Any serious discussion of earnings involves the price/earnings ratio—also 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 investment— assuming, of course, that the company’s earnings stay constant. However, you don’t have to go through this exercise because the p/e ratio of 10 tells you it’s ten years.

THE FAMOUS P/E RATIO

Consistent winners raise their bet as their position strengthens, and they exit the game when the odds are against themConsistent winners also resign themselves to the fact that they’ll 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 I’m delighted. If six out of ten of my stocks perform as expected, then I’m thankful. 6 out of 10 is all it takes to produce an enviable record on Wall Street.

Consistent Winners

<ul><li>IF IT’S GONE DOWN THIS MUCH ALREADY, IT CAN’T GO MUCH LOWER.</li><li>YOU CAN ALWAYS TELL WHEN A STOCK’S HIT BOTTOM</li><li>IF IT’S GONE THIS HIGH ALREADY, HOW CAN IT POSSIBLY</li></ul>GO HIGHER?<ul><li>IT’S ONLY $3 A SHARE: WHAT CAN I LOSE?</li><li>EVENTUALLY THEY ALWAYS COME BACK</li><li>IT’S ALWAYS DARKEST BEFORE THE DAWN</li><li>WHEN IT REBOUNDS TO $10, I’LL SELL</li><li>WHAT ME WORRY? CONSERVATIVE STOCKS DON’T FLUCTUATE MUCH</li><li>IT’S TAKING TOO LONG FOR ANYTHING TO EVER HAPPEN</li><li>LOOK AT ALL THE MONEY I’VE LOST: I DIDN’T BUY IT!</li><li>I MISSED THAT ONE, I’LL CATCH THE NEXT ONE THE STOCK’S GONE UP, SO I MUST BE RIGHT, OR… THE STOCK’S GONE DOWN SO I MUST BE WRONG</li></ul>

The Twelve Silliest (and Most
Dangerous)
Things People Say About
Stock Prices

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 doesn’t 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 industryThere’s plenty of risk in fast growers, especially in the younger companies that tend to be overzealous and underfinanced.

THE FAST GROWERS

market-capitalization rule: Size is measured by multiplying the number of outstanding shares by the current stock price.

Market Cap

If the p/e of Coca-Cola is 15, you’d 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 “12-percent grower”) 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.

Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m 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 you’re able to tell the story of a stock to your family, your friends, or the dog (and I don’t mean “a guy on the bus says Caesars World is a takeover”), and so that even a child could understand it, then you have a proper grasp of the situation.

2-Minute Monologue:

The best time to sell a turnaround is after it’s 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 aren’t embarrassed to own it again. If the turnaround has been successful, you have to reclassify the stock.

WHEN TO SELL A TURNAROUND

Better than boring alone is a stock that’s boring and disgusting at the same time. Something that makes people shrug, retch, or turn away in disgust is ideal.

(3) IT DOES SOMETHING DISAGREEABLE

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”—John D. Rockefeller, 1901

DIVIDENDS

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 train—and succumbing to the social pressure, often buys.If you aren’t clever at selling hot stocks (and the fact that you’ve bought them is a clue that you won’t be), you’ll soon see your profits turn into losses, because when the price falls, it’s not going to fall slowly, nor is it likely to stop at the level where you jumped on.

Stocks I’d Avoid

I’m constantly rechecking stocks and rechecking stories, adding and subtracting to my investments as things change. But I don’t go into cash—except 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 you’ve invested in the stock market will always be invested in the stock market, you’ll save yourself a lot of mistimed moves and general agony.

WATERING THE WEEDS

If it is a fast grower, then where and how can it continue to grow fast?Those are some basic themes for the story, and you can fill in as much detail as you want. The more you know the better. I often devote several hours to developing a script, though that’s not always necessary.

There’s a detailed note on inventories in the section called “management’s discussion of earnings” 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, it’s 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 actuallystands for “last in, first out,” and FIFO stands for “first in, and first out.”

INVENTORIES

• 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 can’t compete with foreign producers.

When you traffic in stalwarts, you’re 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: “And how long did you own it?” 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.

