One Up on Wall Street: How to Use What You Already Know to Make Money In Read online

  On the following page I also mention the bloated 500 times earnings shareholders paid for Ross Perot’s Electronic Data Systems. At 500 times earnings, I noted, “it would take five centuries to make back your investment, if the EDS earnings stayed constant.” Thanks to the Internet, 500 times earnings has lost its shock value, and so has 50 times earnings or, in our theoretical example, 40 times earnings for DotCom.com.

  In any event, to become a $100 billion enterprise, we can guess that DotCom.com eventually must earn $2.5 billion a year. Only thirty-three U.S. corporations earned more than $2.5 billion in 1999, so for this to happen to DotCom.com, it will have to join the exclusive club of big winners, along with the likes of Microsoft. A rare feat, indeed.

  I’d like to end this brief Internet discussion on a positive note. There are three ways to invest in this trend without having to buy into a hope and an extravagant market cap. The first is an offshoot of the old “picks and shovels” strategy: During the Gold Rush, most would-be miners lost money, but people who sold them picks, shovels, tents, and blue jeans (Levi Strauss) made a nice profit. Today, you can look for non-Internet companies that indirectly benefit from Internet traffic (package delivery is an obvious example); or you can invest in manufacturers of switches and related gizmos that keep the traffic moving.

  The second is the so-called “free Internet play.” That’s where an Internet business is embedded in a non-Internet company with real earnings and a reasonable stock price. I’m not naming names—you can do your own sleuthing—but several intriguing free plays have come to my attention. In a typical situation, the company at large is valued, say, at $800 million in today’s market, while its fledgling Internet operation is estimated to be worth $1 billion, before it has proven itself. If the Internet operation lives up to its promise, it could prove very rewarding—that part of the company may be “spun off” so it trades as its own stock. Or, if the Internet venture doesn’t do well, the fact that it’s an adjunct to the company’s regular line of work protects investors on the downside.

  The third is the tangential benefit, where an old-fashioned “brick and mortar” business benefits from using the Internet to cut costs, streamline operations, become more efficient, and therefore more profitable. A generation ago, scanners were installed in supermarkets. This reduced pilferage, brought inventories under better control, and was a huge boon to supermarket chains.

  Going forward, the Internet and its handmaidens will create some great success stories, but at this point we’ve mostly got great expectations and inefficient pricing. Companies valued at $500 million today may triumph, while companies valued at $10 billion may not be worth a dime. As expectations turn to reality, the winners will be more obvious than they are today. Investors who see this will have time to act on their “edge.”

  Back to Microsoft, a 100-bagger I overlooked. Along with Cisco and Intel, that high-tech juggernaut posted explosive earnings almost from the start. Microsoft went public in 1986 at 15 cents a share. Three years later you could buy a share for under $1, and from there it advanced eightyfold. (The stock has “split” several times along the way, so original shares never actually sold for 15 cents—for further explanation, see the footnote on .) If you took the Missouri “show me” approach and waited to buy Microsoft until it triumphed with Windows 95, you still made seven times your money. You didn’t have to be a programmer to notice Microsoft everywhere you looked. Except in the Apple orchard, all new computers came equipped with the Microsoft operating system and Microsoft Windows. Apples were losing their appeal. The more computers that used Windows, the more the software guys wrote programs for Windows and not for Apple. Apple was squeezed into a corner, where it sold boxes to 7–10 percent of the market.

  Meanwhile the box makers that ran Microsoft programs (Dell, Hewlett-Packard, Compaq, IBM, and so on) waged fierce price wars to sell more boxes. This endless skirmish hurt the box makers’ earnings, but Microsoft was unaffected. Bill Gates’s company wasn’t in the box business; it sold the “gas” that ran the boxes.

  Cisco is another marquee performer. The stock price is up 480-fold since it went public in 1990. I overlooked this incredible winner for the usual reasons, but a lot of people must have noticed it. Businesses at large hired Cisco to help them link their computers into networks; then colleges hired Cisco to computerize the dorms. Students, teachers, and visiting parents could have noticed this development. Maybe some of them went home, did the research, and bought the stock.

