Beating the Street by Peter Lynch
This book is one of the most highly recommended introductory books for stock picking. I found it very informative when I read it as a junior in college.
There is some stuff that is outdated but there is also some advice that is still relevant. One piece of advice I remember from Peter Lynch was to go to the malls and look at which stores are the most crowded and then look at the stocks.
Peter would get advice on this from his wife and kids as well. This is still kind of relevant but not nearly as much since a lot more of retail is done over the internet today.
There is a lot of good information on investing in S&L companies and cyclical companies in this book as well. One of the most important and fundamental lessons from this book about stock picking is:
"The stock market can test your patience, but if you believe in a company, you hold on until your patience is rewarded."
When yields on long term government bonds exceed the dividend yield of the s&p 500 by 6% or more, sell your stocks and buy bonds.
"The person who never bothers to think about the economy, blithely ignores the condition of the market, and invests on a regular schedule is better off than the person who studies and tries to time his investments, getting into stocks when he feels confident and out when he feels queasy."
A decline in stocks is not a surprising event, its a recurring event- as normal as frigid air in Minnesota. If you live in a cold climate you expect freezing temperatures, so when your outdoor thermometer drops below zero, you don't think of this as the beginning of the next Ice Age. You put on your parka, throw salt on the walk, and remind yourself that by summertime it will be warm outside.
When interest rates go higher a bond fund loses value just like an individual bond with a similar maturity. This is because there are other bonds out there now that offer higher coupon payments because interest rates are higher.
Since small companies are expected to grow at a faster rate than the big companies, small stocks generally sell at a higher p/e ratios than big stocks.
Because small companies grow faster than S&P companies (larger companies) you would expect the p/e ratio of small companies to always be larger than the average p/e ratios of big companies. This isn't the case when the average p/e ratio of smaller company index is equal to the average p/e ratio of big company index, this is the time to buy small companies because based on the p/e ratio they are cheap.
Divide the average p/e ratio of smaller company index (Russell 2000) by the average p/e ratio of bigger company index (S&P 500) and invest when multiple is 1.2 or less.
insurance companies are cyclical. Invest in them when interest rates first begin to rise. it's not uncommon for an insurance stock to double after a rate increase and double again on the higher earnings that result from the rate increase.
Bonds sells for 20 cents on a dollar the stock price will be most guaranteed to sell for nothing. Look at chances of paying back principle on bonds. Look at bond price of low priced stock.
Cyclicals are like black jack because if you invest too long you will lose all your profits.
Lynch, rock and run analysis, the more industries and companies you learn and understand the more stocks you will love. Lynch loved over 100 for 3 years and 73 one year.
Buy stocks form low list in November and December and watch them go up in January because of taxes. This is called the January effect. Prices rebound in January after falling off in late fall due to taxes. This works better for smaller companies.
Go to the mall to find new prodigy stocks. Peter lynch uses the Burlington mall in Boston.
In double-decker malls the most popular retailers are found on the upper floors because mall owner wants customers to walk through bad stores to get to good stores.
What sells in one town will most likely sell in another town.
Look at same store sales for retailers and restaurants. store products sell at a discount in discount stores like Target and Wal-mart and at premiums in specialty and department stores like Lord and Taylor and Neiman Marcus. This gives the company a price niche.
The p/e of a stock (preferably a growth stock) should sell at or below the growth percentage. Growth percentage in these terms are the expected increase (or growth) in earnings for the next year. How much are earnings supposed to grow by?
Sometimes you have to look at the worst places where other investors aren't willing to look to really find out the real story. For example peter lynch looked at median house price for the real estate market when real estate market was in distress and realized that the median house price was going up for the past 3 years. Use median house price and the affordability index from the national association of home builders and the percentage of mortgage loans in default.
When a company buys back shares that once paid a dividend and borrows the money to do it it enjoys a double advantage. The interest on the loan is tax deductible and the company is reducing its outlay for dividend checks which it had to pay in after tax dollars.
The most fundamental measure of a company's health is equity over assets
The following is a simple evaluation for Spenders and Lending companies like banks:
1) If a savings and loan company has a stock price that is below their ipo price then it is worth researching.
2) An equity to asset ratio for savers and lenders of below 5% is not healthy. 5%-7% is moderate and above 7.5 is good and should be the benchmark.
3) Look for constant dividend growth and a good yield. Banks usually offer good dividends. Remember if they cut their dividend even by a cent, caution should be taken and you probably shouldn't invest.
4) Most of S&L assets are in loans so you need to look at who and how they are lending money to. Any S&L that is engaging in high risk loans should always be avoided. Look at sec filings to determine what types of loans they are giving out. If they are not lending high risk loans that you can trust their book value.
5) Look at P/E ratio. Lower means cheap and that's what we want. Compare to industry and S&P 500
6) No high risk assets (like bad loans) should exceed 5-10 percent.
- To calculate high risk loans you check the annual report for the dollar value of all construction and commercial real estate lending listed under assets. Then find the dollar value of all outstanding loans.
Dollar value of all construction and commercial real estate lending
Dollar value of all outstanding loans
7) 90 day non performing assets. These are loans that have already defaulted. This number should be less than 2% of the companies' total assets and should be falling and not rising.
8) Real Estate owned is the property for an S&L that has already foreclosed...this is yesterday's problems as Lynch calls it because the S&L already took a loss on the books for these. Since the loss has already been taken this isn't as significant problem as non-performing assets. If real estate owned is on the rise this is a very bad thing. S&L's aren't in the real estate business so it is hard for them to sell real estate and it cost lots of money to keep fixing the properties.
It is bad for any company to reproduce more shares to the public because it is decreasing the value of the shares. Think of it as like when the government prints too much money.