THE STALWARTS

• 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 can’t go bankrupt• Managerial ability may be important, but it’s quite difficult to assess. Base your purchases on the company’s prospects, not on the president’s 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 won’t make any money.

This gives an incredible head start in anticipating an improvement in earnings—and earnings, as you’ll see, make stock prices go higher.You’re 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. I’ve done it myself numerous times.

Edge as a consumer:

place it into one of six general categories:slow growersstalwartsfast growerscyclicalsasset playsand turnarounds.

THE SIX CATEGORIES

I try to stay away from the tragedies where the outcome is unmeasurable, suchas the Bhopal disaster at the Union Carbide plant in India. This was a terriblegas leak that resulted in thousands of deaths, and how much the families wouldget out of Union Carbide in damages was an open question

TURNAROUNDS

Growth companies that can’t stand prosperity foolishly diworseify and fall out of favor, which makes them into turnarouds McDonald’s 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.

HIGHFLIERS TO LOW RIDERS

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.

(1) IT SOUNDS DULL—OR, EVEN BETTER, RIDICULOUS

I get even more excited when a company with a boring name also does something boring. 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.

(2) IT DOES SOMETHING DULL

you’ve got a virtual monopoly, plus the added protection of the unpopularity of rock pits.The insiders call this the “aggregate” business, but even the exalted name doesn’t alter the fact that rocks, sand, and gravel are as close to inherently worthless as you can get. That’s 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 you’ve got a truck, you can take home and dump on your lawn.

The reverse of buying back shares is adding more shares, also called diluting.

Diluting of shares

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.

“Any idiot can run this business” is one characteristic of the perfect company,the kind of stock I dream about. You never find the perfect company, but if youcan imagine it, then you’ll know how to recognize favorable attributes,

Any idiot can run this business

Another stock I’d avoid is a stock in a company that’s been touted as the next.

BEWARE THE NEXT SOMETHING

efficient-market hypothesis(that everything in the stock market is “known” and prices are always “rational”)

Efficient-Market-Hypothesis(EMH)

If a company must acquire something, I’d prefer it to be a related business, but acquisitions in general make me nervous. 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.

I get calls all the time from people who recommend solid companies for Magellan, and then, usually after they’ve lowered their voices as if to confide something personal, they add: “There’s this great stock I want to tell you about. It’s too small for your fund, but you ought to look at it for your own account.It’s a fascinating idea, and it could be a big winer.”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.

BEWARE THE WHISPER STOCK

The company that sells 25 to 50 percent of its wares to a single customer is in a precarious situation. Short of cancellation, the big customer has incredible leverage in extracting price cuts and other concessions that will reduce the supplier’s profits. It’s rare that a great investment could result from such an arrangement.

BEWARE THE MIDDLEMAN

I could go on for the rest of the book about the edge that being in a businessgives the average stockpicker. On top of that, there’s the consumer’s edge that’shelpful in picking out the winners from the newer and smaller fast-growingcompanies, especially in the retail trades. Whichever edge applies, the excitingpart is that you can develop your own stock detection system outside the normalchannels of Wall Street, where you’ll always get the news late.

“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.”

Don't Gamble

invest in stocks not to preserve capital, but to make money. Then you take yourprofits and invest in more stocks, and make even more money.

Why to invest

<ul>
<li>Patience</li>
<li>Self-reliance</li>
<li>Common sense</li>
<li>A tolerance for pain</li>
<li>Open-mindedness</li>
<li>Detachment</li>
<li>Persistence</li>
<li>Humility</li>
<li>Flexibility</li>
<li>A willingness to</li>
<li>Do independent research, an equal willingness to admit to mistakes, and the</li>
<li>Ability to ignore general panic.</li>
</ul>

PERSONAL QUALITIES IT TAKES TO SUCCEED

The best place to begin looking for the tenbagger is close to homeCan’t think of any such opportunity in your own life? What if you’re retired, live ten miles from the nearest traffic light, grow your own food, and don’t 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

Stalking the Tenbagger

• Understand the nature of the companies you own and the specific reasons for holding the stock. (“It is really going up!” doesn’t count.)• By putting your stocks into categories you’ll 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

Here are some pointers from this section:

Book value gets a lot of attention these days—perhaps because it’s 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, they’re 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.