  I mention Microsoft and Cisco to add contemporary examples to illustrate a major theme of this book. 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 a promising new enterprise makes its debut. While I’m on the subject, a clarification is in order.

  Charles Barkley, a basketball player noted for shooting from the lip, once claimed he was misquoted in his own autobiography. I don’t claim to be misquoted in this book, but I’ve been misinterpreted on one key point. Here’s my disclaimer:

  Peter Lynch doesn’t advise you to buy stock in your favorite store just because you like shopping in the store, nor should you buy stock in a manufacturer because it makes your favorite product or a restaurant because you like the food. Liking a store, a product, or a restaurant is a good reason to get interested in a company and put it on your research list, but it’s not enough of a reason to own the stock! Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition, competitive position, plans for expansion, and so forth.

  If you own a retail company, another key factor in the analysis is figuring out whether the company is nearing the end of its expansion phase—what I call the “late innings” in its ball game. When a Radio Shack or a Toys “R” Us has established itself in 10 percent of the country, it’s a far different prospect than having stores in 90 percent of the country. You have to keep track of where the future growth is coming from and when it’s likely to slow down.

  Nothing has occurred to shake my conviction that the typical amateur has advantages over the typical professional fund jockey. In 1989 the pros enjoyed quicker access to better information, but the information gap has closed. A decade ago amateurs could get information on a company in three ways: from the company itself, from Value Line or Standard & Poor’s research sheets, or from reports written by in-house analysts at the brokerage firm where the amateurs kept an account. Often these reports were mailed from headquarters, and it took several days for the information to arrive.

  Today an array of analysts’ reports is available on-line, where any browser can call them up at will. News alerts on your favorite companies are delivered automatically to your e-mail address. You can find out if insiders are buying or selling or if a stock has been upgraded or downgraded by brokerage houses. You can use customized screens to search for stocks with certain characteristics. You can track mutual funds of all varieties, compare their records, find the names of their top ten holdings. You can click on to the “briefing book” heading that’s attached to the on-line version of The Wall Street Journal and Barron’s, and get a snapshot review of almost any publicly traded company. From there you can access “Zack’s” and get a summary of ratings from all the analysts who follow a particular stock.

  Again thanks to the Internet, the cost of buying and selling stocks has been drastically reduced for the small investor, the way it was reduced for institutional investors in 1975. On-line trading has pressured traditional brokerage houses to reduce commissions and transaction fees, continuing a trend that began with the birth of the discount broker two decades ago.

  You may be wondering what’s happened to my investing habits since I left Magellan. Instead of following thousands of companies, now I follow maybe fifty. (I continue to serve on investment committees at various foundations and charitable groups, but in all of these cases we hire portfolio managers and let them pick the s
tocks.) Trendy investors might think the Lynch family portfolio belongs in the New England Society of Antiquities. It contains some savings-and-loans that I bought at bargain-basement prices during a period when the S&Ls were unappreciated. These stocks have had a terrific run, and I’m still holding on to some of them. (Selling long-term winners subjects you to an IRS bear market—a 20 percent tax on the proceeds.) I also own several growth companies that I’ve held since the 1980s, and a few since the 1970s. These businesses continue to prosper, yet the stocks still appear to be reasonably priced. Beyond that, I’m still harboring an ample supply of clunkers that sell for considerably less than the price I paid. I’m not keeping these disappointment companies because I’m stubborn or nostalgic. I’m keeping them because in each of these companies, the finances are in decent shape and there’s evidence of better times ahead.

  My clunkers remind me of an important point: You don’t need to make money on every stock you pick. In my experience, six out of ten winners in a portfolio can produce a satisfying result. Why is this? Your losses are limited to the amount you invest in each stock (it can’t go lower than zero), while your gains have no absolute limit. Invest $1,000 in a clunker and in the worst case, maybe you lose $1,000. Invest $1,000 in a high achiever, and you could make $10,000, $15,000, $20,000, and beyond over several years. All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out.

