 121 cemeteries, 76 flower shops, 21 funeral product-and-supply manufacturing centers, and 3 casket distribution centers, so theyâre vertically integrated.
They broke into the big-timewhen they buried Howard Hughes.
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I prefer to invest in a low-growth industry like plastic knives and forks, but only if I canât find a no-growth industry like funerals.
Thatâs where the biggest winners are developed.
In a no-growth industry, especially one thatâs boring and upsets people, thereâs no problem with competition.
You donât have to protect your flanks from potential rivals because nobody else is going to be interested.Â
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Iâd much rather own a local rock pit than own Twentieth Century-Fox, because a movie company competes with other movie companies, and the rock
pit has a niche. Twentieth Century-Fox understood that when it bought up Pebble Beach, and the rock pit with it. Certainly, owning a rock pit is safer than owning a jewelry business. If youâre in the jewelry business, youâre competing with other jewelers from across town, across the state, and even abroad, since vacationers can buy jewelry anywhere and bring it home. But if youâve got the only gravel pit in Brooklyn,
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 youâve got a virtual monopoly, plus the added protection of the unpopularity of rock pits.
The insiders call this the âaggregateâ business, but even the exalted name doesnât alter the fact that rocks, sand, and gravel are as close to inherently worthless as you can get.
Thatâs the paradox: mixed together, the stuff probably sells for $3 a ton.
For the price of a glass of orange juice, you can purchase a half ton of aggregate, which, if youâve got a truck, you can take home and dump on your lawn.
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Iâd rather invest in a company that makes drugs, soft drinks, razor blades, or cigarettes than in a company that makes toys. In the toy industry somebody can make a wonderful doll that every child has to have, but every child gets only one each.Â
Eight months later that product is taken off the shelves to make room for the newest doll the children have to haveâmanufactured by somebody else.
Why take chances on fickle purchases when thereâs so much steady business
around?
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When insiders are buying like crazy, you can be certain that, at a minimum, the company will not go bankrupt in the next six months. When insiders are buying, Iâd bet there arenât three companies in history that have gone bankrupt near term. Long term, thereâs 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,
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 thereâs 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.
If the stock price drops after the insiders have bought, so that you have a chance to buy it cheaper than they did, so much the better for you.
But thereâs only one reason that insiders buy: They think the stock price is undervalued and will eventually go up.
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Buying back shares is the simplest and best way a company can reward its investors. If a company has faith in its own future, then why shouldnât it invest in itself, just as the shareholders do? The announcement of massive share buybacks by company after company broke on October 20, 1987 the fall of many stocks, and stabilized the market at the height of its panic. Long term, these buybacks canât help but reward investors.Â
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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.
common alternatives to buying back shares are (1) raising the dividend, (2) developing new products, (3) starting new operations, and (4) making acquisitions.
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The reverse of buying back shares is adding more shares, also called diluting.
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If I could avoid a single stock, it would be the hottest stock in thehottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter trainâand succumbing to the social pressure, often buys.
If you arenât clever at selling hot stocks (and the fact that youâve bought them is a clue that you wonât be), youâll soon see your profits turn into losses, because when the price falls, itâs not going to fall slowly, nor is it likely to stop at the level where you jumped on.
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Another stock Iâd avoid is a stock in a company thatâs been touted as the next.
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Instead of buying back shares or raising dividends, profitable companies often prefer to blow the money on foolish acquisitions. The dedicated diworseifier seeks out merchandise that is (1) overpriced, and (2) completely beyond his or her realm of understanding. This ensures that losses will be maximized.
These frequent episodes of acquiring and then regretting, only to divest and acquire and regret once again
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If a company must acquire something, Iâd prefer it to be a related business, but acquisitions in general make me nervous. Thereâs 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. Iâd rather see a vigorous buyback of shares, which is the purest synergy of all.
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I get calls all the time from people who recommend solid companies for Magellan, and then, usually after theyâve lowered their voices as if to confide something personal, they add: âThereâs this great stock I want to tell you about. Itâs too small for your fund, but you ought to look at it for your own account.Itâs a fascinating idea, and it could be a big winer.â
Whisper stocks have a hypnotic effect, and usually the stories have emotional appeal.