A sneak way that banks and S&L's camouflage problem loans is "if a developer asks to borrow one million dollars for a commercial project, the bank offers him $1.2 million on the basis of an inflated appraisal. The extra 200,000 is held in reserve by the banks. If the developer defaults on the loan the bank can use this extra money ($200,000) to cover the developer's payments. That way what has turned into a bad loan can still be carried on the books as a good loan - at least temporarily" The best way Lynch says to avoid this is to not invest in S&L's with large portfolios of commercial real estate.
Like I learned in my IPO evaluation, companies tend to under price a stock when it goes public. When a company IPOs they raise additional capital from investors and this capital usually goes to the entrepreneur or the original found and his shareholders. This isn't the case for S&L's. Because the depositors and directors own S&L's before they go public the extra equity or capital raised by going public goes back to the company instead of the founder's pockets. This means that it isn't a bad idea to invest in S&L's when they first go public UNLIKE OTHER COMPANIES. [My Note: Be aware that 18 years later Wall Street probably caught onto this brilliant idea.]
Lynch's example of a S&L keeping the additional capital..."Say your local thrift had $10 million in book value before it went public. Then it sold $10 million worth of stock in the offering-1 million shares at $10 a piece. When this $10 million from the stock sale returns to the vault, the book value of this company has just doubled. A company with a $20 book value is now selling for $10 a share.
Buying on good news isn't that bad although you may lose a couple of points. Buying on bad news is a risk that your stock could go a lot lower. Overall, buying on good news is healthier in the long run and you improve your odds considerable by waiting for the proof.
No matter how good a dividend, you will not prosper if the earnings don't continue to grow over the long run. A year end review for a stock picker is to go over your portfolio company by company and try to find a reason that the next year will be better than the last. If you can't find such a reason that the upcoming year won't be better than the last you need to ask yourself, "Why do I own this stock?"
Phantom earnings that can't be claimed are free cash flow. [Free Cash Flow is net income plus non cash charges minus capital expenditures minus changes in working capital]
Cyclicals are aluminum, steels, paper producers, auto manufacturers, chemicals, and airlines.
A low p/e is bad for cyclicals because they are at the end of their prospectus period. Cyclical is a game on anticipating. You are anticipating when the company's upturn will be.
When used car prices drop in price it means they can't sell and that new cars aren't selling either. It is the opposite if used car prices are going up at dealership. New car prices are going up and there is a demand for them.
Corporate economist is a good way to tell if cars are in demand because it shows actual sales and trend (the predicted amount of sales for the year based on demographics). The difference between actual and trend is units of pent up demand and this is what we need to know about. Pent-up demand tells us if cars are in demand. The lower the number of pent up demand the better because this shows us that people are holding off on buying cars and there will be a sales boom soon.
After you sell auto stocks and the pent-up demand is used up you should wait about 4-5 years because this is how long lynch believes people will wait to buy new cars or start up the new pent-up demand.
Pg 247 sums up the distress in utilities.
Stock warrants are options to buy a stock at a higher price.
Fannie Mae earned a lot of money during such times because the cost its borrowing decreased while the proceeds from its portfolio of fixed rate mortgages stayed constant. When interest rates went up the cost of borrowing increased and Fannie Mae lost a lot money.
What separates the good restaurant chains from the bad ones are: capable management, adequate financing and a methodical approach to expanding. Slow and steady is acceptable in this case.
When a company tries to open more than 100 new units a year its likely to run into problems. In this rush to glory it can pick the wrong sites or the wrong managers, pay too much for real estate, and fail to properly train the employees.
For a restaurant company to break even, the sales have to equal the amount of capital invested in the operation. You follow the restaurant story the same way you follow a retailer. The key elements are growth rate, debt and same store sales. You would like to see the same store sales increasing every quarter. The growth rate should not be too fast - above 100 new outlets a year the company is in a potential danger zone. Debt should be non existent if possible or as low as possible.
My calculation for break even would be total invested capital (common stock, preferred stock, and long term debt divided by the amount of chain restaurants. This will give you the average amount of capital invested in each chain and then you divide the revenues by each chain segment. Revenues per chain should exceed capital invested per chain.
Never have a buy and forget strategy
You should check up on your stocks every 6 months according to Lynch. When doing these check ups you need to ask yourself: 1) is the stock still attractively priced relative to earnings? and 2) what is happening in the company to make the earnings go up?
"When the best company in an industry is selling at a bargain price, it often pays to buy that one, as opposed to investing in a lesser competitor that may be selling at a lower price"
There are tax advantages and high yield advantages that occur when you invest in a master limited partnership.
Peter Lynch's analyzing a deal concerning Cedar Fair..."Cedar fair was earning $1.80 a share prior to the purchase. With a million new shares on the books, it will have to come up with an extra $18 million in earnings to maintain the status quo. It will also have to pay $1.7 million in interest on the $27 million it borrowed to make the acquisition. Where will Cedar Fair get this $3.5 million in extra earnings plus interest payments? From the estimated annual revenues in the company they are acquiring"
You can't hold on to a cyclical stock the way you hold on to a retailer in the midst of expansion.
Whether a million investors made or lost money on Chrysler, last month has no bearing on what will happen this year. Lynch tries to teach each potential investment as if it had no history - this is called the be-here-now approach. What is important is whether the stock is cheap or expensive today based on its earnings. Chrysler example: price was $21-$22 and earnings potential was $5-$7)
Pg 305-307 are Lynch's 25 Golden Rules
Undervalued companies are what lynch searches for and they tend to be in industries that are out of favor.
Once again when billions of dollars are pouring into mutual funds, as they have in recent years, it pays to invest in the folks who own and operate the mutual funds.