Book value

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.

Know what to own

There’s 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?

It’s too bad that Xerox didn’t have a name like David’s 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 “advanced,” “leading,” “micro,” or something with an x in it, or it’s a mystifying acronym, people will fall in love with it.

BEWARE THE STOCK WITH THE EXCITING
NAME

There’s 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 company’s 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.

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 you’ll be able to follow the script.

You’ll 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 (14–20). Some bargain hunters believe in buying any and all stocks with low p/e’s, but that strategy makes no sense to me.

There are five basic ways a company can increase earnings*: reduce costs; raiseprices; expand into new markets; sell more of its product in the old markets; orrevitalize, close, or otherwise dispose of a losing operation.

• 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 “dog and pony” show, telling anextremely 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 ofearnings growth are 15–20 percent for the next two years.• Same store sales are down 3 percent in the last quarter.• New store results are disappointing.

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 you’ll see another upswing. Cyclicals are the most misunderstood of all the types of stocks. The major cyclicals are large and well-known companies, they are naturally lumped together with the trusty stalwarts.

THE CYCLICALS

If you find a stock with little or no institutional ownership, you’ve found a potential winner.Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner.

(5) THE INSTITUTIONS DON’T OWN IT, AND THE ANALYSTS
DON’T FOLLOW IT

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 “sell,” you’ll find opportunities that you wouldn’t have thought you’d ever see again.

I’d 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. Eight months later that product is taken off the shelves to make room for the newest doll the children have to have—manufactured by somebody else.Why take chances on fickle purchases when there’s so much steady businessaround?

(10) PEOPLE HAVE TO KEEP BUYING IT

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

AVOID DIWORSEIFICATIONS

A cyclical is a company whose sales and profits rise and fall in regular if not completely predictable fashion. 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 profits’ rise and fall depends on the policies of various administrations.

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, I’d bet there aren’t three companies in history that have gone bankrupt near term. 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,

(11) IT’S A USER OF TECHNOLOGY

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.

WHEN TO SELL A FAST GROWER

What’s wrong with high expectations? If you expect to make 30 percent year after year, you’re 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. It’s only by sticking to a strategy through good years and bad that you’ll maximize your long-term gains.

If you are right, you can get your tenbaggers here, and if you are wrong, you can lose 80–90 percent.Meanwhile, additional tenbaggers are likely to come from fast growers or from turnarounds—both high-risk, high-gain categories.

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. 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.

Even the most thoughtful and steadfast investor is susceptible to the influence of skeptics who yell “Sell” before it’s time to sell. I ought to know. I’ve been talked out of a few tenbaggers myself.It’s 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 there’s a danger of being faked out, I try to review the reasons why I bought in the first place.

WHEN TO SELL

<ul><li> Two top executives and several key employees leave to join a rival firm.</li></ul>• The company recently returned from a “dog and pony” 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 15–20 percent for the next two years.

"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 “sensible investment alternatives.” If this is sensible investing, then the Titanic was a tight ship.

Options, Futures, and Shorts

• If you don’t 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 don’t have to “kiss all the girls.” I’ve missed my share of tenbaggers and it hasn’t kept me from beating the market.

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 they’re vertically integrated. They broke into the big-timewhen they buried Howard Hughes.

(7) THERE’S SOMETHING DEPRESSING ABOUT IT

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 aseller,” then you’ll never make a decent profit in stocks.

• 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 company’s tax-loss carryforward.• Institutional ownership has risen from 25 percent five years ago to 60 percent today—with several Boston fund groups being major purchasers.

WHEN TO SELL AN ASSET PLAY

• Don’t overestimate the skill and wisdom of professionals.• Take advantage of what you already know.• Look for opportunities that haven’t yet been discovered and certified by WallStreet—companies that are “off the radar scope.”• 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.

Lessons from section 1 :

Future earnings—there’s 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 you’d really like to know is what’s 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.