You can get tenbaggers in companies that have already proven themselves. When in doubt, tune in later.
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The company that sells 25 to 50 percent of its wares to a single customer is in a precarious situation.Â
Short of cancellation, the big customer has incredible leverage in extracting price cuts and other concessions that will reduce the supplierâs profits.
Itâs rare that a great investment could result from such an arrangement.
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Itâs too bad that Xerox didnât have a name like Davidâs Dry Copies, because then more people would have been skeptical of it. As often as a dull name in a good company keeps early buyers away, a flashy name in a mediocre company attracts investors and gives them a false sense of security.
 As long as it has âadvanced,â âleading,â âmicro,â or something with an x in it, or itâs a mystifying acronym, people will fall in love with it.
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Sometimes it takes years for the stock price to catch up to a companyâs value, and the down periods last so long that investors begin to doubt that will ever happen.
But value always wins out.
Analyzing a companyâs 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 itâs easy to forget sometimes, a share of stock is not a lottery ticket. Itâs part ownership of a business.
Although itâs easy to forget sometimes, a share of stock is not a lottery ticket. Itâs part ownership of a business.
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Any serious discussion of earnings involves the price/earnings ratioâalso known as the p/e ratio, the price-earnings multiple, or simply, the multiple. This ratio is a numerical shorthand for the relationship between the stock price and the earnings of the company.
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 investmentâ assuming, of course, that the companyâs earnings stay constant. However, you donât have to go through this exercise because the p/e ratio of 10 tells you itâs ten years.
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Youâll also find that the p/e levels tend to be lowest for the slow growers and highest for the fast growers, with the cyclicals vacillating in between.
An average p/e for a utility (7 to 9 these days) will be lower than the average p/e for a stalwart (10 to 14 these days), and that in turn will be lower than the average p/e of a fast grower (14â20). Some bargain hunters believe in buying any and all stocks with low p/eâs, but that strategy makes no sense to me.
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 If you remember nothing else about p/e ratios, remember to avoid stocks with excessively high ones.  With few exceptions, an extremely high p/e ratio is a handicap to a stock.
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Company p/e ratios do not exist in a vacuum. 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.
Interest rates have a large effect on the prevailing p/e ratios, since investors pay more for stocks when interest rates are low and bonds are less attractive. But interest rates aside, the incredible optimism that develops in bull markets can drive p/e ratios to ridiculous levels.
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Future earningsâthereâs the rub. How do you predict those? The best you can get from current earnings is an educated guess whether a stock is fairly priced.
what youâd really like to know is whatâs going to happen to earnings in the next month, the next year, or the next decade.
Earnings, after all, are supposed to grow, and every stock price carries with it a built-in growth assumption.
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Once you got into this game seriously, youâd be boggled by the examples of stocks that go down even though the earnings are up, because professional analysts and their institutional clients expected the earnings to be higher, or stocks that go up even though earnings are down, because that same cheering section expected the earnings to be lower.
If you canât predict future earnings, at least you can find out how a company plans to increase its earnings.
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Already youâve found out whether youâre dealing with a slow grower, a stalwart, a fast grower, a turnaround, an asset play, or a cyclical.
The p/e ratio has given you a rough idea of whether the stock, as currently priced, is undervalued or overvalued relative to its immediate prospects.
The next step is to learn as much as possible about what the company is doing to bring about the added prosperity, the growth spurt, or whatever happy event is expected to occur. This is known as the âstory.â
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With the possible exception of the asset play (where you can sit back and wait for the value of the real estate or the oil reserves or the TV stations to be recognized by others), something dynamic has to happen to keep the earnings moving along. The more certain you are about what that something is, the better youâll be able to follow the script.
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Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons Iâm interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. The two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot. Once youâre able to tell the story of a stock to your family, your friends, or the dog (and I donât mean âa guy on the bus says Caesars World is a takeoverâ), and so that even a child could understand it, then you have a proper grasp of the situation.
