Lynch Learnings

I love the books by Peter Lynch - One Up on Wall Street & Beating the Street. In my opinion the book One Up on Wall Street is the first book one should read if he wants to enter into this field. I have read the book more than once and on every reading I realized that Lynch actually says a lot with only few words. I will use this page to jot down notes for myself so that I can refer to them at will.

I will cover only the two books as of now. I will not make a distinction of what was said where. It's only the ideas I am going to focus on. Somethings are verbatim and some derived from Mr Lynch's books.

Starting with One Up on Wall Street

It's worth reminding ourselves that bull markets don't last forever and that patience is required on both sides.
The typical winner in the Lynch portfolio takes 3 to 10 years to play out.
Stock price is the least useful information but it is the most widely tracked.
On the internet companies Lynch says that few companies will dominate the area. Shareholders in these triumphant companies will prosper, while shareholders in the laggards, the has-beens, and the should-have-beens will lose money.
Whenever you invest in a company you are looking for its market capitalization to rise.
When looking at a company who has say a 100 or a 200 PE look at what it revenues need to be at say a 40 PE. Then see whether that revenue exists today for a company or not. It will be rare that such an enormous amount of revenue will be generated by some company.
On internet businesses he says there are 3 ways to invest in this theme -

First is the 'pick and shovels' method. In the gold rush most lost money but the guys who provided the picks, shovels and the jeans (Levis) made most money. Hell Levis still makes money!
Second, the 'free internet play' where actually an internet business is embedded in the business model already.
Third, where the 'brick and mortar' businesses gain by cutting costs because of internet.

Bill Gate's company wasn't in the box business; it sold the 'gas' that ran the boxes.
An amateur investor can pick tomorrow's big winners by paying attention to new developments at the workplace, the mall, the auto showrooms, the restaurants or anywhere else.
For a business it is important to keep a track of whether the future growth is going to come from and when it is likely to slow down.
You don't have to make money on every stock you pick.
Your loses are limited to the amount you invest, while your gains have no absolute limit.
Cheap stocks can always get cheaper.
A fallen stock (Bethlehem steel) may rise again. But assuming that will happen is wishing, not investing.
Speaking of long-term gains, in eleven years' worth of luncheon and dinner speeches, I've asked for a show of hands: 'How many of you are long-term investors in stocks?' To date, the vote is unanimous - everybody's a long term investor, including the day traders in the audience who took a couple of hours off.
Lynch is more interested in how many stocks went up or down i.e Advance Decline ratio rather than by how much the index went up or down.
Lynch gives a case study of the Nifty 50 stocks which fell 50%-80% in the bear market of 1973-74. If an investor had slept off in the long term this 50 bucket would have still beaten the index.
He advises not to put every penny in the stock market. He says put excess money which you will not require in the next 12 months or so.
The bearish argument always sounds more intelligent.
Stop listening to professionals.
Yes there are 10 baggers in weak markets.
People seem to be very comfortable in putting their life savings into something which they are completely ignorant about.
Ultimately it is not the stock market nor even the companies themselves that determine an investor's fate. It is the investor.
Small investors tend to be pessimistic and optimistic at precisely the wrong times.
All the math you need in the stock market you get in the fourth grade.
The early Greeks used to sit around for days and debate how many teeth a horse has. They thought they could figure it out just by sitting there, instead of checking the horse. A lot of investors sit around and debate whether a stock is going up, as if the financial muse will give them the answer, instead of checking the company.
Professional fund managers resort to 'looking good'. If a big company under performs its the company's fault but if they had invested in a small company and if that under performs then its the fund manager's fault.
Lynch like to own boring, obscure and highly profitable companies.
The stocks that Lynch tries to buy are the very stocks which traditional fund managers overlook. Lynch wants to continue thinking like an amateur as frequently as possible.
Over the long haul stocks always outperform other asset classes.
You will never get a 10 bagger in a bond - unless you are a debt sleuth.
There is no such thing as a can't miss blue-chip.
To Lynch, an investment is simply a gamble in which you've managed to tilt the odds in your favour.
Anyone who plays regularly in a monthly stud poker game soon realizes the same 'lucky stiffs' always come out ahead. These are the players who undertake to maximize their return on investment by carefully calculating and recalculating their chances as the hand unfolds.
Consistent winners raise their bet as their position strengthens, and they exit the game when the odds are against them, while consistent losers hang on to the bitter end of every expensive pot, hoping for miracles and enjoying the thrill of defeat. In stud poker and on Wall Street, miracles happen just often enough to keep the losers losing.
Clearly the stock market has been a gamble worth taking - as long as you know how to play the game.
Before investing in equities one must have 3 things on the personal front clear:

