POINTS TO REMEMBER RISK/REWARD FOR ALL CLASSIFICATIONS
• These notes contain article and interview snippets and summarize 2 books written by High Return Avg. Return Low Return Peter Lynch, with John Rothchild: High Fast Growers Cyclicals o One Up On Wall Street: How to Use Risk 10-100x / 10x / What You Already Know to Make Money (80-100%) (80-100%) in the Market Turnarounds o Beating the Street 10x / • If you haven’t read the original books, read (80-100%) them first. Going through these notes Low Asset Plays Stalwarts Slow Growers without doing so won’t be as helpful since Risk 2-5x +50%/(20%) 0% you’ll lack the basic context in which the Cyclicals over 2 years underlying thoughts were penned. 10x / • In addition to the original thoughts, these (80-100%) notes contain certain takeaways, inputs & charts. Please reach out if you’ve further insights on any of those. High Return • Bear in mind that the source content was 10x published in the late 80’s and early 90’s. As Fast Growers such, some insights may seem dated. 5x & Turnarounds PORTFOLIO DESIGN AND MANAGEMENT • The beauty of Peter Lynch’s books is the fact 2x Asset that he laid bare his portfolio design and Plays Cyclicals management system. Despite the misconceived popular notion, this system is +50% a bit more elaborate than simply walking High Slow Growers around malls and investing in what you like. Low Risk • His portfolio management, the way I see it, Risk (20%) Stalwarts involved picking the right players for the right position, in a sports team. • It begins with splitting all available stocks (50%) into 6 categories, then hitting up the best companies from the categories he prefers, (100%) and avoiding the rest. Low Return • While a fantasy team could include 5 LeBron James, it isn’t necessary that this team would win. It would face disadvantages of LYNCH STOCK CLASSIFICATION SYSTEM size and speed in 3 out of those 5 different • First categorize a company by size. Large positions, and a loss might ensue. companies cannot be expected to grow as • He recognized that a portfolio can’t be one quickly as smaller companies. Big dimensional, and a trophy winning team companies have small moves, small must cover all bases, balancing great offense companies have big moves with solid defence. • Next, categorize a company by its “story” • There is also a distinct recognition of the type. If you can’t figure out what story categories he must avoid (Slow Growers and category a company is, then ask around. Asset Plays), so as to not get stuck in sub- • Categorizing stocks allows you to set the par performing companies. right expectations from an investment, guiding your future actions. PORTFOLIO ALLOCATIONS o Don’t hold onto a Stalwart after it’s 2x, • The portfolio design may change as you grow hoping for 10x. If you buy a great older. Younger investors, with a lifetime of Stalwart for a good price, you may forget earnings ahead of them can afford to take about it for 20 years, but you can’t do so more chances on 10x opportunities, vs older with a Cyclical. investors who may want to live off dividends. • The correct categorization also allows you to know the possible future trajectory of the company, providing an efficient checklist to Magellan Personal Investor gauge its performance. Min. Max. No. of % o Utility can’t beat Stalwart, if it’s not a % % Stocks Turnaround. No point in trading a Fast Slow Growers - - - - Grower as a Stalwart and selling for a Asset Plays - - - - 50% gain, vs, possible 10x. Stalwarts 10 20 2 20 • Assuming you’ve taken the first step of doing Cyclicals 10 20 - - proper research, spreading money among Fast Growers 30 40 4 40 several categories is another way to Turnarounds 50 20 4 40 minimize downside risk. TOTAL 100% 100% 10 stocks 100%
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The Peter Lynch Playbook 1) SLOW GROWERS • After 30-50% rise • When fundamentals deteriorate, even if price Traits has fallen: • Usually large and aging companies, whose o Lost market share for 2 Quarters and Growth rate = GNP Growth rate hires new advertising agency • When industries slow down, most companies o No new products/R&D, indicating that lose momentum as well the company is resting on its laurels • Easy to spot using stock charts o Diworseification (>2 recent unrelated • Pay large and regular dividends M&A’s), excess leverage leaves no room • Bladder theory of corporate finance: the for buybacks/dividend increase more cash that builds up in the treasury, o Dividend yield isn’t high enough, even at the greater the pressure to piss it away. a lower price Companies that don’t pay dividends, have a history of diworseification. 2) ASSET PLAYS • Stocks that pay dividends are favoured vs Traits stocks that don’t. Presence of dividend creates a floor price, keeping a stock from • Local edge is useful, since Wall Street falling away during market crashes. If ignores/overlooks valuable assets. investors are certain that the high dividend Examples yield will hold up, then they’ll buy for the • Railroads, TV stations, minerals, oil & gas, dividend. This is one reason to buy Slow timber, newspapers, real estate, depreciation Growers and Stalwarts, since people flock to on assets that appreciate over time, patents, blue chips during panic. cash, subsidiary valuations, foreign owner • If a Slow Grower stops dividend, you’re priced cheaper than local subsidiary, tax stuck with a sluggish company with little loss carry forwards, goodwill amortization, going for it. brands, holding company / conglomerate Examples discount, depreciated assets that don’t need maintenance capex but still produce FCF • GE, Alcoa, Utilities, Dow Chemical (rental equipment EPS = 0, but FCF =3) People Examples People Examples • Secure jobs + Low salary + Modest raises = • Never do wells, trust fund men, squires, bon Librarians, Teachers, Policemen vivants PE Ratio • Live off family fortunes but never labour – • Lowest levels, per PEG. Utilities = 7-9x issue is what will be left after payments for • Bargain hunting doesn’t make sense without travel, liquor, creditors etc. growth or other catalyst PB Ratio • During bull market optimism, PE may • If 2-5x is the expected return, then entry expand to Fast Growers’ PE of 14-20x point for P/NAV = 20-50% • Therefore, the only meaningful source of return = PE re-rating 2 Minute Drill • What are the assets and what’s their worth? 2 Minute Drill • Stock = $8, but video cassette division = $4 • Reasons for interest? and Real Estate = $7. That a bargain in itself • What must happen for the company to and the rest of the company = ($3). Insiders succeed? are buying and the company has steady • Pitfalls that stand in the path? earnings. There is no debt to speak of. • Dividend Play = “For the past 10 years the company has increased earnings, offers an Checklist attractive dividend yield, it’s never reduced/ • NAV? Any hidden assets? suspended dividend, & has in fact raised it • Debt – does leverage detract from asset during good and bad times, including the value? Is new debt being added? last 3 recessions. As a phone utility, new • Catalyst – how will value get unlocked? cellular division may aid growth.” Raider / activist? Checklist Portfolio Allocation % • Dividends: Check if always paid and raised. • 0% - NO Allocation • Low dividend payout ratio creates cushion, higher % is riskier. Risk/Reward • Low Risk – High Gain, IF you’re sure that Portfolio Allocation % NAV = 2-5x current price • 0% - NO Allocation, because without growth, • If wrong, you probably don’t lose much the earnings & price aren’t going to move. Hold Risk/Reward • If company isn’t going on a debt binge and • Low risk-Low gain, because Slow Growers reducing NAV aren’t expected to do much and are priced accordingly. Sell When • Catalyst occurs – without raider/catalyst, Sell When you may sit for ages
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The Peter Lynch Playbook • Management dilutes/diworseifies out many independent, regional distributors. • Institutional ownership rises to 60% from 25 Thus, it may do better than people think. • Instead of a subsidiary selling for $100, it sells for $60 - calculated NAV maybe inflated Checklist • Tax rate deduction reduces value of tax loss • Price = key issue, since these are big carry forwards companies that aren’t likely to go out of business 3) STALWARTS • Diworseification – capital misallocation may reduce future earnings. Board of Directors’ Traits is better off returning cash to shareholders. • Growth rate = 2x GNP growth rate • Long Term Growth Rate – has company kept • Growth Rates: Slow Growers (1x GNP) < up with growth rate momentum in recent Stalwarts (2x GNP) < Fast Growers (20-25%) years? Is it slowing/speeding? • Fairly large sized companies • Long Term Holding – how did it fare during • You can profit, based on time and price of previous recessions / market correction? purchase. Long term return will be = bonds • Good performers, but not stars – 50% return Portfolio Allocation % in 2 years is a delightful result. Sell more • 10-20% Allocation, in order to moderate readily than Fast Growers. risks in portfolio full of Fast Growers and • Good performers in good markets. Take 30- Turnarounds. 50% returns, and then rotate money into • Average 20% Allocation in a personal another Stalwart. investor’s 10 stock portfolio. • Operating performance of such defensives Risk/Reward helps them survive recessions. No down • Low Risk – Moderate Gain. quarter for 20-30 years. • 2 year hold may give 50% upside vs 20% • Offer good protection in hard times. Won’t go downside. bankrupt, soon enough they’ll be reassessed, and their value will be restored. • 6 rotations of 25-30% CAGR Stalwarts = 4- 5x, or 1 big winner. • Don’t hold after 2x, hoping for 10x. Can hold for 20 years only if you bought a “Great” Sell When company at a “Good” price. • Stalwarts with heavy institutional ownership • Can hardly go wrong by making a full and lots of Wall Street coverage, that have portfolio of companies that have raised outperformed the market and are overpriced, dividends for 10-20 years in a row. are due for a rest or decline. • Hidden assets like brands & patents grow • 10x not possible. If P>E, or, PE>Normal, sell larger, while the company punishes P&L and rotate. If Price gets ahead, but the story EPS via amortization, R&D, branding etc. is still the same, sell and rotate. EPS will jump when these expenses stop, or, • New products of last 2 years have mixed the new product hits the market. results & new testing products are >1 year o Due to these hidden assets and low from market launch maintenance capex, FCF > EPS. • PE = 15x, vs similar quality company from o Possible to cut costs, raise prices and same industry at 11-12x PE also capture market share in slow growth • No Executive/CXO/Director has bought markets. shares in last 1 year o If you can find a company that can raise • Large division (>25% of sales) is vulnerable prices without losing customers, you’ve to an ongoing economic slump (housing, oil) found a terrific investment. • Growth rate is slowing down and though Examples earnings have been maintained via cost • Pharma, Tobacco, FMCG, Alcohol cuts, there’s no further room left.
People Examples 4) TURNAROUNDS
• Command good salaries and get predictable Traits raises – mid level employees • No growth, potential fatalities – a poorly PE Ratio managed company is a candidate for trouble • Average = 10-14x. • Make up lost ground very quickly and • PEG <0.5-1x is fine, but 2x is expensive. performance isn’t related to market moves • Can’t compile a list of failed Turnarounds, 2 Minute Drill since their records get deleted after collapse • Key issues are PE, recent price run-ups, and • Turnaround types: what, if anything is happening to accentuate i) Bail Us Out Or Else: whole deal depends growth rate? on a government bailout. • Coke is selling at the low end of its PE range. ii) Who Would’ve Thought: can lose money Stock hasn’t gone anywhere for 2 years, even in utilities? though the company has improved in many iii) Unanticipated Problem: minor tragedy ways. Sold 50% of Columbia Pictures. Diet perceived to be worse, leading to major drinks have dramatically sped up growth opportunity. Be patient. Keep up with rate. Foreign sales are excellent. Has better news. Read it with dispassion. Stay away control over sales & distribution after buying from tragedies where the outcome is immeasurable.