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If itâs a slow-growing company youâre thinking about, then presumably youâre in it for the dividend, (Why else own this kind of stock?) Therefore, the important elements of the script would be: âThis company has increased earnings every year for the last ten, it offers an attractive yield; itâs never reduced or suspended a dividend, and in fact itâs raised the dividend during good times and bad, including the last three recessions. Itâs a telephone utility, and the new cellular operations may add a substantial kicker to the growth rate.â
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If itâs a cyclical company youâre thinking about, then your script revolves around business conditions inventories, and prices
If itâs an asset play, then what are the assets, how much are they worth?
Insiders are buying, and the company has steady earnings and thereâs no debt to speak of
If itâs a turnaround, then has the company gone about improving its fortunes, and is the plan working so far?
If itâs a stalwart, then the key issues are the p/e ratio, whether the stock already has had a dramatic run-up in price in recent months, and what, if anything, is happening to accelerate the growth rate.
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THE PRICE/EARNINGS RATIO
Weâve gone on about this already, but hereâs a useful refinement: The p/e ratio of any company thatâs fairly priced will equal its growth rate.
Iâm talking about growth rate of earnings here. How do you find that out? Ask your broker whatâs the growth rate, as compared to the p/e ratio.
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If the p/e of Coca-Cola is 15, youâd expect the company to be growing at about 15 percent a year, etc.
But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year (also known as a â12-percent growerâ) and a p/e ratio of 6 is a very attractive prospect.
On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown.
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In general, a p/e ratio thatâs half the growth rate is very positive, and one thatâs twice the growth rate is very negative.
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A slightly more complicated formula enables us to compare growth rates to earnings, while also taking the dividends into account.
Find the long-term growth rate (say, Company Xâs is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the p/e ratio (Company Xâs is 10). 12 plus 3 divided by 10 is 1.5. Less than a 1 is poor, and 1.5 is okay, but what youâre really looking for is a 2 or better.
A company with a 15 percent growth rate, a 3 percent dividend, and a p/e of 6 would have a fabulous 3.
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Find out how much cash is the company is sitting onÂ
formula= cash from opertions - Purchases of new plants,machinery etc - Long term debt = Free cash
Now just divide this cash by number of shares out standing and you will get Free cash per share.Â
peter lynch found out that ford had accumulated the $16.30 a share in cash beyond debt, for every share of ford he owned, there was this $16.30 bonus sitting there on paper like some delightful hidden rebate
The $16.30 bonus changed everything. it meant that he bought ford not for $38 a share, but for $21.70 ($38 minus the $16.30 in cash)Â
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Analysts were expecting Ford to earn $7 a share from its auto operations, which at the $38 price gave P/E of 5.4, but at the $21.70 price it had a p/e of 3.1.
Nevertheless, itâs always advisable to check the cash position (and the value of related businesses) as part of your research. You never know when youâll stumble across a Ford.
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How much does the company owe, and how much does it own? Debt versus equity. Itâs just the kind of thing a loan officer would want to know about you in deciding if you are a good credit risk.
A normal corporate balance sheet has two sides. On the left side are the assets (inventories, receivables, plant and equipment, etc.). The right side shows how assets are financed. One quick way to determine the financial strength of a company is to compare the equity to the debt on the right side of the balance sheet.
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âDo you know the only thing that gives me pleasure? Itâs to see my dividends coming in.â
âJohn D. Rockefeller, 1901
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Book value gets a lot of attention these daysâperhaps because itâs such an easy number to find. You see it reported everywhere. Popular computer programs can tell you instantly how many stocks are selling for less than the stated book value. People invest in these on the theory that if the book value is $20 a share and the stock sells for $10, theyâre getting something for half price. 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.
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Just as often as book value overstates true worth, it can understate true worth.
This is where you get the greatest asset plays.Companies that own natural resourcesâsuch as land, timber, oil, or precious metalsâcarry those assets on their book at a fraction of the true value.
Brand names such as Coca-Cola or Robitussin have tremendous value that isnât reflected on the books. So do patented drugs, cable franchises, TV and radio stationsâall are carried at original cost, then depreciated until they, too, disappear from the asset side of the balance sheet.