  Let me give you an update on two companies I don’t own but that I wrote about in this book: Bethlehem Steel and General Electric. Both teach a useful lesson. I mentioned that shares of Bethlehem, an aging blue chip, had been in decline since 1960. A famous old company, it seems, can be just as unrewarding to investors as a shaky start-up. Bethlehem, once a symbol of American global clout, has continued to disappoint. It sold for $60 in 1958 and by 1989 had dropped to $17, punishing loyal shareholders as well as bargain hunters who thought they’d found a deal. Since 1989 the price has taken another fall, from $17 to the low single digits, proving that a cheap stock can always get cheaper. Someday, Bethlehem Steel may rise again. But assuming that will happen is wishing, not investing.

  I recommended General Electric on a national TV show (it’s been a tenbagger since), but in the book I mention that GE’s size (market value $39 billion; annual profits $3 billion) would make it difficult for the company to increase those profits at a rapid rate. In fact, the company that brings good things to life has brought more upside to its shareholders than I’d anticipated. Against the odds and under the savvy leadership of Jack Welch, this corporate hulk has broken into a profitable trot. Welch, who recently announced his retirement, prodded GE’s numerous divisions into peak performance, using excess cash to buy new businesses and to buy back shares. GE’s triumph in the 1990s shows the importance of keeping up with a company’s story.

  Buying back shares brings up another important change in the market: the dividend becoming an endangered species. I write about its importance on page 204, but the old method of rewarding shareholders seems to have gone the way of the black-footed ferret. The bad part about the disappearing dividend is that regular checks in the mail gave investors an income stream and also a reason to hold on to stocks during periods when stock prices failed to reward. Yet in 1999 the dividend yield on the five hundred companies in the S&P 500 sank to an all-time low since World War II: near 1 percent.

  It’s true that interest rates are lower today than they were in 1989, so you’d expect yields on bonds and dividends on stocks to be lower. As stock prices rise, the dividend yield naturally falls. (If a $50 stock pays a $5 dividend, it yields 10 percent; when the stock price hits $100, it yields 5 percent.) Meanwhile companies aren’t boosting their dividends the way they once did.

  “What is so unusual,” observed The New York Times (October 7, 1999), “is that the economy is doing so well even while companies are growing more reluctant to raise their dividends.” In the not-so-distant past, when a mature, healthy company routinely raised the dividend, it was a sign of prosperity. Cutting a dividend or failing to raise it was a sign of trouble. Lately, healthy companies are skimping on their dividends and using the money to buy back their own shares, à la General Electric. Reducing the supply of shares increases the earnings per share, which eventually rewards shareholders, although they don’t reap the reward until they sell.

  If anybody’s responsible for the disappearing dividend, it’s the U.S. government, which taxes corporate profits, then taxes corporate dividends at the full rate, for so-called unearned income. To help their shareholders avoid this double taxation, companies have abandoned the dividend in favor of the buyback strategy, which boosts the stock price. This strategy subjects shareholders to increased capital gains taxes if they sell their shares, but long-term capital gains are taxed at half the rate of ordinary income taxes.

  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 day traders in the audience who took a couple of hours off. Long-term investing has gotten so popular, it’s easier to admit you’re a crack addict than to admit you’re a short-term investor.

  Stock market news has gone from hard to find (in the 1970s and early 1980s), then easy to find (in the late 1980s), then hard to get away from. The financial weather is followed as closely as the real weather: highs, lows, troughs, turbulence, and endless speculation about what’s next and how to handle it. People are advised to think long-term, but the constant comment on every gyration puts people on edge and keeps them focused on the short term. It’s a challenge not to act on it. If there were a way to avoid the obsession with the latest ups and downs, and check stock prices every six months or so, the way you’d check the oil in a car, investors might be more relaxed.