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The Peter Lynch Playbook iv) Good Company Inside a Bad one: • If Slow Grower = Turnaround, then it’s possible bankruptcy spinoff. Look for performance maybe > Stalwart/Fast Grower institutional selling and insider buying. • Remind yourself of the Even Bigger Picture – Did the parent strengthen the company’s that stocks in good companies are worth balance sheet pre-spinoff? owning. What’s the worst that can happen? v) Restructuring: company diworseified Recession turns into depression? Then earlier, now the loss making business is interest rates will fall, competitors will falter being sold off, costs cut etc. etc. if things go right, how much can I earn? • How will earnings change? What’s the reward side of the equation? Take i) Lower costs the industry which is surrounded by the ii) Higher prices most doom and gloom. If the fundamentals iii) Expansion into new markets are positive, you’ll find some big winners. iv) Higher volume sold in old markets v) Changes in loss making operations Examples • Buy companies with superior financial • Auto (Ford Chrysler), paper, airlines condition. Young company + Heavy Debt = (Lockheed), steel, electronics, non-ferrous Higher Risk. Determine extent of leverage metals, real estate, oil & gas, retail, Penn and what kind is it? Long term funded debt Central, General Utilities, Con Edison, Toys is preferable to Short/Medium term callable R Us spinoff, Union Carbide, Goodyear. bank debt, which may trigger bankruptcy. • Record with troubled utilities is better than • Inventory growth > Sales growth = Red flag, troubled companies in general, because of & inventory growth is a bad sign. Depleting regulations. A utility may cancel dividends / inventory means things maybe turning declare bankruptcy, but if people depend on positive. High inventory build up overstates it, a way must be found to let it continue earnings - may mean that management is functioning. Regulation determines prices, deferring losses by not marking down the profits, passing on costs to customers. Since unsold items & getting rid of them quickly. the government has a vested interest in its • Asset/inventory values maybe inflated. Raw survival, the odds are overwhelming that it materials are liquidated better than finished will be allowed to overcome its problems. goods. Check for pension liabilities and • Troubled Utility Cycle: capitalized interest expense in asset values. i) Disaster Strikes: some huge cost (fuel) • Upswing favours Turnarounds > Normal can’t be passed along, or, because a huge companies. So look for low margin asset is mothballed & removed from the companies to succeed via operating leverage base rate. Stock drops 40-80% in 1-2 / high cost of production. years, horrifying people who view utilities • If the industry is robust in general and the as safe & stable investments. Soon, it company’s business doesn’t do well, then starts trading at 20-30% P/B. Wall Street one maybe pessimistic about its future. is worried about fatal damage – how long • If the entire industry is in a slump & due for it takes to reverse this impression varies. a rebound, & the company has strengthened 30% P/B implies bankruptcy, emergence its balance sheet and is close to the break- from which may take upto 4 years. even point, then it has the potential to do ii) Crisis Management: utility attempts to jumbo sales when the industry picks up. respond by cutting costs and capex. • Name changes may happen due to M&A or Dividend maybe decreased / eliminated. some fiasco that they hope will be forgotten. Begins to look as if the company will survive, but price doesn’t reflect the • Are Turnarounds obvious winners? In improved prospects. hindsight, yes, but a company doesn’t tell iii) Financial Stabilization: cost cuts have you to buy it. There’s always something to succeeded, allowing it to operate on worry about. There are always respected current revenues. Capital markets maybe investors who say that you’re wrong. You’ve unwilling to lend money for new projects to know the story better than they do and & it’s still not earning money for owners, have faith in what you know. but survival isn’t in doubt. Prices recover • For a stock to do better than expected, it has to 60-70% P/B, 2x from stage (i), (ii) to be widely underestimated. Otherwise, it’d iv) Recovery At Last: once again capable of sell for a higher price to begin with. When earning and Wall Street has reason to the prevailing opinion is more negative than expect improved earnings and the yours, you’ve to constantly check & re-check reinstatement of dividends. P/B = 1x. the facts, to assure yourself that you’re not How things progress from here depends being foolishly optimistic. The story keeps on, (a) reception from capital markets, changing for better or worse, and you’ve to because without capital, a utility cannot follow these changes and act accordingly. increase its base rates, and, (b) support • With Turnarounds, Wall Street will ignore from regulators’, ie, how many costs are changes. The Old company had made such a allowed to be passed on? powerful impression that people can’t see • One person’s distress is another man’s the New one. Even if you don’t see it right opportunity. You don’t need to rush into away, you can still profit more than enough. troubled utilities to make large profits. Can • Cyclicals with serious financial problems wait until the crisis has abated, doomsayers collapse into Turnarounds. Also, fast are proven wrong, and, still make 2-4x in growers that diworseify & fall out of favour. short term. Buy on the omission of dividend
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The Peter Lynch Playbook & wait for the good news. Or buy when the flourish more than Stalwarts. In the opposite first good news has arrived in stage (ii). direction, they can lose >50% very quickly • The problem that some people have is they and may take years before another upswing. think they’ve missed it if the stock falls to • Most misunderstood type, and investors can $4, then rebounds to $8. A troubled lose money in stocks considered safe. Large company has a long way to go and you’ve to Cyclicals are falsely classified as Stalwarts. forget that you’ve missed the bottom. • If a defensive Stalwart loses 50% in a slump, then Cyclicals may lose 80%. People Examples • It’s much easier to predict upswing, vs, a • Guttersnipes, drifters, down and outers, downturn, so one has to detect early signs of bankrupts, unemployed – if there’s energy business changes. You get a working edge if and enterprise left. you’re in the same industry – to be used to your advantage. Most important in Cyclicals. 2 Minute Drill • Unreliable dividend payers. If they’ve • Has the company gone about improving its financial problems, then they become fortunes and is the plan working? potential Turnaround candidates. • General Mills has made great progress on • Inventory build-up = bad sign. Inventory diworseification. Cut down from 11 to 2 growth > Sales growth = red flag. Inventory businesses that are key and the company build-up with companies having fluctuating does best. Others were sold at good price end product pricing causes larger problems. and the cash was used for buybacks. 1 key • Monitor inventory to figure out business business’ market share has improved from 7 direction. If inventory is depleting in a to 25% and is coming up with new products. depressed company, it’s the first evidence of Earnings are up sharply. a possible business turnaround. Checklist • High Operating Profit Margin (OPM) = Lowest • Plan – how will it turnaround? Sell loss Cost producer, who’s got a better chance of making subsidiaries? Cut costs? What’s the survival if business conditions deteriorate. impact of these actions? Is business coming • Upswing favours companies with Low back? New products? OPM’s. Therefore, what you want to do is to • Survival – can it survive a raid by short term Hold relatively High OPM companies for long creditors? Check cash/debt position, capital term and play relatively Low OPM companies structure, can it sustain more losses? for successful Turnarounds / cycle turns. • Bottom Fishing – if it’s bankrupt already, Normal Upswing then what’s left for owners? A B A B B Sales 100 100 110 110 110 Portfolio Allocation % Costs 88 98 92.4 105.84 102.9 • 20-50% Allocation, based on where greater PBT 12 2 17.6 4.16 7.1 value exists - Turnarounds or Fast Growers Δ PBT +47% +108% +255% Risk/Reward • High Risk – High Gain. • The best time to get involved with Cyclicals is when the economy is at its weakest, • Higher potential upside (10x) vs higher earnings are at their lowest, and public potential downside (100% loss). sentiment is at its bleakest. Even though Sell When Cyclicals have rebounded in the same way 8 • After Turnaround is complete, trouble is times since WWII, buying them in the early over, everyone is aware of changed situation, stages of an economic recovery is never easy. & the company is re-classified as a Cyclical/ • Every recession brings out sceptics who Fast/Slow Grower etc. Stockholders aren’t doubt that we will ever come out of it, who embarrassed to own the shares anymore. predict a depression and the country going • Stock is judged to be a 2x, but not 5-10x bankrupt. If there’s any time not to own • PE is inflated vs Earnings prospects, sell and Cyclicals, it’s in a depression. “This one is rotate into juicier Turnaround opportunities, different,” is the doomsayer’s litany, and, in where Fundamentals are better than Price. fact, every recession is different, but that • Debt, which has declined for 5 consecutive doesn’t mean it’s going to ruin us. quarters, rises again. Indicates increased • Whenever there was a recession, Lynch paid chances of relapse. attention to them. Since he always thought • Inventory rise > 2x Sales increase. positively and assumed that the economy will improve, he was willing to invest in • >50% sales of the company’s strongest Cyclicals at their nadir. Just when it seems division’ come from some customer whose it can’t get any worse, things begin to get sales are slowing down. better. A comeback of depressed Cyclicals 5) CYCLICALS with strong balance sheets is inevitable. • Cyclicals lead the market higher at the end Traits of a recession – how frequently today’s • Sales and profits rise and fall in regular, if mountains turn into tomorrow’s molehills, not completely regular fashion, as business and, vice versa. expands and contracts. • Cyclicals are like blackjack: stay in the game • Timing is everything. Coming out of a too long and it’s bound to take back all your recession into a vigorous economy, they profits. Things can go from good to worse
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The Peter Lynch Playbook very quickly and it’s important to get out at But if you follow the trend, you’d know the right time. the pent up demand was 7mm, which • As business goes from lousy to mediocre, wasn’t exhausted until 1988, which was investors in Cyclicals can make money; as it the year to sell your auto stocks, since goes from mediocre to good, they can make pent up demand from early 80’s got used money; from good to excellent, they may up. Even though 1989 was a good year, make a little more money, though not as units sold fell by 1mm. much as before. It’s when business goes o If industry had 5 good years, it means from excellent back to good that investors it’s somewhere in the middle of the cycle. begin to lose; from good to mediocre, they Can predict upturn, not downturn. lose more; and from mediocre to lousy, o Chrysler EPS for 1988, ’89, ’90 & ’91 they’re back where they started. was $4.7, $11.0, $0.3 & Loss, • So, you have to know where we are in the respectively. When your best case is cycle. But it’s not quite as simple as it worse than everyone’s worst case, worry sounds. Investing in Cyclicals has become a that the stock is floating on fantasy. game of anticipation, making it doubly hard • At one point, high yield Utilities were 10% of to make money. Large institutions try to get Magellan’s AUM. This usually happened a jump on competitors by buying Cyclicals when interest rates were declining and the before they’ve shown any signs of recovery. economy was in a splutter. Therefore, treat This can lead to false starts, when stock Utilities as interest rate Cyclicals and time prices run up and then fall back with each entry and exit accordingly. Can also treat contradictory statistic (we’re recovering, Fannie / NBFC’s as interest rate Cyclicals we’re not recovering) that is released. benefitting from rate cuts. • The principal danger is that you buy too • In the Gold Rush, people selling picks and early, then get discouraged, and, sell. To shovels did better than the miners. During succeed, you’ve to have some way of periods when mutual funds are popular, tracking the fundamentals of the industry investing in the fund companies is more and the company. It’s perilous to invest rewarding than putting money into their without the working knowledge of the funds. When interest rates are falling, bond industry and its rhythms. & equity funds attract most cash. Money • Timing the cycle is only half the battle. market funds prosper when rates rise. Other half is picking companies that will • In US /Europe insurance companies, the gain Most from an upturn. If Industry pick = rates go up months before earnings show Right, but Company pick = Wrong, then you any improvement. If you buy when the rates can lose money just as easily as if you were first begin to rise, you can make a lot of wrong about the industry. money. It’s not uncommon for a stock to • If investing in a troubled industry, buy become 2x after a rate increase and another companies with staying power. Also, wait for 2x on the higher earnings that result from a signs of revival. Some troubled industries rate increase. never came back. • If you sell at 2x, you won’t get 10x. If the People Examples original story is intact or improving, stick • Make all their money in short bursts, then around to see what happens and you’ll be try to budget it through long, unprofitable amazed at the results. stretches. Farmers, resort employees, camp operators, writers, actors. Some may also Examples become Fast Growers. • Auto, airlines, steel, tyres, chemicals, aerospace & defence, non-ferrous metals, PE Ratio nursing, lodging, oil & gas • Slow Growers (7-9x) < Cyclicals (7-20x) < • Autos: 3-4 up years, after 3-4 down years. Fast Growers (14-20x) Worse Slump = Better Recovery. An extra • Assigning PE’s: Peak EPS (3-4x) < Decent bad year brings longer and more sustainable EPS (5-8x) < Average EPS (8-10x) upside. People will eventually replace their • Stock Pattern: 1990 EPS = $6.5, Price Range cars, even if put off for 1-2 years. = $23 - $36, PE Range = 3.6-5.5x. 1991 EPS o Units of pent up demand – compare = $3.9, Price drops to $26. PE = 6.7x, higher Actual Sales vs Trend, ie, estimate of than previous year PE, that had higher EPS. how many units should’ve been sold • With most stocks, a Low PE is regarded as a based on demographics, previous year good thing, but not with Cyclicals. When sales, age of cars on road etc. Low, it’s usually a sign that they are at the o 1980-83 = sluggish economy + people end of a prosperous interlude. saving up, therefore pent up demand = • Unwary investors hold onto their shares 7mm. 1984-89 boom, sales exceeded since business is still good & the company trendline by 7.8mm. continues to show higher earnings, but this o After 4-5 years below trend, it takes will change soon. Smart investors sell their another 4-5 years above trend, before shares early to avoid the rush. the car market can catch upto itself. If • When a large crowd begins to sell, the Price you didn’t know this, you might sell your and PE drops, making a Cyclical more auto stocks too soon. After 1983, sales attractive to the uninitiated. This can be an increased from 5mm to 12.3mm and you expensive misconception. Soon, the economy might sell fearing the boom was over. will falter and earnings will decline at a