Do I own a house
Do I need the money
Do I have the qualities to be successful at investing

Only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.
Lynch lists the following qualities to succeed as an investor:

Patience
Self-reliance
Common sense
Tolerance for pain (stoic)
open mindedness
Detachment
Persistence
Humility
Flexibility
Willingness to do independent research
An equal willingness to admit to mistakes
The ability to ignore general panic
Ability to make decisions without complete information

Things are almost never clear on Wall Street, or when they are, then it's too late to profit from them. The scientific mind that needs to know all the data will be thwarted here.
The true contrarian is not the investor who takes the opposite side of a popular hot issue. The true contrarian waits for things to cool down and buys stocks that nobody cares about, and especially those that make Wall Street yawn.
When it comes to predicting the market, the important skill here is not listening, it's snoring.
Stand by your stocks as long as the fundamental story of the company hasn't changed.
Is this a good market? Please don't ask.
Remember, things are never clear until it's too late.
When the neighbors tell me what to buy and then I wish I had taken their advice, it's a sure sign that the market has reached a top and is due for a tumble.
If you want to buy stocks if the market is going up then you are doing it wrong.
When you can't find a single company that is reasonably priced or doesn't satisfy the criteria for investment then consider it to be a non investible market.
Stocks are most likely to be accepted as prudent at the moment they're not.
Don't overestimate the skill and wisdom of professionals.
Take advantage of what you already know.
Look for opportunities that haven't been discovered and certified by Wall Street - companies that are "off the radar scope."
Invest in a house before you invest in a stock.
Invest in companies, not in the stock market.
Ignore short-term fluctuations.
Large profits can be made in common stocks
Large losses can be made in common stocks.
Predicting the economy is futile.
Predicting the short term direction of the stock market is futile.
The long term returns from stocks are both relatively predictable and also far superior to the long term returns from bonds.
Keeping up with a company in which you own stock is like playing an endless stud-poker hand.
Common stocks aren't for everyone, nor even for all phases of a person's life.
The average person is exposed to interesting local companies and products years before the professionals.
Having an edge will help you make money in stocks.
In the stock market, one in the hand is worth ten in the bush.
The best place to begin looking for the ten-bagger is close to home - if not in the backyard then down at the shopping mall, and especially wherever you happen to work.
So often we struggle to pick a winning stock, when all the while a winning stock has been struggling to pick us.
The discovery of a company is not a buy signal.
Investing without research is like playing stud poker and never looking at the cards.
All you have to do is put as much effort into picking your stocks as you do into buying your groceries.
Always ask: What effect will the success of a product (you got impressed by) have on the bottom line of the company?
The size of a company has a great deal to do with what you can expect to get out of the stock.
Big stocks don't make big stock moves.
Small stocks make big moves.
Sometimes a series of misfortunes will drive a big company into desperate straits and if it recovers it will make a big price move.
Usually big companies don't make a ten bagger.
Once the relative size of the company is established Lynch places them in one of the six general categories:

Slow growers
Stalwarts
Fast growers
Cyclicals
Asset plays
Turnarounds

Growth stocks can be divided into - slow, medium and fast
Slow growers - they didn't start out this way. They grow slower than a country's gross national product. When an industry slows down most of the companies in it slow down too.
Fast growers sooner or later will turn slow growers.
The slow growers generally give generous dividends.
The stalwarts - Not very agile but faster than slow growers
If someone says I doubled my money on a stalwart ask him how long did he hold it.
Take money off the table 30%-50% with stalwarts. They offer good protection in recessions.
The fast growers - Small, aggressive new enterprises that grow 20%-25% every year.
Fast growers make 20 baggers & even 200 baggers. A couple of these can make an investing career.
There is plenty of risk in fast growers. But they know how to replicate success in one domain or geography.
The trick is to find out when they will stop growing. Because if there is no growth it will get beaten down in price.
The cyclicals - a company whose sales and profits rise and fall in predictable patterns.
Autos, tire, steel, chemicals are all cyclical companies.
Coming out of a recession the cyclicals can flourish more than stalwarts.
You can lose 50% of your investment quickly if you buy cyclical at the wrong point of time.
Cyclicals are the most misunderstood type of stocks.
The turnarounds - they have been battered, beaten, depressed and often barely drag themselves into bankruptcy.
A poorly managed cyclical is almost always a candidate for a turnaround.
Turnarounds make up lost ground very quickly.
Be cognizant of 'diworseifications'. When the company goes back to its originality it is a candidate for a turnaround.
The asset plays - A company which is sitting on something valuable but the market doesn't know it.
Asset can be cash or real estate.
Fast growers can lead exciting lives but can burn out very fast.
Putting stocks into categories is the first step to developing a story.
When someone says 'Any idiot can run this place', sooner or later someone will. This is a plus sign.
Thirteen attributes of a favorable stock:

It sounds dull - or even better ridiculous
It does something dull
It does something disagreeable
It's a spinoff
The institutions don't own it and analysts don't follow it
The rumours abound: It's involved with toxic waste and/or the mafia
There's something depressing about it
It's a no growth story
It's got a niche
People have to keep buying it
It's a user of technology
The insiders are buyers - There can be many reasons insiders sell but only one reason why they buy the stock
The company is buying back shares - alternative to buying back shares - raising dividends, developing new products, starting new operations or making acquisitions

If I could avoid a single stock, it would be the hottest stock in the hottest industry which everyone talks about.
Hot stocks rise up very fast but come down even faster. Going way beyond the price you bought them at.
If you had to live off the profits of hot stocks soon you will be on welfare.
In business, imitation is the sincerest form of battery.
Negative growth industries do not attract a flock of investors.
Avoid the next IBM, the next Disney, the next McD
When in doubt, tune in later.
The company which sells 25% of its wares to a single customer is in a precarious position.
Sometimes it takes years for the price to catch up with the value of a stock. The waiting period lasts so long that investors start to doubt their thesis. But value always wins - or at least most of the times that we believe in this.
The share of a stock is not a lottery ticket.
The PE can be thought as the number of years it will take to earn back your investment.
Buying low PE strategy makes no sense to Lynch when the 'low' is not comparable.
It is silly to get bogged down in PEs but you don't want to ignore them.
Company PEs don't exist in a vacuum, the whole market has a PE.
There are 5 basic ways in which companies can increase earnings:

Reduce costs
Raise prices
Expand into new markets
Sell more of its products in old markets
Revitalize, close or dispose of a losing operation

Once you can tell the story of a company to a child and he or she understands it then you have an understanding of the company.
When an executive of a company says his competitor is doing good then there is something really good in the competitor.
When seeing the same sky the people in mature industries see clouds but people in immature industries see pie.
Wandering through stores and tasting things is a fundamental strategy.
Some key numbers to analyse:

Percent of sales
PE ratio - PEG ratio (below 1 is poor, 1.5 is ok, over 2 is good)
Cash position
Debt factor - It is debt which determines which companies survive and which go bankrupt. Bank debt is the worst as it van be called. Funded debt is better as long as the company pays the interest.
Dividends - smaller companies are usually not paying dividends because they are using that cash to grow
Book value - An investor has to understand what the actual book value is
Any hidden assets
Cash flows - Free Cash flow is the metric to track
Inventories - if inventory grows faster than sales it is a big red flag. But if the company has been depressed and the inventories have been reducing it is a good sign
Pension plans
Growth rates - the only growth rate which matters is that of the earnings. If you find an investment which increases sales year after year despite increasing its selling price it is probably a terrific investment. A 20 PE company growing at a 20% growth rate is better than a 10 PE company growing at 10%.
The bottomline - depressed companies on the verge of disaster can become very good rebounds.

There are 3 phases to a company's life - startup, rapid growth and mature.
The startup phase is the riskiest, the rapid growth phase is where the most money is made and the mature phase is where the company runs into limitations.
Airlines are a precarious business just like restaurants.
It is only by sticking through a strategy through the good and bad years will you maximize long term gains.
In small portfolios I'd be comfortable owning 3 to 10 stocks.
If you don't like researching stick to index funds.
A price drop in a good stock is only a tragedy if you sell at that price.

If you can't convince yourself that "When I'm down 25% I am a buyer" then you will never make long term profits.