FUTURE EARNINGS

<ul><li> Find a story line to follow as a way of monitoring a company’s progress.</li><li>Look for companies that consistently buy back their own shares.</li><li>Study the dividend record of a company over the years and also how its earnings have fared in past recessions.</li><li>Look for companies with little or no institutional ownership.</li><li>Insider buying is a positive sign, especially when several individuals are buying at once.</li><li>Be patient. Watched stock never boils.</li><li>Buying stocks based on stated book value alone is dangerous and illusory. It’s real value that counts.</li></ul>

If it’s a cyclical company you’re thinking about, then your script revolves around business conditions inventories, and pricesIf it’s an asset play, then what are the assets, how much are they worth?Insiders are buying, and the company has steady earnings and there’s no debt to speak ofIf it’s a turnaround, then has the company gone about improving its fortunes, and is the plan working so far?If it’s 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.

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, “Any idiot could run this joint,” that’s a plus as far as I’m concerned, because sooner or later any idiot probably is going to be running it.

The story of the perfect stock

I’ve heard people say they’d be satisfied with a 25 or 30 percentannual return from the stock market! Satisfied? At that rate they’d soon own half the country along with the Japanese and the Bass brothers. Even the tycoons of the twenties couldn’t guarantee themselves 30 percent forever, and Wall Street was rigged in their favor.In certain years you’ll make your 30 percent, but there will be other years when you’ll only make 2 percent, or perhaps you’ll lose 20. That’s just part of the scheme of things, and you have to accept it.

Designing a Portfolio

After all that’s been said, I don’t want to sound like a market timer and tell you that there’s a certain best time to buy stocks. The best time to buy stocks will always be the day you’ve convinced yourself you’ve found solid merchandise at a good price—the 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.It’s no accident that the most severe drops have occurred between October and December.

The Best Time to Buy and Sell

Already you’ve found out whether you’re 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 “story.”

The Two-Minute Drill

These are the stocks that I frequently replace with others in the category. There’s 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 price—or 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/e’s of 11–12

WHEN TO SELL A STALWART

Companies don’t stay in the same category forever. Over my years of watching stocks I’ve 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 can’t 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.

(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. 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.

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 X’s is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the p/e ratio (Company X’s is 10). 12 plus 3 divided by 10 is 1.5. Less than a 1 is poor, and 1.5 is okay, but what you’re 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.

Growth-rate to PE ratio

• 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 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.

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.

THE P/E OF THE MARKET

There’s another unwritten rule here: The closer you get to a finished product, the less predictable the resale value.When you buy a stock for its book value, you have to have a detailed understanding of what those values really are.

﻿STOCKS IN GENERALfinancial strength• The cash position. With $16 in net cash, I know Ford is unlikely to dropbelow $16 a share. That’s the floor on the stock.

SLOW GROWERS• Since you buy these for the dividends (why else would you own them?) youwant to check to see if dividends have always been paid, and whether they areroutinely raised.• When possible, find out what percentage of the earnings are being paid outas dividends. If it’s a low percentage, then the company has a cushion in hardtimes. It can earn less money and still retain the dividend. If it’s a high percentage, then the dividend is riskier.

I can’t really help you with this one, because I don’t own many slow growers in the first place. The ones I do buy, I sell when there’s been a 30–50 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.

WHEN TO SELL A SLOW GROWER

<ul><li>All else being equal, favor companies in which management has a significant personal investment over companies run by people that benefit only from their salaries. </li><li>Devote at least an hour a week to investment research. Adding up your dividends and figuring out your gains and losses doesn’t count.</li><li>When in doubt, tune in later.</li><li>Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.</li></ul>

Find out how much cash is the company is sitting on formula= cash from opertions - Purchases of new plants,machinery etc - Long term debt  = Free cashNow just divide this cash by number of shares out standing and you will get Free cash per share. 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 rebateThe $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)

THE CASH POSITION

I prefer to invest in a low-growth industry like plastic knives and forks, but only if I can’t find a no-growth industry like funerals.That’s where the biggest winners are developed.In a no-growth industry, especially one that’s boring and upsets people, there’s no problem with competition. You don’t have to protect your flanks from potential rivals because nobody else is going to be interested.