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The Peter Lynch Playbook breathtaking speed. As more investors head • Sell when something has actually gone for the exit, price will plummet. Buying wrong. Rising costs, 100% utilization but Cyclicals after years of record earnings and spending on capacity expansion, labour asks when PE has hit a low point is a proven for increased wages, which were cut in the method to lose ~50% in a short time. previous bust etc. • Conversely, a High PE may be good news for • Final product demand slows down. a Cyclical. Often, it means that a company is Inventory builds up and the company can’t passing through the worst of the doldrums get rid of it. If storage is full of finished and soon its business will improve, earnings goods, you may already be late in selling. will exceed expectations, and investors will • Falling commodity prices, Futures < Spot start buying the stock. Price. Oil, steel prices turn lower much earlier than EPS impact. 2 Minute Drill • Strong competition for market share leads to • Script revolves around business conditions, price cuts. Company tries cost cuts but can’t inventories and prices. compete against cheap imports. • There’s been a 3 year slump in autos but this year things have turned around. I know 6) FAST GROWERS that because car sales are up across the board for the first time in recent memory. Traits GM’s new models are selling well and in the • Small, aggressive new companies. Growing last 18 months GM closed down 5 inefficient at 20-25%. plants, cut 20% labour and earnings are • Land of the 10-40x, even 200x. 1-2 such about to turn higher. companies can make a career. • Lousy Industry Checklist o May not belong to fast growing industry. • Inventories: keep a close eye on inventory Can expand in the room in a slow growth levels, changes, and, the supply & demand industry by taking market share. relationship. o Depressed industries are likely places to • Competition: new entrants / added supply = find potential bargains. If business dangerous development, because they may improves from lousy to mediocre, you are cut prices to capture market share. rewarded, rewarded again when mediocre • Know your Cyclical: if you do, then you have turns to good, and good to excellent. an advantage in figuring things out and o Moderately fast growers (20-25%) in slow timing the cycles. growth industries are ideal investments. • Balance Sheet: strong enough to survive the Look for companies with niches that can next downturn? Can it outlast competitors? capture market share without price Is capex on upgradation / expansion a cause competition. In business, competition is for concern? How much of a drag is it on never as healthy as total domination. FCF? Is CF > Capex, even in bad years? Are o Growth ≠ Expansion, leading people to plant & machinery in good shape? overlook great companies like Phillip Morris. Industry wide cigarette Portfolio Allocation % consumption may decline, but company • 10-20% Allocation can increase earnings by cost cuts and price increases. Earnings growth is the Risk/Reward only growth that really counts. If costs • Low Risk – High Gain; or rise 4%, but prices rise 6%, and profit High Risk – Low Gain, depending on margin is 10%, then extra 2% price rise investor adeptness at anticipating cycles. = 20% increase in earnings. • +10x / (80-90% loss) o Greatest companies in lousy industries • Get out of situations where Price overtakes share certain characteristics: Fundamentals and rotate into Fundamentals i) low cost operators / penny pinchers > Price in the executive suite ii) avoid leverage Sell When iii) reject corporate hierarchies • Understand strange rules to play game iv) workers are well paid and have a successfully, because Cyclicals are tricky. stake in the company’s future Sell towards the end of the cycle, but who v) they find niches, parts of the market knows when that is? Who even knows what that bigger companies overlook. Zero cycles they’re talking about? Sometimes, the Growth Industry = Zero Competition. knowledgeable vanguard sells 1 year before • Hot Industry any signs of decline, so price falls for no o Hot Stocks + Hot Industry = Greater apparent reason. Competition. Companies can thrive only • Whatever inspired you to buy after the last due to niche/moat/patents etc. bust, will help clue you in that the latest o Growth ≠ Expansion. In low growth boom is over. If you’d enough of an edge to industries, companies expand by buy in the first place, then you’ll notice capturing market share, cutting costs changes in business and price. and raising prices. When an industry • Company spends on new technological gets too popular, nobody makes money expansion, instead of cheaper expenditures there anymore. on modernizing old plants.
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The Peter Lynch Playbook • Life Phases of a Fast Grower: each may last o Companies may fall into 2 categories at several years. Keep checking earnings, the same time, or, pass through all growth, stores to check aura of prosperity. categories over time (Disney). Ask, what will keep earnings going? • During 1949-1995, an investment in the 50 i) Startup phase: companies work out growth stocks on Safian’s Growth Index kinks in the basic business. Riskiest returned 230x, while the Safian Cyclical phase for the investor because success is Index only returned 19x. not yet established. • Growth companies were the star performers ii) Rapid Expansion: company enters new during and after 2 corrections (1981-82 and markets. Safest phase for investor where 1987), and they held their own in the 1990 most amount of money is made, because Saddam selloff. The only time you wished growth is merely an act of duplication you didn’t own them was 197374, when across markets. Company reinvests all growth stocks were grossly overpriced. FCF into expansion. No dividends help faster expansion. IPO helps in expanding Buying and Holding Tips without bank debt / leverage. • Fast Grower => 2x GNP growth rate. iii) Maturity / Saturation: company faces the Sustaining 30% growth rate is very difficult, fact that there’s no easy way to continue even for 3 years. 20-25% growth rate is more expansion. Most problematic phase sustainable (investing sweet spot). because company runs into its own • Best place to find a 10x stock is close to limitations. Other ways must be found to home – if not the backyard, then in the increase earnings, possibly only, via kitchen, mall, workplace etc. You’ll find a luring customers away from competitors. likely prospect ~2/3 times a year. The If M&A / diworseification follows, then person with the edge is always in a position you know management is confused. to outguess the person without an edge. • Find out growth plans and check if plan is • Long shots almost never pay off. Better to working? miss the 1st stock move (during phase I), or i) Cost cuts – the proof is in decrease of even the late stage of phase I, when the selling and administrative costs. company’s only reached 5-10% of market ii) Raise prices saturation, and wait to see if it’s plans are iii) Entry into new markets working. If you wait, you may never need to iv) Sell more volume in existing markets buy, since failure would’ve become visible. v) Exit loss making operations • Does the idea work elsewhere? Must prove • What continues to triumph, vs, flop, is: that cloning works in other markets, and i) Capable management show its ability to survive early mistakes, ii) Adequate financing limited capital, find required skilled labour. iii) Methodical approach to expansion – slow • The most fascinating part of long term, Fast but steady wins this kind of race. Growers is how much time you have to catch o When a company tries to open >100 them. Even a decade later and with stock stores/year, it’s likely to run into already up 20x, it’s not too late to capitalize problems. In its rush to glory, it can on an idea that has still not run its course. pick the wrong sites or managers, pay • Emerging growth stocks are much more too much for real estate, and, fail to volatile than larger companies, dropping and properly train employees. It is easier soaring like sparrow hawks around the to add 35-40 stores / year. stable flight of buzzards. After small caps • Re-classification away from Fast Grower have taken one of these extended dives, they o A large fast growth company faces eventually catch upto the buzzards. devaluation risk, since growth may slow • Small Company Index PE / S&P 500 PE: down as it runs out of space for further Since small companies are expected to grow expansion. faster than larger ones, they’re expected to o Inability to maintain double digit growth sell at higher PE’s, theoretically. In practice, may see a re-classification into a Slow this isn’t always the case. During periods Grower, Cyclical or Stalwart. High fliers when Emerging Growth is unpopular with of one decade are groundhogs of the next. investors, these small caps get so cheap that o Fast Growers like hotels/retail having their PE = S&P 500 PE. When wildly popular prime real estate turn into Asset Plays. and bid up to unreasonably high levels, it is o There’s high risk, especially in younger = 2x S&P 500 PE. companies that are overzealous and • In such cases, small caps may get clobbered underfunded. The headache of for several years afterward. Best time to buy underfinancing may lead to bankruptcy. is when Small PE / Large PE < 1.2x. To reap o Fast Grower’s that can’t stand prosperity, the reward from this strategy, you’ve to be diworseify, fall out of favour, and, turn patient. The rallies in small cap stocks can into Turnaround candidates. take a couple of years to gather storm and o Every Fast Grower turns into a Slow then several more years to develop. Grower, fooling many people. People have • A similar pattern applies to the Growth vs a tendency to think that things won’t Value pots. Be patient. Watched stock never change, but eventually they do, boils. When in doubt, tune in later. o Very few companies switch from being a • Look for a good balance sheet and large Slow Grower to a Fast Grower. profits. Trick is in figuring out when the growth stops and how much to pay for it?
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The Peter Lynch Playbook • Recent price run-ups shouldn’t matter, so o The important issue to analyze was long as PEG still makes it attractive. not whether the Wal-Mart stock • If PEG =1x, then 20% growth @ 20x PE is > would punish its holders, but 10% growth @ 10x PE. Higher compounded whether the company had saturated earnings will compensate even for PE the market. The answer was No. multiple shrinkage. Wal-Mart’s reach was only 15% of • High PE leaves little room for error. Best way USA. Over the next 11 years, the to handle a situation where you love the stock went up another 50x. company but not the price (great company, high growth, but high PE), is to make a Sell When small commitment and then increase it in • Hold as long as earnings are growing, the next selloff. One can never predict how expansion continues and no impediments far the price may fall. Even if you buy after a arise. Check the story every few months as if setback, be prepared for further declines you’re hearing it for the very first time. when you might consider buying even more • If a Fast Grower rises 50% and the story shares. If the story is still good, after review, starts sounding dubious, sell and rotate into then you’re happy that the price fell. another, where the current price is <= your • So, the important issue is why has the stock purchase price, but the story sounds better. fallen so much? If the long term story is still • Main thing to watch is the end of phase II of intact and the growth will continue for a rapid expansion. Company has no new long time, then buy more. If you can place stores, old stores are shabby, and the stock the company in its attractive, mid-life phase, is out of fashion. ex. 2nd decade of 30 years of growth, then • Wall Street covers the stock widely, you shouldn’t mind paying 20x PE for a 20- institutions hold 60%, and 3 national 25% growth rate, especially if market PE = magazines fawn over the CEO. 18-20x with an 8-10% growth rate. • Large companies with 50x PE!? Even at 40x, • If you sell at 2x, you won’t get 10x. As long and with wide, saturated presence, where as same store sales are rising, company isn’t will the large company grow? crippled with excess debt, and is following • Last quarter same-store sales are down 3%, its stated expansion plans, stick around. If new store sales are disappointing, and the the original story stays intact, you’ll be company is telling positive stories, vs, amazed at the results in several years. showing positive results. • Trick is to not lose a potential 10x, but know • Top executives / employees leave to join a that, if earnings shrink, then so will the PE rival. that’s been bid up high – double whammy. • PE = 30x, but next 2 years’ growth rate = • It’s harder to stick with a winning stock after 15%. Therefore, PEG = 2x (very negative) price increases, vs, continuing to believe in a company after price falls. If you’re in danger Examples of being faked out into selling, revisit the • Annheuser Busch, Marriott, Taco Bell, reasons / story, as to why you bought it in Walmart, Gap, AMD, Texas Instruments, the first place. There are 2 ways investors Holiday Inn, carpets, plastics, retail, can fake themselves out of the big returns calculators, disk drives, health maintenance, that come from great growth companies. computers, restaurants i) Waiting to buy the stock when it looks • While it’s possible to make 2-5x in Cyclicals cheap: Throughout its 27-year rise from and Undervalued situations (if all goes well), a split-adjusted 1.6 cents to $23, Wal- payoffs in Fast Growers like restaurants and Mart never looked cheap compared to retailers are bigger. Restaurants/retailers the market. Its PE rarely dropped <20x, can expand across the country and keep up but earnings were growing at 25-30% the growth rate at 20% for 10-15 years. Any business that keeps up a 20-25% • Not only do they grow as fast as high tech growth rate for 20 years rewards its companies, but unlike an electronics or shoe owners with a massive return even if the company, restaurants are protected from overall market is lower after 20 years. competition. Competition is slower to arrive ii) Underestimating how long a great and you can see it coming. A restaurant growth company can keep up the pace. chain takes a long time to work its way These "nowhere to grow" theories come across the country and no foreign company up often & should be viewed sceptically. can service local customers. o Don't believe them until you check • Taste homogeneity helps scale in food, for yourself. Look carefully at where drinks, entertainment, makeup, fashion etc. the company does business and at Popularity in 1 mall = popularity in another. how much growing room is left. Certain brands prosper at else’s expense. Whether or not it has growing room • Ways to increase earnings (restaurants): may have nothing to do with its age. i) Add more locations o Wal-Mart IPO’d in 1970. By 1980 = ii) Improve existing operations stock 20x, with 7x number of stores. iii) High turnover with low priced meals Was it time to sell, not be greedy, & iv) High priced meals with lower turnover put money elsewhere? Stocks don’t v) High OPM because of food made with care who owns it and questions of cheaper ingredients, or, due to low greed are best resolved in church, operating costs not in brokerage accounts.