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the amount that was paid for the bottling franchises above and beyond the cost of the plants, inventory, and equipment. Itâs the intangible value of the franchises.
tax breaks turn out to be a wonderful hidden asset in turnaround companies.
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Cash flow is the amount of money a company takes in as a result of doing business.All companies take in cash, but some have to spend more than others to get it.
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For instance, a $20 stock with $2 per share in annual cash flow has a 10-to-1 ratio, which is standard. A ten percent return on cash corresponds nicely with the ten percent that one expects as a minimum reward for owning stocks long term. A $20 stock with a $4-per-share cash flow gives you a 20 percent return on cash, which is terrific. And if you find a $20 stock with a sustainable $10-per-share cash flow, mortgage your house and buy all the shares you can find.
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Thereâs a detailed note on inventories in the section called âmanagementâs discussion of earningsâ in the annual report.
I always check to see if inventories are piling up. With a manufacturer or a retailer, an inventory buildup is usually a bad sign. When inventories grow faster than sales, itâs a red flag.
There are two basic accounting methods to compute the value of inventories,
LIFO and FIFO. As much as this sounds like a pair of poodles, LIFO actually
stands for âlast in, first out,â and FIFO stands for âfirst in, and first out.â
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If you find a business that can get away with raising prices year after year without losing customers (an addictive product such as cigarettes fills the bill), youâve got a terrific investment.
One more thing about growth rate: all else being equal, a 20-percent grower selling at 20 times earnings (a p/e of 20) is a much better buy than a 10-percent grower selling at 10 times earnings (a p/e of 10).
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Profit before taxes, also known as the pretax profit margin, is a tool I use in analyzing companies. Thatâs whatâs left of a companyâs annual sales dollar after all the costs, including depreciation and interest expenses, have been deducted
Retailers have lower profit margins than manufacturers. On the other hand, companies that make highly profitable drugs got 25 percent pretax or better.
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There are three phases to a growth companyâs life: the start-up phase, during which it works out the kinks in the basic business; the rapid expansion phase, during which it moves into new markets; and the mature phase, also known as the saturation phase
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STOCKS IN GENERAL
⢠The p/e ratio. Is it high or low for this particular company and for similar companies in the same industry.
⢠The percentage 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 balance sheet or a weak balance sheet (debt-to-equity ratio) and how itâs rated for
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SLOW GROWERS
⢠Since you buy these for the dividends (why else would you own them?) you
want to check to see if dividends have always been paid, and whether they are
routinely raised.
⢠When possible, find out what percentage of the earnings are being paid out
as dividends. If itâs a low percentage, then the company has a cushion in hard
times. It can earn less money and still retain the dividend. If itâs a high percentage, then the dividend is riskier.
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⢠These are big companies that arenât likely to go out of business. The key issue is price, and the p/e ratio will tell you whether you are paying too much.
⢠Check for possible diworseifications that may reduce earnings in the future.
⢠Check the companyâs 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.Â
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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 peak earnings are achieved.
⢠If you know your cyclical, you have an advantage in figuring out the cycles.
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(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. People can put off replacing cars for a year or two longer than expected, but sooner or later they are back in the dealerships.Â
The worse the slump in the auto industry, the better the recovery. Sometimes I root for an extra year of bad sales, because I know it will bring a longer and more sustainable upside.
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FAST GROWERS:
⢠Investigate whether the product thatâs supposed to enrich the company is a major part of the companyâs business.
⢠What the growth rate in earnings has been in recent years. (My favorites are the ones in the 20 to 25 percent range
⢠That the company has duplicated its successes 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
⢠That few institutions own the stock and only a handful of analysts have ever heard of it
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⢠Most important, 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 out its problems without going bankrupt?Â
⢠If itâs bankrupt already, then whatâs left for the shareholders?
⢠How is the company supposed to be turning around? Has it rid itself of unprofitable divisions?Â
⢠Is business coming back?
⢠Are costs being cut?
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⢠Whatâs the value of the assets? Are there any hidden assets?