(8) IT’S A NO-GROWTH INDUSTRY

• Sometime in the next month, year, or three years, the market will decline sharply.• Market declines are great opportunities to buy stocks in companies you like. Corrections—Wall Street’s definition of going down a lot—push outstanding companies to bargain prices.• Trying to predict the direction of the market over one year, or even two years, is impossible.• To come out ahead you don’t 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.

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

• Debt, which has declined for five straight quarters, just rose by $25 millionin the latest quarterly 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 percent of its output to one leading customer, and that leading customer is suffering from a slowdown in its own sales.

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 resources—such as land, timber, oil, or precious metals—carry those assets on their book at a fraction of the true value.Brand names such as Coca-Cola or Robitussin have tremendous value that isn’t reflected on the books. So do patented drugs, cable franchises, TV and radio stations—all are carried at original cost, then depreciated until they, too, disappear from the asset side of the balance sheet.

MORE HIDDEN ASSETS

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), you’ve 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).

GROWTH RATE

• 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 whether 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.

STALWARTS

An asset play is any company that’s 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 that’s understood, all you need is patience.

THE ASSET PLAYS

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.

It’s hard to think of a more perfect industry than waste management.If there’s anything that disturbs people more than animal casings, grease and dirty oil, it’s sewage and toxic waste dumps.

(6) THE RUMORS ABOUND: IT’S INVOLVED WITH TOXIC
WASTE AND/OR THE MAFIA

I’d much rather own a local rock pit than own Twentieth Century-Fox, because a movie company competes with other movie companies, and the rockpit 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 you’re in the jewelry business, you’re 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 you’ve got the only gravel pit in Brooklyn,

(9) IT’S GOT A NICHE

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.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 there’s only one reason that insiders buy: They think the stock price is undervalued and will eventually go up.

Timing is everything in cyclicals, and you have to be able to detect the earlysigns that business is falling off or picking up. If you work in some professionthat’s connected to steel, aluminum, airlines, automobiles, etc., then you’ve gotyour edge, and nowhere is it more important than in this kind of investment.

• Distrust diversifications, which usually turn out to be diworseifications.• Long shots almost never pay off.• It’s better to miss the first move in a stock and wait to see if a company’s 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.

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. (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

• Different categories of stocks have different risks and rewards.• You can make serious money by compounding a series of 20–30 percent gains in stalwarts.• Stock prices often move in opposite directions from the fundamentals but longterm, the direction and sustainability of profits will prevail.• Just because a company is doing poorly doesn’t mean it can’t do worse.• Just because the price goes up doesn’t mean you’re right.• Just because the price goes down doesn’t mean you’re wrong.

These are some lessons that peter lynch thought us in one up on wall street

THE NATIONAL BESTSELLING BOOK THAT EVERY INVESTOR SHOULD OWN Peter Lynch is America's number-one money manager. His mantra: Average investors can become experts in their own field and can pick winning stocks as effectively as Wall Street professionals by doing just a little research. Now, in a new introduction written specifically for this edition of One Up on Wall Street, Lynch gives his take on the incredible rise of Internet stocks, as well as a list of twenty winning companies of high-tech '90s. That many of these winners are low-tech supports his thesis that amateur investors can continue to reap exceptional rewards from mundane, easy-to-understand companies they encounter in their daily lives. Investment opportunities abound for the layperson, Lynch says. By simply observing business developments and taking notice of your immediate world -- from the mall to the workplace -- you can discover potentially successful companies before professional analysts do. This jump on the experts is what produces "tenbaggers," the stocks that appreciate tenfold or more and turn an average stock portfolio into a star performer. The former star manager of Fidelity's multibillion-dollar Magellan Fund, Lynch reveals how he achieved his spectacular record. Writing with John Rothchild, Lynch offers easy-to-follow directions for sorting out the long shots from the no shots by reviewing a company's financial statements and by identifying which numbers really count. He explains how to stalk tenbaggers and lays out the guidelines for investing in cyclical, turnaround, and fast-growing companies. Lynch promises that if you ignore the ups and downs of the market and the endless speculation about interest rates, in the long term (anywhere from five to fifteen years) your portfolio will reward you. This advice has proved to be timeless and has made One Up on Wall Street a number-one bestseller. And now this classic is as valuable in the new millennium as ever.

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