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The Peter Lynch Playbook • To break even, a restaurants’ sales must = • Runway – does it still have room to grow? Capital Employed. Restaurant group as a • PE – is it high or low, vs, growth rate? whole may only grow slowly at 4%, but as • Δ Growth rate – is expansion speeding up or long as Americans eat >50% of their meals slowing down? For companies doing sales out of home, there’ll be new 20x stocks. via large, single deals, vs, selling high volume & low ticket items, growth slowdown People Examples can be devastating because doing more • Higher failure rate than Stalwarts, but if and volume at bigger ticket sizes is difficult. when one succeeds, it may boost income 10- When growth slows, stock drops 20-100x. dramatically. • Actors, real estate developers, musicians, • Institutional ownership / Analyst coverage – small businessmen, athletes, criminals no presence is a positive, as growth expectations are still not captured in the PE Ratio Price or PE. • Highest for Fast Growers at 14-20x. Company with a High PE must have Portfolio Allocation % incredible growth (for next 2 years) to justify • 30-40% Allocation in Magellan. Magellan’s its price. It’s a miracle for even a small allocation to Fast Growers was never >50%. company to justify a 50x PE, as may so • 40% in Personal investor’s 10 stock portfolio happen during a bull market. • If looking for 10x stocks, likelihood increases • 1 year forward PE of 40x = dangerously high as you hold more stocks. Among several, the and in most cases extravagant. Even fastest one that actually goes the farthest maybe a growing companies can rarely achieve 25% surprise. The story may start at a certain growth, and 40% is a rarity. Such frenetic point, with specific expectations, and get growth isn’t sustainable for long & growing progressively better. There’s no way to too fast tends to lead to self destruction. anticipate pleasant surprises. • 40x PE @ 30% growth isn’t attractive, but • More stocks provide greater flexibility for not bad if S&P 500 = 23x PE & Coke PEG = fund rotation. If something happens to a 2x (PE = 30x @ 15% growth). secondary company, it may get promoted to • Unlike Cyclical where the PE contracts near being a primary selection. the end of the cycle, Fast grower’s PE gets bigger and may reach absurd, illogical levels. Risk/Reward • Earnings are not constant and PE of 40x vs • High Risk – High Gain. Higher potential 3x shows investor willingness to gamble on upside = Greater potential downside. higher earnings, vs, scepticism about the • +10x / (-100%) cheaply priced company’s future. • Major bankruptcy risk for small fast grower’s via underfinanced, overzealous expansion PEG • Major rapid devaluation risk for large fast 0.5x 1x 2x growers once growth falters, because there’s no room left for future expansion Very Fair Very Positive Negative DESIGNING A PORTFOLIO • Determine Stock : Bond Mix based on Growth : Income wants. Most people err on (Growth + Dividend Yield) / PE the side of income and short change growth. o Can hardly go wrong by making a full <1x 1.5x >2x 3x portfolio of companies that have raised Poor Fair Want Fabulous dividends for 10-20 years in a row. o Stock allocation % depends on how much you can afford to invest in stocks, 2 Minute Drill and how quickly you’re going to need to • Where and how can the company continue spend this money. Increase the stock % to grow fast? to the limits of your tolerance. • La Quinta Motels started in Texas. Company o In 50/50 portfolio, combined return = successfully duplicated its formula in 4.5% (1.5% dividend + 7.5% 10 year Arkansas & Louisiana. Last year it added bonds). Historically, stocks return 10% = 28% more units. Earnings have increased 8% growth + 2% dividend yield. So every quarter. Plans rapid future expansion portfolio growth in 50/50 mix = 4%, & debt isn’t excessive. Motels are low growth (8+0)/2, which is < Inflation. industry and very competitive but La Quinta o It's incorrect to state that you can’t has found something of a niche. Long way to afford the loss in fixed income, because go before it saturates the market. over the long term, growth more than Checklist makes up for any losses. But fear factor comes into play. • Percentage of sales – is a new fast growing o The person who uses stocks as a product a large % of sales? substitute for bonds not only must ride • Recent growth rate – favour 20-25% growth out the periodic corrections, but also rates. Be wary if growth is > 25%. Hot must be prepared to sell shares, industries show growth >50%. sometimes at depressed prices, to meet • Proof – has company duplicated its success living expenses. in >1 city, for planned expansion to work?
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The Peter Lynch Playbook o This is especially difficult in the early o When any fund does poorly, the natural stages, when a market setback could temptation is to switch to a better fund. cause portfolio to drop below purchase People, who switch, tend to lose patience price. Such worries of wiping out the at precisely the wrong time, jumping capital keeps people in bonds, even from a value fund to a growth fund, just when they’re aware of the long term as value is starting to wax and growth is wisdom of investing in stocks. starting to wane. o Assume that the day you go 100% into o In fact, when a value fund does better stocks, the market corrects 25%. You’d than its rivals in a bad year for value still equal bond returns, even if you style, it’s not necessarily a cause for imagine the most prolonged disaster in celebration. It maybe so, that the modern finance – a 20 year severe manager has used other styles to recession, when earnings and dividends outperform in the short term, but such only grow at 4% instead of 8%. benefits will be fleeting. When value • Bonds vs Bond Funds returns, he won’t be fully invested in it. o 30 year T-bond is safe only if you get 30 o Picking a Winner years of low inflation. If inflation is ▪ Don’t spend a lot of time over a >10%, then the bonds will lose 20-30% fund’s past performance. Not to say of their value. you shouldn’t pick a fund with a o Bonds are safer to buy in funds, only if good long term record, but it’s better they’re corporate / junk bonds, where to stick with a steady and consistent diversification limits default risk. performer, vs, a fund whose • Stocks vs Stock Funds performance moves in and out of o The only way to benefit from funds is to best / worst performing lists. keep owning it, just like owning a stock. ▪ Check bear market performance. This requires a strong will. For people Some funds lose more, but regain who can be scared out of stocks, fund more on rebound; some lose less & investments don’t solve the problem. gain less; while some lose more & o Buffett’s admonition that people who gain less. Avoid the third group. can’t tolerate seeing their stocks lose ▪ Forbes grades funds A-F, based on 50% of their value shouldn’t own stocks, its performance in 2 preceding bear also applies to funds. and bull markets. Funds that fare o During a correction, it’s a common A/B in both situations get into the occurrence for the best performing funds honour roll. to decline > the average stock. To o Sector Funds: not recommended, unless benefit, you’ve to stay invested. you’ve special industry knowledge. o Distribute equity portfolio by buying o Convertible Funds: underrated way to several funds of varying styles and enjoy the best of both worlds – high philosophies. Markets and conditions performance of secondary and small cap change, and one style of manager or stocks + stability of bonds. Customarily, fund won’t succeed in all seasons. the conversion price is 20-25% higher i) Capital Appreciation: can buy all than the market price. Investors are types of stocks and isn’t forced to better off investing via funds, rather adhere to any particular philosophy. than directly. Buy convertible funds ii) Value: Assets, not earnings, are the when the spread between convertible main attraction. and corporate bonds is narrow (1.5-2%), iii) Quality Growth: Mid-Large cap and sell when it widens. companies that are well established, o Closed End Funds: trade on exchanges, expanding at a respectable and ∴ fluctuate like stocks – selling at a steady rate, increasing earnings at discount / premium to NAV. Look for >15%. This cuts out cyclicals, slow opportunities during market sell offs. growing blue chips and utilities. o Country Funds: to succeed, you’ve to iv) Emerging Growth: small caps have patience and a contrarian bent. v) Special Situations: companies have They arouse a desire for instant nothing in common, except that gratification. The best time to buy a something unique has occurred to closed end country fund is when it’s change their prospects. unpopular and trading at a 20-25% o Anyone can create a stock portfolio by discount to NAV. Drawbacks include, a) picking 1 fund from each of the above, higher fees and expenses, b) not just and adding 1 more fund that invests in companies, currency must remain utilities / equity income fund, as a strong as well, and, c) government ballast for stormy markets. mustn’t ruin the party with extra taxes o Can also add 2 index funds, 1 each for or regulations that hurt business. S&P 500 (covers quality growth) and Check, a) whether the fund manager has Russell 2000 (covers emerging growth). worked there, knows people in o Divide money equally between funds and companies and can follow their stories?, also deploy new money equally. The b) is information disclosure proper, or sophisticated way to do it is to adjust sketchy and misleading? the weight of the funds, putting Only the • How Many Stocks Is Too Many? new money into sectors that’ve lagged.