⢠How much debt is there to detract from these assets? (Creditors are 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?
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⢠Understand the nature of the companies you own and the specific reasons for holding the stock. (âIt is really going up!â doesnât count.)
⢠By putting your stocks into categories youâll have a better idea of what to expect from them.
⢠Big companies have small moves, small companies have big moves.
⢠Consider the size of a company if you expect it to profit from a specific product
⢠Look for small companies that are already profitable and have proven that their concept can be replicated
⢠Be suspicious of companies with growth rates of 50 to 100 percent a year
⢠Avoid hot stocks in hot industries
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⢠Distrust diversifications, which usually turn out to be diworseifications.
⢠Long shots almost never pay off.
⢠Itâs better to miss the first move in a stock and wait to see if a companyâs plans are working out.
⢠People get incredibly valuable fundamental information from their jobs that may not reach the professionals for months or even years.
⢠Separate all stock tips from the tipper, even if the tipper is very smart, very rich, and his or her last tip went up.
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⢠Some stock tips, especially from an expert in the field, may turn out to be quite valuable. However, people in the paper industry normally give out tips on drug stocks, and people in the health care field never run out of tips on the coming takeovers in the paper industry.
⢠Invest in simple companies that appear dull, mundane, out of favor, and havenât caught the fancy of Wall Street.
⢠Moderately fast growers (20 to 25 percent) in nongrowth industries are ideal investments.
⢠Look for companies with niches.
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⢠When purchasing depressed stocks in troubled companies, seek out the ones with the superior financial positions and avoid the ones with loads of bank debt.
⢠Companies that have no debt canât go bankrupt
⢠Managerial ability may be important, but itâs quite difficult to assess. Base your purchases on the companyâs prospects, not on the presidentâs resume or speaking ability.
⢠A lot of money can be made when a troubled company turns around.
⢠Carefully consider the price-earnings ratio. If the stock is grossly overpriced, even if everything else goes right, you wonât make any money.
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Iâve heard people say theyâd be satisfied with a 25 or 30 percent
annual return from the stock market! Satisfied? At that rate theyâd soon own half the country along with the Japanese and the Bass brothers. Even the tycoons of the twenties couldnât guarantee themselves 30 percent forever, and Wall Street was rigged in their favor.
In certain years youâll make your 30 percent, but there will be other years when youâll only make 2 percent, or perhaps youâll lose 20. Thatâs just part of the scheme of things, and you have to accept it.
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Whatâs wrong with high expectations? If you expect to make 30 percent year after year, youâre more likely to get frustrated at stocks for defying you, and your impatience may cause you to abandon your investments at precisely the wrong moment. Or worse, you may take unnecessary risks in the pursuit of illusory payoffs. Itâs only by sticking to a strategy through good years and bad that youâll maximize your long-term gains.
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Thereâs a long-standing debate between two factions of investment advisors, with the Gerald Loeb faction declaring, âPut all your eggs in one basket,â and the Andrew Tobias faction retorting, âDonât put all your eggs in one basket. It may have a hole in it.â
(1) If you are looking for tenbaggers, the more stocks you own the more likely that one of them will become a tenbagger. Among several fast growers that exhibit promising characteristics, the one that actually goes the furthest may be a surprise.
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(2) The more stocks you own, the more flexibility you have to rotate funds between them. This is an important part of my strategy.
I never put more than 30â40 percent of my fundâs assets into growth stocks. .
Normally I keep about 10â20 percent or so in the stalwarts,another 10â20 percent or so in the cyclicals, and the rest in the turnarounds.
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Spreading your money among several categories of stocks is another way to minimize downside risk.
Slow growers are low-risk, low-gain because theyâre not expected to do much and the stocks are usually priced accordingly. Stalwarts are low-risk, moderate gain.
 Asset plays are low-risk and high-gain if youâre sure of the value of the assets. If you are wrong on an asset play, you probably wonât lose much, and if you are right, you could make a double, a triple, or perhaps a five-bagger.
Cyclicals may be low-risk and high-gain or high-risk and low-gain, depending on how adept you are at cycles.