  Nobody believes in long-term investing more passionately than I do, but as with the Golden Rule, it’s easier to preach than to practice. Nevertheless, this generation of investors has kept the faith and stayed the course during all the corrections mentioned above. Judging by redemption calls from my old fund, Fidelity Magellan, the customers have been brilliantly complacent. Only a small percentage cashed out in the Saddam Hussein bear market of 1990.

  Thanks to the day traders and some of the professional hedge fund managers, shares now change hands at an incredible clip. In 1989, three hundred million shares traded was a hectic session on the New York Stock Exchange; today, three hundred million is a sleepy interlude and eight hundred million is average. Have the day traders given Mr. Market the shakes? Does the brisk commerce in stock indexes have something to do with it? Whatever the cause (I see day traders as a major factor), frequent trading has made the stock markets more volatile. A decade ago stock prices moving up or down more than 1 percent in a single trading session was a rare occurrence. At present we get 1 percent moves several times a month.

  By the way, the odds against making a living in the day-trading business are about the same as the odds against making a living at racetracks, blackjack tables, or video poker. In fact, I think of day trading as at-home casino care. The drawback to the home casino is the paperwork. Make twenty trades per day, and you could end up with 5,000 trades a year, all of which must be recorded, tabulated, and reported to the IRS. So day trading is a casino that supports a lot of accountants.

  People who want to know how stocks fared on any given day ask, Where did the Dow close? I’m more interested in how many stocks went up versus how many went down. These so-called advance/decline numbers paint a more realistic picture. Never has this been truer than in the recent exclusive market, where a few stocks advance while the majority languish. Investors who buy “undervalued” small stocks or midsize stocks have been punished for their prudence. People are wondering: How can the S&P 500 be up 20 percent and my stocks are down? The answer is that a few big
stocks in the S&P 500 are propping up the averages.

  For instance, in 1998 the S&P 500 index was up 28 percent overall, but when you take a closer look, you find out the 50 biggest companies in the index advanced 40 percent, while the other 450 companies hardly budged. In the NASDAQ market, home to the Internet and its supporting cast, the dozen or so biggest companies were huge winners, while the rest of the NASDAQ stocks, lumped together, were losers. The same story was repeated in 1999, where the elite group of winners skewed the averages and propped up the multitude of losers. More than 1,500 stocks traded on the New York Stock Exchange lost money in 1999. This dichotomy is unprecedented. By the way, we tend to think the S&P 500 index is dominated by huge companies, while the NASDAQ is a haven for the smaller fry. By the late 1990s, NASDAQ’s giants (Intel, Cisco, and a handful of others) dominated the NASDAQ index more than the S&P 500’s giants dominated its index.

  One industry that’s teeming with small stocks is biotechnology. My high-tech aversion caused me to make fun of the typical biotech enterprise: $100 million in cash from selling shares, one hundred Ph.D.’s, 99 microscopes, and zero revenues. Recent developments inspire me to put in a good word for biotech—not that amateurs should pick their biotech stocks out of a barrel, but that biotech in general could play the same role in the new century as electronics played in the last. Today a long list of biotechs have revenue, and three dozen or so turn a profit, with another fifty ready to do the same. Amgen has become a genuine biotech blue chip, with earnings of $1 billion plus. One of the numerous biotech mutual funds might be worth a long-term commitment for part of your money.

  Market commentators fill airspace and magazine space with comparisons between today’s market and some earlier market, such as “This looks a lot like 1962,” or “This reminds me of 1981,” or when they’re feeling very gloomy, “We’re facing 1929 all over again.” Lately the prevailing comparison seems to be with the early 1970s, when the smaller stocks faltered while the larger stocks (especially the highly touted “Nifty Fifty”) continued to rise. Then, in the bear market of 1973–74, the Nifty Fifty fell 50–80 percent! This unsettling decline disproved the theory that big companies were bearproof.