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The Peter Lynch Playbook o Best to own as many stocks as there are back on once you’ve sold a stock that’s situations in which: gotten ahead of itself. ▪ You have an edge, and, o Magellan owned 1400 stocks, of which, ▪ You’ve uncovered an exciting 50% of AUM was in the top 100 stocks, prospect that passes all your tests. 2/3rd in top 200 and 1% spread over 500 o It could be 1 stock or a dozen, there’s no secondary stocks that were monitored use of diversifying into unknown periodically, with the possibility of companies just for the sake of diversity. tuning in later. If something happened to o However, it isn’t safe to own a single a secondary stock to bolster confidence, stock, because despite your best efforts, it got promoted to a primary selection. the one you choose maybe a victim of unforeseen circumstances. STOCK PICKING o In small portfolios. One can be Favourable Company Attributes comfortable holding 3-10 stocks. There i) Sounds Dull, or Ridiculous – simple are several possible benefits: business with a boring name. More boring, ▪ The more stocks you own, the more the better. No analyst’s recommend such likely that one of them will 10x. names. ▪ More stocks provide greater ii) Does Something Dull – boring name + boring flexibility to rotate funds between business = keeps Wall street away. them. This was an important part of iii) Does Something Disagreeable – better than Lynch’s strategy. Some people boring = boring + disagreeable. Makes people ascribe his success to having shrug/retch in disgust. specialized in growth stocks, but iv) It’s a Spinoff – have strong balance sheets that’s only partly accurate. He never and well prepared to succeed. put >30-40% into growth stocks. o Spinoffs are misunderstood and get little o Small investors can follow the Rule of 5 attention. and limit portfolio to 5 stocks. If just 1 o New management can cut costs and take becomes 10x, and other 4 go nowhere, creative measures to improve earnings. the portfolio becomes 3x. Look for insider buying after 1-2 months. o You can have a paper portfolio, with 10- o Spinoff shares are dismissed by 15 stocks that you actively research, and institutions as pocket change. own 5 or 6 that you judge to be o Spin off reports are hastily prepared and attractive. This will be great practice, are more boring than annual reports. and you’ll learn what your strengths and o Fertile area for amateurs, especially weaknesses are, and in what areas of during an M&A frenzy. the economy you’ve better skills. v) Institutions Don’t Own it and Analysts Don’t o The practice of buy, sell & forget, in a Follow It – might frequently happen in long string of companies isn’t likely to sectors having many companies. Be equally succeed. Investors want to put their old enthusiastic about once popular stocks that stocks out of their minds, because it are now abandoned. invokes a painful memory. With a stock vi) Rumours Abound – it’s involved with toxic you once owned, especially if it went up waste or the mafia. Such rumours repel after selling, it’s human nature to avoid respected investors. looking at its quote. You must train vii) Something Depressing About It – ex. burial yourself to overcome this phobia. Think company of investments not as discontinued viii) It’s a No Growth Industry – nothing thrilling events, but as continuing sagas, which about a high growth industry, except seeing need to be rechecked from time to time. the stocks go down. For every single product Unless a company goes bankrupt, the in a high growth industry, there are many story is never over. To keep up with old others trying to make it better and cheaper. favourites, keep a large notebook in o This doesn’t happen in a slow growth which you record important details from industry, where the biggest winners are company reports & reasons why you created, since there’s no competition. decided to buy/hold the last time. ix) It’s Got a Niche – exclusive franchise, o Don’t pick a new and different company, newspaper, cable, brands, rock pits, otherwise, you’ll end up with too many pharma/chemical patents. stocks and you won’t remember why you x) People Have to Keep Buying It – Steady bought them. Getting involved with a business is better than fickle purchases. manageable number of companies and Drugs/soft drinks/razors/cigarettes > Toys. confining your buy/sell to these is not a xi) It’s a User of Technology – ADP benefits from bad strategy. Inevitably, some gloomy computer price war, vs, Dell. Retailer scenario will cause a general retreat in benefits from scanner usage, vs, buying the stock market, your old favourites will scanner companies. once again become bargains and you xii) Insiders are Buyers – when management can add to your investment. owns stock, rewarding owners is prioritized o If all stocks went up at the same rate, over paying salaries or growing at all costs. there would be nothing left to buy and o In general, insiders are net sellers. investors everywhere would be out of Insider selling ≠ automatic sign of business. Fortunately, this is not the trouble, and it’s silly to react to it. case. There’s always a laggard to fall o Many reasons for selling, but only 1 for buying – believe the stock is undervalued
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The Peter Lynch Playbook o If price drops after insider buying, so much the better. • With every company, there is something to xiii) Share Buy-backs – alternative uses for worry about, but the question is, which cash include: a) Dividend raise, b) new worries are valid and which are not? There’s product development, c) start of new no such thing as a worry-free investment. operations, and, d) M&A. The trick is to separate the valid worries from the idle worries, and then check the Perfect Stocks worries against the facts. The very existence Dull Name Dull Business Spinoffs of doubt creates the conditions for a big gain Disgusting Depressing Niches / in the stock once the fears are put to rest. Business Business Moats • The trick is to put your fears to rest by doing Habit Cost Benefits Insider the research & checking facts – before the Purchases from Tech Buying competition does. The stocks Lynch bought No Low Industry False, are the very stocks that others overlooked. Institutional Growth, no Negative The stock market demands convictions, as Ownership Competition Rumours surely as it victimizes the unconvinced. Buybacks • Take the industry that’s surrounded with the most doom & gloom, & if fundamentals Stocks to Avoid are positive, you’ll find some big winners. i) Hot Stuff – Avoid the hottest stock in the • In cases where quiet facts point in a positive hottest industry. If you aren’t clever at direction, a much different story than the selling, you’ll soon see your profits turn to negative news being trumpeted, wait until losses. High growth and hot industries the prevailing theory is that things have attract smart competitors. gone from bad to worse, then buy the ii) Next Something – when people tout a stock strongest companies. Invest in a company as the next IBM, it often marks the end of that can survive in a depressed state, rather prosperity not only for the imitator, but also than one that can thrive in boom times, but for the original. is untested for bad times. iii) Diworseifications – instead of buybacks / dividends, a dedicated diworseifier seeks • The popular prescription “Buy at the sound purchases that are a) overpriced, b) beyond of cannons & sell at the sound of trumpets” the realm of understanding. can be misguided advice. Buying on bad o Every second decade, companies switch news can be very costly, especially since bad between diworseification and news has the habit of getting worse. restructuring • Buying on good news is healthier long term, o 1960’s was the greatest decade for and you improve your odds considerably by diworseification, which ended in the waiting for the proof. Maybe you lose a dollar crash of 1973/74 or so by waiting for the announcement, as o Synergy (2+2=5): theory of putting opposed to buying the rumour, but if there’s together related businesses and making a real deal it will add many more dollars to the whole thing work, which doesn’t the future price. And if there isn’t a real always happen. A vigorous buyback is deal, you’ve protected yourself by waiting. the purest synergy of all. • In the short term, the story looks ‘fuzzy’ and iv) Whisper Stocks - long shot companies with due to uncertainty, the stock might fall. It’s whiz bang stories. best not to own the company during this o Are often on the brink of solving the uncertain stage, unless you’re prepared in latest national problem with a solution advance to respond to such a drop by that’s: a) very imaginative, or, b) buying more – over the long term, you must impressively complicated. be convinced that the company will do well. o The great story has no substance, but it • Combat Theory of Investing: During a war, relieves the investor of the burden of don't buy the companies that are doing the checking the financials. fighting; buy the ones that sell bullets. o If prospects are so phenomenal, then it • Industry Bets: an individual can bet heavily will be a fine investment next year as on the most promising company and put all well. Wait till the company has his money there, but a fund manager has to established a record. spread out his money. 2 ways to do this: v) Beware the Middleman – company sells large i) Decide “I want 8% autos” because you’ve % of sales (20-50%) to a single customer. a hunch they’ll do well. The sector pick is Short of order cancellation, that customer deliberate & companies are incidental. has enormous leverage in getting cuts and ii) Analyze each company on a case by case concessions that reduce profits. basis. The choice of companies is vi) Beware the Stock with an Exciting Name – deliberate & the weighting is incidental. flashy name of a mediocre company attracts • Lynch’s stock picking was entirely empirical. investors and gives them a false sense of Sniffing from one case to another, like a security. bloodhound that’s trained to follow a scent. Care more about the details of a story, than Avoid whether the company’s sector is under/over Hot stock / Diworseification Large weighed in the portfolio. Following scents in Industry Customer every direction proves that a little knowledge Next Whisper Stock / Exciting about a lot of industries isn’t necessarily a something Story Name dangerous thing.
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The Peter Lynch Playbook • Investment flexibility is key, if you’ve a blood branches, also don’t have expansively hound style. Lynch bought companies with furnished headquarters. unions, steel / textiles. He always thought o An S&L with excess equity, loyal deposit there were good opportunities everywhere & base & lending capacity is prized by researched stocks himself. Taco Bell was one large banks as a takeover target. of his earliest picks – when people wouldn’t o If an S&L with a boring story and look at a small restaurant company. If you fortress balance sheet gets in trouble, its look at 10 companies, you’ll find 1 that’s competitors are walking the plank. interesting, if you look at 20, you’ll find 2, or o Problem Loan Camouflaging – approve 10 in a 100. The person that turns over the $120 on a $100 request, using inflated most rocks wins the game – that was always appraisals. Excess $20 is held back in Lynch’s philosophy. banks’ reserve and used at default to • Rather than being on the defensive, buying cover interest payments. Helps reclassify stocks, and then thinking of new excuses for bad loans as good, at least temporarily. holding onto them (Wall Street style), Lynch o Traditionally, an S&L is owned stayed on the offensive, searching for better cooperatively, and has no shareholders. opportunities that were more undervalued Net worth belongs to all, who have than the ones already in the portfolio. accounts in branches. • Rejecting a stock because the price has o As long as the cooperative form of become 2-3-4x in the recent past can be a ownership is maintained, you get big mistake. Whether a million investors lost nothing for your stake. Things change or made money on a stock has no bearing on when it comes for an IPO: what the future holds. Treat each potential i) The Directors, who put together the investment as if it’d no history – the ‘be here deal, and the stock buyers, are on now’ approach. Whatever occurred earlier is the same side. Directors will buy irrelevant. The important thing is whether shares, so the IPO price is set low. the stock is cheap/expensive today, vs it’s ii) Depositors & Directors will be able earnings potential. to buy at the IPO price. Because • How to Rate a Savings & Loan Company depositors own cooperatives, it’s o Equity / Assets – measures financial inconvenient to divvy IPO proceeds strength and survivability. Higher the to many sellers, who’re also buyers. better. <5x = Danger, 5.5-6x = Average, > Instead, the money becomes a part 7.5x = Preferred. of equity & goes back to the S&L, o Book Value – if high risk lending has rather than going into the been avoided, then assets and book promoters’ pocket. Pre-IPO Book value may accurately reflect net worth. Value = $10. Further $10 shares Look for P/B < 1x. sold, but proceeds are added back, o PE – lower the better. If PE = 7x, and so Post-IPO Equity = $20. Therefore, growth = 15%, that’s very promising, $10 share price < $20 book value. especially when S&P 500 PE = 23x. • Master Limited Partnerships o High Risk Assets – get nervous when o MLP holder needs to do some extra commercial and construction loans are paperwork. Special tax forms have to be >5-10% of lending portfolio, since one prepared. Once a year, you get a letter can’t analyze a commercial lending asking for confirmation about how many portfolio from the outside. shares you bought and own. But this is o 90 Day NPA’s – these have already nuisance enough to dissuade investors, defaulted. Preferably represent <2% of especially fund managers, from buying total assets. Trend should be falling. them. This lack of popularity helps keep o Dividend – higher yield is a plus, when prices down and creates bargains. other criteria are met. o Companies tend to be involved in down o Real Estate Owned – foreclosed to earth activities. It takes an properties already written off and an imaginative person to be attracted to the index of yesterday’s problems. High idea of owning shares in an MLP, then number isn’t worrisome, unless it’s on he runs into paperwork, which most the rise. If there’s a lot of REO, you’ve to imaginative people can’t stand. assume that the S&L is having trouble Therefore, a small minority of getting rid of it. imaginative people with retentive o Large banks like Citibank may spend qualities are left to reap the rewards. 2.5-3% of their entire loan portfolio just o An MLP distributes all its earnings as for overheads and related costs. A good dividends, which are unusually high, S&L may break even at 1.5%. almost as good as junk bonds. o Best S&L’s are no frills, low cost o A high PE ratio is fairly common. operators, have a solid base of loyal neighbourhood depositors, are content INVESTING PSYCHOLOGY to make traditional low-cost residential • Know Yourself mortgages (<$1000k), avoid hiring high o Before buying stocks, make some basic priced credit analysts, have big branches decisions: with enormous deposits, which is more i) About the market profitable than having many small ii) About how much you trust companies