The best time to buy is when you have convinced yourself that you found a good business at a reasonable price.
The second best time to buy is during the crashes, if you have the courage.
A drumbeat effect is when a message is repeated again and again until you can't get away from it.
When to sell a slow grower:

Lost market share consecutively over 2 years
No new products, no R&D, the company appears to be resting on its laurels
Acquisitions which are diworsefications
Even at a lower price the dividend yield will not be high enough

When to sell a stalwart:

New products introduced have had mixed reactions
Stock is overvalued to similar companies
No insider buying
A division which contributes to 25% of sales is under threat or about to slump
Growth rate has been slowing down

When to sell a cyclical:

Towards the end of the cycle but who knows when it is
Very difficult to understand dynamics of cyclicals
PE becomes small at the end usually

When to sell a fast grower:

A growth company's PE usually grows bigger (this is a good sign)
Same store sales down
New store results are disappointing
Top executives leave to join rival
The company is selling stories to institutional investors
The stock is overvalued

When to sell a turnaround:

Debt which declined for many quarters again has increased
Inventories rising faster than sales
Overvaluation

When to sell an asset play:

Equity dilution
Corporate raiding why famous investors at times
Sale of a division at a lower value than expected
Rise in institutional ownership

Twelve silliest things people say about stock prices:

If it's gone down this much already, it can't go much lower
You can always tell when a stock's hit bottom
It it's gone this high already, how can it possibly go higher
It's only $3 a share: What can I lose
Eventually they always come back
It's always darkest before dawn
When it rebounds to $10, I'll sell
What me worry? Conservative stocks don't fluctuate much
It's taking too long for anything to ever happen
Look at all the money I've lost: I didn't buy it
I missed that one, I'll catch the next one
The stock's gone up, so I must be right or...The stock's gone down so I must be wrong

The checklist for stocks in general:

Study valuations of the company and the industry
Lower the institutional, the better
Earnings growth and its consistency
Strong or a weak balance sheet. Pay particular attention to Debt Equity ratio
The cash position of the company

The additional checklist for slow growers:

Check dividends and it as a percentage to earnings

The additional checklist for stalwarts:

Valuations is important
Check for diworseifications
Long term growth rate
Check how did the stock do during recessions

The additional checklist for cyclicals:

Watch the inventories
Anticipate a shrinking PE as the business recovers
Figure out the cycle of the company
The worst the slump in auto industry, the better its recovery

The additional checklist for fast growers:

Check contribution of the star product to its total earnings
What is the growth rate in recent years
Has the company duplicated its success in more than one location
Does the company still have the room to grow
Is the stock selling at a PE ratio close to the earnings growth rate
Is the expansion speeding up or slowing down
Institutional holding

The additional checklist for turnarounds:

Can the company survive a raid by the creditors
If already bankrupt what is left for the shareholders
How is the company supposed to turnaround
How will business comeback
Is the company cutting costs

The additional checklist for asset plays:

What is the value of assets
How much debt is there to detract from assets
Is the company taking on new debt
Is there a raider to help the shareholders

Understand the true nature of the company.
Put stocks into categories it will help have a better idea.
Big companies make small moves. Small companies make big moves.
Be suspicious when companies grow 50-100% in a year
Avoid hot stocks in hot industries.
Distrust diversification they usually end up as diworseification.
Long shots almost never payoff.
It is always better to miss the first move of a company's stock price.
People get valuable fundamental information from their jobs.
Separate all stock tip from the tippers. Even if the tippers are very smart.
Some stock tips from industry experts is usually very valuable.
Invest in simple companies which appear dull and mundane.
Moderate fast growers in non growth industries are ideal investments.
Look for companies with niches.
When looking at companies in depressed industries look for ones with good financial position.
Companies that have no debt don't go bankrupt.
Managerial ability may be important but it's quite difficult to assess it.
A lot of money can be made when a troubled company turns around
Find a story line to follow a company's progress.
Look for companies that buy back their own shares.
All things being equal favour companies in which management has a higher stake.
Insider buying is a positive sign especially when many individuals are buying.
Devote an hour to investment research. Portfolio calculations doesn't count as investment research.
Be patient. Watched stocks never boils.
Buying stocks based on stated book value alone is dangerous.
Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.
Markets, like individual stocks can move in the opposite direction of the fundamentals over the short term.
You can make serious money by compounding a series of 20-30 percent gains in stalwarts.
Buying a company with mediocre prospects just because it is cheap is a losing technique.
Selling a fast grower if it is slightly overpriced is a losing technique.
Companies don't grow for no reason, nor do fast growers stay that way forever.
A stock doesn't know that you own it.
Don't get complacent that you stop tracking your ten bagger.
When favorable cards turn up add to your bet and vice versa.
You won't improve the results by pulling out the flowers and watering the weeds.
There is always something to worry about.
Keep an open mind to new ideas.
You don't have to kiss all the girls.

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