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Iâm constantly rechecking stocks and rechecking stories, adding and subtracting to my investments as things change. But I donât go into cashâexcept to have enough of it around to cover anticipated redemptions. Going into cash would be getting out of the market.
My idea is to stay in the market forever, and to rotate stocks depending on the fundamental situations. I think if you decide that a certain amount youâve invested in the stock market will always be invested in the stock market, youâll save yourself a lot of mistimed moves and general agony.
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Some people automatically sell the âwinnersââstocks that go upâand hold on to their âlosersââstocks that go down-which is about as sensible as pulling out the flowers and watering the weeds.Â
A better strategy, it seems to me, is to rotate in and out of stocks depending on what has happened to the price as it relates to the story. 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.
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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, Iâll 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.
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After all thatâs been said, I donât want to sound like a market timer and tell you that thereâs a certain best time to buy stocks. The best time to buy stocks will always be the day youâve convinced yourself youâve found solid merchandise at a good priceâthe same as at the department store. However, there are two particular periods when great bargains are likely to be found.
The first is during the peculiar annual ritual of end-of-the-year tax selling.Itâs no accident that the most severe drops have occurred between October and December.
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The second is during the collapses, drops, burps, hiccups, and freefalls that occur in the stock market every few years. If you can summon the courage and presence of mind to buy during these scary episodes when your stomach says âsell,â youâll find opportunities that you wouldnât have thought youâd ever see again.
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Even the most thoughtful and steadfast investor is susceptible to the influence of skeptics who yell âSellâ before itâs time to sell. I ought to know. Iâve been talked out of a few tenbaggers myself.
Itâs normally harder to stick with a winning stock after the price goes up than it is to believe in it after the price goes down. These days if I feel thereâs a danger of being faked out, I try to review the reasons why I bought in the first place.
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This is one instance where the amateur investor is just as vulnerable to folly as the professional. We have fellow experts whispering into our ears; you have friends, relatives, brokers, and assorted financial factotums from the media.
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If the market canât tell you when to sell, then what can? No single formula could possibly apply. âSell before the interest rates go upâ or âsell before the next recessionâ would be advice worth following, if only we knew when these things would happen, but of course we donât, and so these mottos become platitudes as well.
Over the years Iâve learned to think about when to sell the same way I think about when to buy. I pay no attention to external economic conditions, except in the few obvious instances when Iâm sure that a specific business will be affected in a specific way.
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I canât really help you with this one, because I donât own many slow growers in the first place. The ones I do buy, I sell when thereâs been a 30â50 percent appreciation or when the fundamentals have deteriorated.
⢠The company has lost market share for two consecutive years and is hiring another advertising agency.
⢠No new products are being developed, spending on research and development is curtailed, and the company appears to be resting on its laurels.
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⢠Two recent acquisitions of unrelated businesses look like diworseifications, and the company announces it is looking for further acquisitions âat the leading edge of technology.â
⢠The company has paid so much for its acquisitions that the balance sheet 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.
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These are the stocks that I frequently replace with others in the category. Thereâs no point expecting a quick tenbagger in a stalwart, and if the stock price gets above the earnings line, or if the p/e strays too far beyond the normal range, you might think about selling it and waiting to buy it back later at a lower priceâor buying something else, as I do
⢠New products introduced in the last two years have had mixed results and others still in the testing stage are a year away from the marketplace
⢠The stock has a p/e of 15, while similar-quality companies in the industry have p/eâs of 11â12
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The best time to sell is toward the end of the cycle, but who knows when that is? Who even knows what cycles theyâre talking about? Sometimes the knowledgeable vanguard begins to sell cyclicals a year before thereâs a single sign of a companyâs decline. The stock price starts to fall for apparently no earthly reason.
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⢠Two key union contracts expire in the next twelve months, and labor 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 modernizing the old plants at low cost.
⢠The company has tried to cut costs but still canât compete with foreign producers.