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The Peter Lynch Playbook iii) About whether you need to invest in the farthest in the long run, give you the stocks & what you expect from them most bumps and bruises along the way. iv) About whether you’re a short, or, long o Small investors are capable of handling term investor all sorts of markets, as long as they own v) About how you’ll react to sudden, good merchandise. After all, market unexpected, and severe price drops crashes are only losses to people who o Define your objectives and clarify your took the losses. That isn’t the long term attitude beforehand (do I really think investor, it’s the margin player. stocks are safer than bonds?). If you’re o There’s not a lot you can do when the undecided and lack conviction, then market’s in a cascade. 1987 wasn’t you’re a potential market victim who analyzed very well. You’ve to put it in abandons all hope and reason at the perspective. 1982, the market’s 777. By worst moment & sells at a loss. 1986, the market moves to 1700. Then it o When you invest in stocks, you’ve to adds 1,000 points, reaching 2,700 by have a basic faith in human nature, Aug ‘87. Then it falls 1,000 points in 2 capitalism, the country & in future months, 500 points the last day. So if prosperity in general. the market went sideways at 1,700, no o Do I Own a House? one would’ve worried, but it went up a ▪ Before stocks, consider buying a 1,000 in 10 months & then down a house. It’s the one good investment 1,000 in 2 months, people said, “The decision that almost everyone makes. world’s over.” It was the same price. So it ▪ Unlike stocks, houses are likely to be was really a question of the market just held by the same person for many kept going up and up and it just went to years, vs a high churn rate in stocks. such an incredible high price, but people ▪ You never get scared out of your forget that it was basically unchanged house just because of price falls. for 1 year. It’d gone 1,000 points up, ▪ People spend months choosing a then 1,000 points down, and they only house, asking the right questions, remember the down. but pick stocks in a few minutes. o You get recessions, you have market o Do I Need the Money? declines. If you don’t understand that’s ▪ Set aside cash for 2-3 years, as per going to happen, then you’re not ready – your family budget. you won’t do well in the markets. If you o Do I Have the Personal Qualities? go to Minnesota in January, you should ▪ Patience know that it’s gonna be cold. You don’t ▪ Self reliance panic when the thermometer falls <0. ▪ Common sense o If you can summon the courage & ▪ Tolerance for pain presence of mind to buy during scary ▪ Open mindedness periods that occur every few years, when ▪ Detachment your stomach says sell, you’ll find ▪ Persistence opportunities that you never thought ▪ Humility you’d ever see again. ▪ Flexibility o If you can’t convince yourself, “When I’m ▪ Willingness to do independent down 25%, I’m a buyer”, and banish research forever the thought “When I’m down ▪ Willingness to admit mistakes 25%, I’m a seller”, then you’ll never ▪ Ability to ignore general panic make a decent profit in stocks. ▪ Important to make decisions without o Ultimate success or failure depends on complete or perfect information. your ability to ignore the worries of the Things are never clear. When they world long enough to allow your are, it’s too late to profit from them. investments to succeed. It isn’t the head, ▪ It’s crucial to be able to resist your but the stomach that that determines human nature & gut feelings. Only a the fate of the stock picker. rare investor doesn’t secretly harbour o The skittish investor, no matter how the belief that he can divine prices, intelligent, is always susceptible to despite the fact that most of us have getting flushed out of the market by the been proven wrong again & again. brush beaters of the doom. Experience is o When people discover they’re no good at always an expensive teacher. sports, they give up, but when they o As the indices hit new records, many discover they’re no good at stock picking small companies may be ignored. That's they continue anyway. Be open mind to not to say owning these laggards will new ideas. If you don’t think you can protect you if the bottom drops out of beat the market, then buy mutual funds the market. If that happens, the stocks & save yourself extra work & money. that didn't go up will go down just as • Dealing with Price Drops hard & fast as the stocks that did. o The best time to buy stocks will always Before the selling is over, companies that be the day you’ve convinced yourself look cheap, get much cheaper. you’ve found solid merchandise at a • The Even Bigger Picture good price – same as at the mall. o It’s simple to tell yourself, “Gee, I guess o Perhaps there’s some poetic justice in I’ll ignore the bad news the next time the the fact that that stocks that take you stock market is going down and pick up
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The Peter Lynch Playbook some bargains.” But since each crisis story. Eg. If a Stalwart rises 40% and seems worst than the last, ignoring bad nothing wonderful has happened with news gets harder. the company to make you think that o The best way to not get scared out of there are wonderful surprises ahead, stocks is regular systematic investing. If replace it with another Stalwart you find you don’t buy with monthly discipline, attractive, that hasn’t gone up. In the you’ve got to find some way to keep the same situation, if you didn’t want to sell faith. Without faith, you may invest in a all of it, you could sell some of it. good fund, but you’ll sell at the point of o A price drop in a good stock is only a maximum fear, ie, at the bottom. tragedy, if you sell at that price and o What sort of faith? Faith that the never buy more. A price drop is an country will survive, that people will go opportunity to load up on bargains from to work, that the companies they work among your worst performers and your for will make money, faith that as old laggards that show promise. companies lose momentum, new exciting o How can someone complain after selling companies will emerge to take their a stock at 5x? When you’ve found the place, faith that the country is a nation right stock and bought it, all the of hardworking and creative people. evidence tells you it’s going higher, and o Whenever you’re concerned about the everything is working in your favour, Current Big Picture, concentrate on the then it’s a shame if you sell a 25x for 5x. Even Bigger Picture. This tells us that • Ignore others in favour of your own research. over the last 70 years, stocks have Investing ≠ surgery/hairdressing/plumbing. returned 10.3%, vs, 4.8% for bonds. The smart money isn’t smart, and the dumb Despite all the great & minor calamities money isn’t as dumb as it thinks. It’s only that occurred in the last century, stocks dumb when it listens to the smart money. have rewarded 2x. Acting on this bit of • Inferiority complex causes investors to do 1 information is more lucrative than acting of 3 self-destructive things: on the opinions of commentators i) Imitate the pros by buying “hot” stocks predicting the coming depression. or trying to “catch the turn” in, say, IBM. o These 70 years have seen 40 scary ii) Become “sophisticated” by investing in declines of >10%, of which, 13 were futures, options, etc. >33%, including the 1929-33 selloff. iii) Buy what a pro has recommended in a o Scare Proofing Drill – concentrate on the magazine or on the news. Information is Even Bigger picture during scary so readily available that the celebrity tip periods, assuming that the worst has replaced the old-fashioned tip from wouldn’t happen, and then ask yourself, Uncle Harry as the most compelling if it didn’t, what then? Things can only reason to invest in a company. get better than they are. Investors • The Double Edge: attempt to prepare for total disaster by o Oil executive’s knowledge about his bailing out of their best investments is industry ≠ consumer knowledge about stupid: a) If total disaster strikes, cash brands. What do you possibly know that in bank would be as useless as stocks. other people don’t know a lot better? If b) If it doesn’t strike (much more likely nothing, then your edge is = 0. outcome), the cautious types have just o Professional’s edge is useful in knowing become the reckless ones, selling their when and when not to buy companies valuable assets for a pittance. that have been around a while, o When you sell in desperation, you especially Cyclicals. always sell cheap – you should ignore o On top of the professional’s edge is the the market ups & downs. Even if the consumer edge. This is helpful in picking 1987 crash made you nervous about the out the winners from the newer and market, you didn’t have to sell that day, smaller fast growing companies, or the next. You could’ve gradually especially in retail. reduced your stocks and come out • True contrarian isn’t the one who takes the ahead of the panic sellers. opposite view of a popular hot issue. The • Watering the Weeds true contrarian waits for things to cool down o Some people automatically sell winners & buys stocks that nobody cares about, and hold onto the losers, which is about especially those that make Wall Street yawn. as sensible as pulling out flowers and • Penultimate Preparedness: no matter how watering the weeds. Others sell their we arrive at the latest conclusion, we always losers and hold onto winners, which seem to be preparing ourselves for the last doesn’t work out much better. thing that happened, vs, what’s going to o Both strategies fail because they’re tied happen next. This extrapolation is our way to the current price movements as an of making up for the fact that we didn’t see indicator of a company’s value. Price the last thing coming along in the first place. tells us nothing about future prospects, • Drumbeat Effect – a particularly ominous and it occasionally moves in the opposite message is repeated over and over until it’s direction of fundamentals. impossible to get away from it. Friends, o A better strategy is to rotate in and out relatives, brokers etc whisper in your ears. of stocks depending on what has You might get the “congratulations, don’t be happened to the price, as it relates to the greedy” message, on a particular stock. Most
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The Peter Lynch Playbook of the drumbeat messages revolve around • Some “lucky stiffs” come out ahead macroeconomic or political issues. regularly. They undertake to maximize their • Biggest trouble with stock market advice is ROI by carefully calculating, and re- that good or bad, it stocks to your brain. calculating their chances as the hand Every single dumb idea you hear about unfolds. Consistent winners raise their bets stocks, will get into your brain. You can’t get as their position strengthens, and they exit it out of your head, and someday, sometime, the game when the odds are against them. you’ll find yourself reacting to it. • Meanwhile, consistent losers hang onto the • A stock doesn’t know that you own it. When bitter end of every pot, hoping for miracles Lynch ran Magellan, the market had 9 and enjoying the thrill of defeat. In stud declines of >10% in 13 years. He had a poker, as on Wall Street, miracles happen perfect record, all 9 times, his fund went just often enough to keep the losers losing. down. He didn’t spend any time predicting • Consistent winners also resign themselves to the economy, or the stock market – he spent the fact that they’ll occasionally lose to all his time looking at companies. miracles, even when they’ve a very strong • ‘Playing the Market’ has done more damage hand. They accept their fate and go onto the to investing than anyone can imagine. next hand, confident that their basic method • If you said you were an investment manager, will reward them over time. people would just move onto the next topic. • Successful investors also accept periodic That was sort of the attitude in the ’60s and losses, setbacks & unexpected occurrences. ’70s. As the market started to heat up, you’d Calamitous drops don’t scare them out of say you were an investor, “That’s interesting. the game. They realize the stock market isn’t Are there any stocks you’re buying?” Then like chess, where the better position always people would listen not avidly, but think wins. You’re never going to be right 9/10. about it. But then as the ’80s piled on, they This isn’t like pure science where you go started writing things down. So people would “Aha” and you’ve got the answer. By the time really take an interest, “What do you like?” you’ve got “Aha,” the stock quadruples. And then it turned & the final page of the You’ve to take a little bit of risk. chapter would be you’d be at a party and • You don’t need to make money on every everybody would be talking about stocks, & stock pick. A 60% win rate can produce an then people would recommend stocks. And enviable record. All you need for a lifetime of not only that, but the stocks would go up successful investing is a few big winners. over the next 3 months. So you’ve done the The pluses from them will overwhelm full cycle of speculation that people hate minuses from stocks that don’t work out. If stocks; don’t want to hear anything about 7/10 stocks perform as expected be them; now they’re buying everything; & delighted. 6/10 = Be Thankful. cabbies are giving stock tips. That was the • Management ability might be important, but cycle going through from the ’60s & early it’s quite difficult to assess. Instead, buy on ’70s all the way to 1987. a company’s prospects. • Gold is about sentiment & psychology, much • Two Minute Drill more so than any other commodity. o After company classification and figuring out whether the PE is high / low vs RISK MANAGEMENT immediate prospects, figure out the • Frankly, there’s no way to separate investing company’s “story”. from gambling. Historically, stocks are o Except possibly Asset Plays, something regarded as investments or dismissed as dynamic has to happen to keep earnings gambling in routine and circular fashion, moving along. The more certain you are and, usually at the wrong time. about what that something is, the easier • As long as people are willing to pay foolish it gets to follow the script. prices for things, no plan is foolproof. o Be able to give a 2 minute monologue • Once the unsettling fact of risk is accepted, that covers the: we can separate gambling from investing not ▪ Reasons you’re interested in it by the type of the activity but by the skill, ▪ What has to happen for the dedication, and enterprise of the participant. company to succeed? • To a veteran handicapper with the skill to ▪ The pitfalls that stand in its path stick to a system, betting on horses offers a o Once you’re able to tell the story such relatively secure long term return. that even a child can understand it, then Meanwhile, to the rash and impetuous stock you have a proper grasp of the situation. picker, an ‘investment” in stocks is no more • The 6 Month Checkup reliable than throwing darts. o A healthy portfolio requires a regular • An investment is simply a gamble in which checkup – every 6 months. you’ve managed to tilt the odds in your o Even with blue chips, buy and forget can favour. The stock market = a 7 card stud result in wasted opportunities and huge poker game. losses. It happens to people who imagine • You can never be certain what will happen, that betting with blue chips relieves but each new corporate event is like turning them of the need to pay attention. up another card. As long as the cards o It’s not simply a matter of checking suggest favourable odds of success, you stay prices – you can’t assume anything. in the game. o You’ve got to follow the stories and get the answer to 2 basic questions:
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The Peter Lynch Playbook i) Is the stock still attractively Priced, • His idea was to stay in the market forever, vs Earnings? and to rotate stocks depending on the ii) What’s happening to the company to fundamental situations. If you decide that a make the Earnings go up? certain amount you’ve invested in the stock o Answer – 3 possible conclusions: market will always be invested in the stock i) Story has gotten better = you might market, then you’ll save yourself a lot of want to increase your investment. mistimed moves and general agony. ii) Story has gotten worse = you can • The bearish argument always sounds more decrease your investment. intelligent. It’s said that “the market climbs iii) Story unchanged = you can either a wall of worry”, take note that the worry stick with your investment or put wall is fairly good sized & growing every day. the money into another company That’s not to say there’s no such thing as an with more exciting prospects. overvalued market, but there’s no point worrying about it. The way you’ll know the Price market is overvalued is when you can’t find Higher Same Lower a single company that’s reasonably priced or Higher Hold Buy BUY!!! meets your other investment criteria. Earnings Same Sell Hold Buy • Corrections (>10% decline) occur every 2 Lower SELL!!! Sell Hold years, bear markets (>20%) every 6 years, and severe bear markets (>30%) have + Buy more happened 5 times between 1932/33-2000. • It’d be wonderful if we could avoid setbacks with timely exits, but nobody can predict E = Hold, or Switch them. Moreover, if you exit stocks & avoid a decline, how can you be sure that you’ll get (-) Sell back in for the next rally? • Things inside humans make them terrible stock market timers. Unwary investors (-) Did Earnings rise? continually pass through 3 emotional states: Is stock still worth it? i) Concern: he’s concerned after a market drop or when the economy seems to P = Is PE same? falter, which keeps him from buying good companies at bargain prices. + Did Earnings fall? ii) Complacency: after he buys at higher If Not, buy more prices, he gets complacent because his stocks are going up. This is precisely the • Silly to get bogged down in PE’s, but you time he ought to be concerned enough to don’t want to ignore them. Are PE’s of your check the fundamentals, but isn’t. stocks High/Low/ Fair, vs, industry norms? iii) Capitulation: finally, when his stocks fall Is company selling at a premium or on hard times and prices fall below discount, vs peers? Track a company’s purchase price, he capitulates and sells historical PE track record through several in a fit of irritation. years to get a sense of its normal levels. • If you spend 13 minutes on economics (as • Quick way to tell if a stock is overpriced is to forecasting the future), you’ve wasted 10 compare Price line vs Earnings line. Buy, minutes. Think about what’s happening - when Price < Earnings. Sell, when Price >>> deal in facts, not forecasts. That’s crystal Earnings (dramatically higher). ball stuff, which doesn’t work. • Liquidity: avoiding wonderful small • Assuming you have a forecast of a big companies, because the stocks are thinly market decline, how can you prepare? traded. In stocks, as in romance, ease of Mostly by doing nothing. A market calamity divorce isn’t a sound basis for commitment. is different from a meteorological calamity. If you’ve chosen wisely to begin with, you Since we’ve learned to take action to protect won’t want a divorce. And if you haven’t, ourselves from snowstorms, it’s only natural you’re in a mess no matter what. If a that we would try to prepare ourselves for company is a loser, you’ll lose money no corrections, even though this is one case matter how many shares it trades, and if it’s where being prepared can be ruinous. a winner, you can unwind profits leisurely. i) The 1st mistake is hedging the portfolio. • People who want to know how stocks fared Anticipating a drop in the market, the ask - where did the Dow close? Lynch was skittish investor begins to dabble in interested in the Advance/Decline ratio. futures and options, thinking of this as • If the stock’s current price is < IPO price, the correction insurance. It seems cheap at stock ‘maybe’ undervalued first, but the options expire every couple of months, & if stocks don’t go down on MARKET TIMING schedule people have to buy more • Lynch constantly rechecked stocks and options to renew the policy. Suddenly, stories, adding / subtracting as things investing isn’t so simple. Investors can’t changed. But he never went into cash – decide whether they’re rooting for stocks except to have enough of it to cover to falter, so their insurance will pay off, anticipated redemptions. Going into cash = or for a rally, for the sake of the portfolio. getting out of the market. Hedging is a tricky business even the
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The Peter Lynch Playbook pros haven’t mastered – otherwise, why’d mind is the intrinsic value vs current price. so many hedge funds go out of business? As long as value stays high or improves, a ii) The 2nd and more prevalent mistake is falling price only helps to make it a better the ritual known as lightening up, selling bargain. some or all stocks. Or putting off buying ii) You Can Always Tell When A Stock Hits A stocks you like & sitting on cash, waiting Bottom for the crash. “Better safe than sorry,” is o You must buy for a more sensible reason the mantra. “I’ll wait for the day of than the fact that a stock’s gone so far, it reckoning, when all the suckers who looks up to you. didn’t see this coming are wailing and o It’s a good idea to wait until the knife hits gnashing their teeth, and I’ll snap up the ground, sticks, vibrates for awhile, bargains left and right.” (But once the and settles down, before you grab it. market bottoms, cash sitters are likely to o But even so, you aren’t going to get the continue to sit on cash. They’re waiting bottom price. What usually happens is for further declines that never come, and that a stock sort of vibrates itself out they miss the rebound.). They may still before it starts up again. Generally, this call themselves long-term investors, but takes 2-3 years, sometimes longer. they’re not. They’ve turned into market o Find charts of those companies that timers & unless their timing is very good, declined sharply, and then went sideways the market will run away from them. for a couple of years. If it’s gone sideways • People waste so much time trying to figure for some time, fundamentals are decent, out “When should I invest?” Lynch did a & you can find something that’s new & study – for 30 years (1965-1995), if you had positive in the company/ industry, then incredible good luck to invest $1,000 at the if you’re wrong, it’ll probably keep going yearly low, your return would’ve been 11.7%. sideways and you won’t lose much. But if Some other unlucky soul put $1,000 at the you’re right, that stock is going north. yearly high, earning 10.6%. That’s the only iii) If It’s Gone This High Already, How Can It difference between the yearly high and low. Possibly Go Higher? Someone else put it on the 1st day of the o Multibaggers break these barriers, year year, earning 11%. Just buy, hold, and after year. when the market goes down 10%, add to it. o Never able to predict which stocks will go • The only problem with market timing is up 10x, or, 5x. Stick with them as long getting the timing right. You’ll never meet as the story’s intact, hoping to be many people who’ve done it successfully. pleasantly surprised. The success of a Maybe once in a row, but not consistently. company isn’t the surprise, but what the • There’s no telling how many timers miss big shares bring, often is. gains by making ill-timed exits. Far more iv) Its Only $3 A Share, What Can I Lose? money has been lost trying to anticipate o If it goes to 0, you still lose everything. A corrections or preparing for corrections than lousy cheap stock is as risky as a lousy has been lost in corrections themselves. expensive one. • People have more time than they think to o Short sellers usually buy nearer to the ride out corrections, which is why you bottom than to the top. They wait until a shouldn’t worry about the next one. company is so obviously floundering, that Corrections are unpredictable. By selling bankruptcy is inevitable. stocks to avoid pain, you can miss the next v) Eventually They Always Come Back – gain. As soon as you realize you can afford consider the 1000’s of companies that went to wait out any correction, the calamity also bankrupt, or solvent ones who never becomes an opportunity to pick up bargains. recovered prosperity, or were bought out at • Ask yourself this: If stock prices dropped 10- prices far below their peak price. 25%, would you add to your positions, or vi) It’s Always Darkest Before The Dawn – would you cash out and cut your losses? If human tendency to believe that things that you’d cash out, then do it now & avoid the have gotten a little bad, can’t get worse. misery that is sure to come later. vii) When It Rebounds To $10, I’ll Sell • A 40 year review of the S&P 500 going back o No downtrodden stock ever returns to the to 1954 shows how expensive it is to be out level at which you’ve decided to sell. This of stocks during the short stretches when painful process may take a decade, and they make their biggest jumps. If you kept all this while you’ll tolerate an investment all your money in stocks throughout, your you don’t even like. annual return was 11.4%. If you were out of o Unless you’re confident enough to buy stocks for the 10 most profitable months, more, you should be selling immediately. your return dropped to 8.3%. If you missed viii) What, Me Worry? Conservative Stocks Don’t the 20 most profitable months, your return Fluctuate Much – Utilities can be as risky as was 6.1%; the 40 most profitable, and you Biotech, even riskier, because you aren’t made only 2.7%. If you cut enough losses, aware of unknown changes. sooner or later there’s nothing left to cut. ix) It’s Taking Too Long For Anything To Happen o If you give up because you’re waiting for SILLIEST (AND MOST DANGEROUS) THINGS something wonderful to happen, then PEOPLE SAY ABOUT STOCK PRICES something wonderful will happen the day i) If It’s Gone Down This Much Already, It Can’t after you sell. Go Down Much More – only thing to keep in
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The Peter Lynch Playbook o It takes remarkable patience to hold onto be able to explain why, in language that a a stock that excites you, but which is 5th grader could understand, & quickly ignored by everybody else. You begin to enough so the 5th grader won’t get bored. think others are right and you’re wrong. To avoid undermining one another’s o Most of the money Lynch made was in confidence, no feedback was allowed. the 3rd/4th year. If fundamentals are ii) Gentlemen Who Prefer Bonds, Don’t Know positive and whatever attracted you What They’re Missing hasn’t changed, then sooner or later, o Interest income may or may not beat patience will be rewarded. inflation, but stocks will provide 5-6% x) Look At All The Money I Lost, I Didn’t Buy It real return. In the long run, a portfolio of o You aren’t a cent poorer than you were – well-chosen stocks/mutual funds will money lost via fictional missed always outperform a bond portfolio or a opportunities and omission errors are money-market account. simply self torture. o In the long run, a portfolio of poorly o This isn’t a productive attitude. It can chosen stocks won't beat the money left only lead to total madness. under the mattress. o The worst part about such thinking, is iii) Never Invest In Any Idea That You Can’t that it leads people to try to play catch Illustrate With A Crayon up by buying stocks they shouldn’t, if o St. Agnes Portfolio (class 7 students) only to protect themselves, from losing ▪ Simple stock picking methods are more than they’ve already “lost”. more rewarding than boutique xi) I Missed That One, I’ll Catch The Next One techniques. o The original good company at a high ▪ Teacher asks students to put >10 price is better than the next bargain. stocks in the portfolio. Kids aren’t o Trouble is the next one rarely works. If allowed to buy any company unless you missed a great company that they can explain what it does. continued to go up, and then bought a ▪ 50% of stocks must provide a fairly mediocre one that went down, then you good dividend. Good companies took a mistake that cost nothing and usually increase dividends each year. turned it into a mistake that cost plenty. ▪ It takes a long time to make money, xii) The Stocks Gone Up, So I Must Be but you can lose it in a short time. Right...or...The Stocks Gone Down, So I Must ▪ Don’t buy a stock because it’s cheap, Be Wrong – people confuse prices with but because you know a lot about it. prospects. Unless they’re short term traders A cheap stock can always get cheaper. who’re looking for 20% gains, the short term Someday it may rise again, but fanfare means nothing. Price movements assuming that will happen = wishing after your purchase only tell you that there ≠ investing. was someone willing to pay more/less, for ▪ Never fall in love with a stock; always the identical merchandise. have an open mind. Rule of 5 stocks, 1 = Great, 3 = OK, 1 = Really Bad. PETER’S PRINCIPLES; and o Better Investing (NAIC – National 25 GOLDEN RULES; and Association of Investors Corporation) WHAT ADVICE WOULD I GIVE TO SOMEONE ▪ Represents >10,000 stock picking WITH $1MM TO INVEST? THE SAME I’D clubs that invest on a regular GIVE TO ANY INVESTOR: FIND YOUR EDGE timetable. This takes the guesswork AND PUT IT TO WORK BY ADHERING TO out of where the market is headed, THE FOLLOWING RULES: and doesn’t allow for the impulse decisions that spoil many nest eggs. i) When Operas : Football Games :: 3:1, There’s ▪ An individual might be scared out of Something Wrong With Your Life stocks and later regret it, but in the o Nobody at his deathbed said I wish I’d clubs, nothing can happen without a spent more time at the office. majority vote. Rule by committee isn’t o Lynch left home at 6 am, reaching office a good thing, but in this case, it helps at 6:45. Working hours were 0930-2130. ensure that no foolish proposal to sell Work days were 16 hours long. Secret to everything will be carried out. success = visiting 400+ companies and ▪ Maxims, per NAIC Manual: reading 700+ annual reports, per year. - Invest regularly. o Fidelity made all managers responsible - Hold no more stocks than you can for their own research. They couldn’t remain informed on. blame analysts anymore. Analysts, doing - You want to see, a) Sales & EPS parallel independent research, couldn’t growing at an acceptable rate, and, protect themselves by simply touting b) stock price is reasonable. acceptable, worn out companies, for - Understand the reasons for past which they couldn’t get criticized. Thus, sales growth to form a good there was 2x investigation, vs a judgment as to the likelihood of customary division of labour. past growth rates continuing. o Formalized information swap sessions, - Consider financial strength & debt where everyone presented their picks of structure to see if a few bad years the week in 1.5-3 minutes. 90 seconds is can hinder the long term progress. enough to tell a stock’s story. If you’ve to invest in a company, then you ought to