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Here, the trick is not to lose the potential tenbagger. On the other hand, if the company falls apart and the earnings shrink, then so will the p/e multiple that investors have bid up on the stock. This is a very expensive double whammy for the loyal shareholders.Unlike the cyclical where the p/e ratio gets smaller near the end, in a growth company the p/e usually gets bigger, and it may reach absurd and illogical dimensions.Â
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⢠Same store sales are down 3 percent 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 âdog and ponyâ show, telling an
extremely positive story to institutional investors in twelve cities in two weeks.
⢠The stock is selling at a p/e of 30, while the most optimistic projections of
earnings growth are 15â20 percent for the next two years.
⢠Same store sales are down 3 percent in the last quarter.
⢠New store results are disappointing.
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⢠The company recently returned from a âdog and ponyâ show, telling an extremely positive story to institutional investors in twelve cities in two weeks.
⢠The stock is selling at a p/e of 30, while the most optimistic projections of earnings growth are 15â20 percent for the next two years.
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The best time to sell a turnaround is after itâs turned around. All the troubles are over and everybody knows it. The company has become the old self it was before it fell apart: growth company or cyclical or whatever. The shareholders arenât embarrassed to own it again. If the turnaround has been successful, you have to reclassify the stock.Â
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⢠Debt, which has declined for five straight quarters, just rose by $25 million
in the latest quarterly report.
⢠Inventories are rising at twice the rate of sales growth.
⢠The p/e is inflated relative to earnings prospects.
⢠The companyâs strongest division sells 50 percent of its output to one leading customer, and that leading customer is suffering from a slowdown in its own sales.
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⢠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 companyâs tax-loss carryforward.
⢠Institutional ownership has risen from 25 percent five years ago to 60 percent todayâwith several Boston fund groups being major purchasers.
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GO HIGHER?
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"STAY AWAY"
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 âsensible investment alternatives.â If this is sensible investing, then the Titanic was a tight ship.
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⢠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. CorrectionsâWall Streetâs definition of going down a lotâpush outstanding companies to bargain prices.
⢠Trying to predict the direction of the market over one year, or even two years, is impossible.
⢠To come out ahead you donât have to be right all the time, or even a majority of the time.
⢠The biggest winners are surprises to me, and takeovers are even more surprising. It takes years, not months, to produce big results.
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⢠Different categories of stocks have different risks and rewards.
⢠You can make serious money by compounding a series of 20â30 percent gains in stalwarts.
⢠Stock prices often move in opposite directions from the fundamentals but long
term, the direction and sustainability of profits will prevail.
⢠Just because a company is doing poorly doesnât mean it canât do worse.
⢠Just because the price goes up doesnât mean youâre right.
⢠Just because the price goes down doesnât mean youâre wrong.
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⢠Stalwarts with heavy institutional ownership and lots of Wall Street coverage that have outperformed the market and are overpriced are due for a rest or a decline.
⢠Buying a company with mediocre prospects just because the stock is cheap is a losing technique.
⢠Selling an outstanding fast grower because its stock seems slightly overpriced is losing technique.
⢠Companies donât grow for no reason, nor do fast growers stay that way forever.
⢠You donât lose anything by not owning a successful stock, even if itâs a tenbagger.
⢠A stock does not know that you own it.
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⢠Donât become so attached to a winner that complacency sets in and you stop monitoring the story.
⢠If a stock goes to zero, you lose just as much money whether you bought it at
$50, $25, $5, or $2âeverything you invested.
⢠By careful pruning and rotation based on fundamentals, you can improve your results. When stocks are out of line with reality and better alternatives exist, sell them and switch into something else.
⢠When favorable cards turn up, add to your bet, and vice versa.
⢠You wonât improve results by pulling out the flowers and watering the weeds.
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⢠If you donât think you can beat the market, then buy a mutual fund and save yourself a lot of extra work and money.
⢠There is always something to worry about.
⢠Keep an open mind to new ideas.
⢠You donât have to âkiss all the girls.â Iâve missed my share of tenbaggers and it hasnât kept me from beating the market.
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IDEAS CURATED BY
CURATOR'S NOTE
These are some lessons that peter lynch thought us in one up on wall street
â
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