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The Peter Lynch Playbook ▪ Clubs meet once a month to discuss double digits and long-term U.S. ideas and decide what to buy next. Treasuries were yielding 13-14%. He Each person is responsible for didn't buy bonds for defensive purposes. researching 1-2 companies and He bought them since 13-14% > 10-11% keeping tabs on latest developments. historical stock returns. ▪ Mostly buy stocks in well managed o If you can't find any companies that you growth companies with a history of think are attractive, put your money into prosperity and rising earnings. the bank until you discover some. ▪ Rule of Five: NAIC advises portfolio ix) Not All Common Stocks Are Equally Common with >5 stocks. 1 = will do better than o The theory that a large fund can’t beat you could’ve possibly imagined, and the market is misguided. An imaginative will surprise you with phenomenal fund manager can pick 1-2000 stocks, in return, 3 = will perform as expected, 1 unusual companies, most of which never = will run into unforeseen trouble, appear in the typical Wall Street portfolio. and disappoint. o The market is dominated by a herd of ▪ $1,000 invested each year on Jan 31, professional investors. Contrary to 1940, grew 334x over 52 years. popular belief, this makes it easier for the ▪ Adding $1,00 annually on Jan 31, amateur investor. You can beat the improved corpus to 3,554x, from a market by ignoring the herd. further $52,000 investments. x) The Best Stock To Buy May Be The One You ▪ Adding another $1,000 every time Already Own market fell 10% (31 times), improved o The number of really brilliant companies corpus further to 6,295x ($83,000). is finite, so when you do have one it’s iv) You Can’t See The Future Through A Rear better to buy more of it, than to go out to View Mirror find something else. o Pessimism in 1990 reached a peak xi) A Sure Cure For Taking A Stock For Granted, during the Iraq War. 1991 was the best Is A Big Drop In Price year in 2 decades with S&P up 30%, Dow o Sometimes good luck can mask bad skill. up 25%, small stocks up 60%. Like many people who invest with great o Successful investors develop a disciplined initial success, Lynch had attained approach that enables them to block out something of a God complex, thinking he their own distress signals. was immune to the lumps and bumps of o Avoid weekend worrying & ignore the the market. The shocks of 1978 & 1987 latest dire predictions because nobody provided the necessary kick in the pants can predict interest rates, the direction of to remind him of who the real boss is. the economy/market. Dismiss all such xii) Never Bet On A Comeback When They’re forecasts and concentrate on what's Playing “Taps” actually happening to the company. Sell o Taps is the name of a bugle tune played a stock if fundamentals deteriorate, not at military funerals. Don’t buy just because the sky is falling. because price has fallen. There’s no v) There’s No Point Yo-Yo Ma To Play The Radio shame in losing money on a stock. o Don’t invest in treasuries via bond funds Everybody does it. What is shameful is to and pay extra fees & expenses. hold onto a stock, or worse, to buy more, vi) As Long As You’re Picking A Fund, You Might when the fundamentals are deteriorating. As Well Pick A Good One – easier said than xiii) If You Like the Store, Chances Are You’ll Like done. 75% of funds perform < market the Stock average. If a fund equals market returns, it’s o The very homogeneity of taste in food and in the top 25% of all funds. Why? fashion that makes for a dull culture, o Lousy stock pickers – throw darts instead also makes fortunes for owners of retail o Herd instinct produces camp followers. and restaurant companies. They pretend to pursue excellence, when o Your edge is not something you get from actually, they’re closet indexers. Wall Street experts. It's what you already o Indexing popularity has created a self- have. You can outperform experts if you fulfilling prophecy. S&P stocks tend to use your edge by investing in companies represent large companies that did well or industries you already understand. recently, enjoying undue momentum. o In every industry and every region of the vii) The Extravagance Of Any Corporate Office Is country, the observant amateur can find Directly Proportional To Management’s great growth companies long before the Reluctance To Reward The Shareholders professionals have discovered them. o Great companies are thrifty, & maximize xiv) When Insiders Are Buying, It’s A Good Sign returns by running efficient operations. o When several insiders are buying the viii) When Long Term Bond Yields > Dividend stock at the same time, it's a positive. Yield Of S&P500 By => 6%, Sell Your Stocks xv) In Business, Competition Is Never As Healthy And Buy Bonds As Total Domination o Should you exit the market to avoid the o As a place to invest, lousy industries are correction? A confirmed stock picker better than great industries anytime. In a sticks with stocks until he can't find a lousy industry, one that’s growing slowly, single issue worth buying. The only time if at all, the weak drop out and the Lynch took a big position in bonds was in survivors get a bigger market share. A 1982, when inflation was running at company that can capture an ever
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The Peter Lynch Playbook increasing share of a stagnant market is success of its stock over a few months or better than one that has to protect a even a few years. In the long term, there is a dwindling share of an exciting market. 100% correlation between the success of the o Avoid hot stocks in hot industries. Great company and its stock – This disparity is the companies in cold, no growth industries key to making money; it pays to be patient, are consistent big winners. and to own successful companies. The xvi) All Else Being Equal, Invest In The stocks that rewarded Lynch the most made Company With The Fewest Colour Photos In their greatest gains in the 3rd or 4th year of The Annual Report – a thrifty company ownership. A few took 10 years. strives for efficiency in all areas. xxiv) Owning stocks is like having children - don't xvii) When Even The Analysts Are Bored, It’s get involved with more than you can handle – Time To Start Buying The part-time stock picker probably has o The real bargains are in industries Wall time to follow 5-12 companies, & to buy and Street ignores. Giant conglomerates have sell shares as conditions warrant. There 50 analysts watching their every move. don't have to be >5 companies in the Being popular, they’re often bought up to portfolio at any time. Nobody forces you to silly PE’s. It is the whole phenomenon of own any of them. If you like 7, buy 7. If you the market buying what they are familiar like 3, buy 3. If you like 0, buy 0. with, rather than what is good. xxv) The biggest losses come from companies o When investing in a troubled industry, with poor balance sheets – Before risking buy companies with staying power. Also, money, check the balance sheet to see if the wait to see signs of revival. Buggy whips company is financially sound. & radio tubes were troubled industries xxvi) With small companies, you’re better off to that never came back. wait until they turn a profit before investing – o Pay attention to facts, not forecasts. Ask Enter early -- but not too early. Think of yourself: What do I make if I'm right, and investing in growth companies in terms of what could I lose if I'm wrong? Look for a baseball. Try to join the game in the 3rd risk-reward ratio of 3:1 or better. inning, because a company has proved itself o A stock-market decline is as routine as a by then. If you buy before the line-up is winter Colorado blizzard. If prepared, it announced, you're taking unnecessary risks. can't hurt you. A decline is a great There's plenty of time (10-15 years, at times) chance to pick up bargains left behind by between the 3rd and the 7th innings, which is those who’re fleeing the storm in panic. where the 10-50 baggers are made. If you o Long shots usually backfire or become buy in the late innings, you may be too late. "no shots." Don't buy "cheap" stocks just xxvii) If you invest $1,000, all you can lose is because they're cheap. Buy them $1,000, but you stand to gain $10,000 or because the fundamentals are improving. even $50,000, if you're patient – The average xviii) Unless You’re A Short Seller Or A Poet person can concentrate on a few good Looking For A Wealthy Wife, It Never Pays To companies, while the fund manager is forced Be Pessimistic – Since Lynch always thought to diversify. By owning too many stocks, you positively, and assumed that the economy lose this advantage of concentration. It only would improve, he was always willing to takes a handful of big winners to make a invest in Cyclicals at their nadir. Just when lifetime of investing worthwhile. it seems things can’t get any worse with xxviii) Everyone has the brainpower to make Cyclicals, things begin to get better. money in stocks. Not everyone has the xix) Companies, Like People, Change Their stomach – If you are susceptible to selling Names Either Because They’ve Gotten everything in a panic, you ought to avoid Married, Or They’ve Been Involved In Some stocks and stock mutual funds altogether. Fiasco That They Hope The Public Will Forget. xxix) If you have the stomach for stocks, but xx) Whenever The Queen Is Selling, Buy It – In a neither the time nor the inclination to do the democracy, investors vote & governments homework, invest in equity mutual funds – don’t want disgruntled investors who’ve lost Here, it's a good idea to diversify. You should money. The British learnt this in 1983, after own a few different kinds of funds, with 2 privatizations came out overpriced & managers who pursue different styles of prices dropped. Since then, the British have investing: growth, value, small companies, structured deals such that investors don’t large companies, etc. Investing in six of the lose money, at least in the short term. same kind of fund is not diversification. xxi) Investing is fun, exciting and dangerous, if xxx) If you don't study companies, you'll have you don’t do any work – Keep track of every the same success buying stocks as you do in stock’s story in a logbook. Note any new poker when betting without looking at cards. events & pay close attention to earnings. Is xxxi) If you study 10 companies, you'll find 1 it a growth, value or cyclical play? with bright prospects that aren’t reflected in xxii) Behind every stock is a company, find out the price - pleasant surprises are always to what it's doing – Stocks do well for a reason be found in the market - companies whose and do poorly for a reason. Make sure you achievements are overlooked on Wall Street. know the reasons. You have to know what xxxii) Time is on your side when you own shares you own, and why you own it. "This baby is of superior companies – You can afford to be a cinch to go up!" doesn't count. patient, even if you missed Wal-Mart in the xxiii) Often, there is no correlation between the first 5 years, it was a great stock to own in success of a company's operations and the the next 5 years. Time is against you when
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The Peter Lynch Playbook you own options. Don't invest on margin, share may truly be overpriced. Does that because a market drop can wipe you out. person ‘deserve’ to be so rich? xxxiii) The capital gains tax penalizes investors • As a personal rule, once a month, Lynch who switch too much – If you've invested in held at least 1 personal conversation with a funds that have done well, don't abandon representative of each major industry group them capriciously. Stick with them. just in case business was starting to xxxiv) Among the major world markets, the US turnaround or there were new developments ranks 8th in total return over the past decade overlooked by Wall Street. This was an – You can take advantage of faster-growing effective early warning system and in 2/10 economies by investing some assets in an cases he’d discover something important. overseas fund with a good record. • Be careful to note the name of everyone you meet. After very contact, note the company, SCUTTLEBUTT current price and a 1-2 line summary of the • Calling the Company story you’d just heard. Every investor o Amateurs never call; professionals do so benefits from keeping such notes, without all the time. For specific questions, which, it’s easy to forget buying reasons. investor relations is a good source. In small companies, you may reach high WALL STREET placed executives when you call. • Street Lag: a stock isn’t truly attractive until o Before calling, prepare questions. a number of large institutions have o Do small talk before slipping in serious recognized its suitability and an equal questions wrt business conditions, number of analysts recommend it. plans, mood at the company, anything • Don’t believe that professional management unusual in the recent quarter. Pepper has brought new prudence, sophistication & questions with little bits of information, intelligence to the market. These stock so the source thinks you’re prepared. pickers are usually right, but only for the o What you really want is a reaction to last 20% of a typical stock move. It’s that whatever script you’ve been trying to last 20% that they study for, clamour for, develop. Does it make sense? Is it and then line up for – all the while with a working? Enquire about inventories, sharp eye on the exits. The idea is to make a product/project development, capacity quick gain and then stampede out the door. utilization, prices, debt repayments, • Small investors don’t have to fight this mob. market share, expansion, asset values. They can calmly walk in the entrance when o Don’t ask, Why is the share price falling? there’s a crowd at the exit, and walk out the o Don’t ask about expected EPS directly. exit, when there’s a crowd at the entrance. Indirect, subtle way to do is to ask about • The fund manager is looking for reasons Wall Street EPS estimates. “not” to buy exciting stocks, so that he can o If your story line is well developed, then offer the proper excuses if these exciting you’ll know what to ask. Even if you stocks go up. Too small, no track record, don’t have a script, simply ask: non growth industry, union employees, ▪ What are the positives this year? unproven management, high competition – ▪ What are the negatives? these maybe reasonable concerns that merit o Sum up conversation as follows: 4 investigation, but often they’re used to fortify positives, 3 negatives. snap judgments and wholesale taboos. o You’ll find something extraordinary in • Unwritten rule: you’ll never lose your job, 1/10 calls. While calling depressed losing client money on IBM. Clients & bosses companies, 9 will confirm bad news, as will ask what’s wrong with IBM? But if an expected, but 1 will give some cause for investment in a small unknown company optimism, that isn’t generally perceived. goes bad, they’ll ask, what’s wrong with you? The unexpected can be very profitable. • Discounting = Euphemism for pretending to • Always end discussion with: which have anticipated surprising results. competitor do you respect the most? • Getting the Most out of a Broker Managements speak negatively about o You’re probably paying much higher competition 95% of the time and it doesn’t commissions if you use a full service mean much. However, nothing is more broker. Make them sweat for their bullish than a rival’s begrudging respect. money if you use their services. • Visiting Headquarters o If you use the broker as an advisor, then o Get a feel for the place. When’s the last make him do the 2 minute drill. time an analyst visited? Longer the time period, better it is. o Bad signs include fine antiques expensive furnishings, furniture, etc. o Can also meet front office employees and investor relation representatives informally at annual meetings. o Calculate the net worth of company representatives based on shares held. If you can’t imagine how a representative got so rich, and could get richer if stock rises, chances are you may be right and
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