Keep on the lookout for tomorrow’s big baggers. You’re likely to find one.
Peter Lynch is America’s number one money manager. He believes average investors can become experts in their own field and can pick winning stocks as effectively as Wall Street professionals by just doing a little research.
This book is a must on every investors’ shelf purely for inspirational purposes. If you hadn’t realised how many great companies and how easy it is to make money in stocks, you will realise once you’ve read this book. Multibagger stocks are all around us and they are achievable for the average person who puts the effort in.
The advantages of dumb money
Stop listening to professionals! Dumb money is only dumb when it listens to the smart money. The amateur investors has many built-in advantages that, if exploited, should result in beating the experts comfortably.
The power of common knowledge helps a lot in stocks. Analysts can quantify everything and crunch the numbers, but anyone can see if a business is expanding or a certain product is a best-seller and follow up on the lead. Peter’s wife Carolyn found L’eggs, which Peter promptly bought after doing the research and it became a six bagger before being taken over.
An example of a private investor who reads the Wall Street Journal and follows tips is given. The unfortunate investor doesn’t realise that by following the smart money, he is the last in the food chain and very often by the time everyone has heard about the exciting prospect then it is the end of the move. Remember Bitcoin? Everyone was stumbling over themselves to buy it at $16,000, $18,000, and $20,000, but nobody wants it now at $3,000.
We can find terrific opportunities in everyday life way before the media and the institutions start to pick up on it. The average person is exposed to interesting companies and products years before the professionals. Lynch advises that we should not invest if we need the money in the immediate future and that we should make sure we have the personal qualities that will bring success in stocks.
The qualities necessary for investing
This list of qualities includes patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, humility, flexibility, a willingness to do independent research, an equal willingness to admit mistakes, and the ability to ignore general market panic. IQ is not relevant though he does suggest that the real geniuses get too bogged down in theory and calculations to make money in the stock market.
Winners are everywhere. The author gives plenty of US examples but some of these are from the 70s. Who hasn’t heard of Fever-Tree, ASOS, Boohoo, Domino’s? All of these stocks were and are used in everyday life. What about Amazon? Since the start of 2015, Amazon stock went from below $300 to hitting a peak of $2,000. Facebook? Netflix? Google? We don’t even need to find these companies when they are small – any one of us could’ve decided to look into the story.
Developing the story
We might have a great idea, or a lead, to follow this up properly we need to give it the care it deserves. Investing without researching is like playing poker and not even looking at the cards. For some reason, the stock market is the only industry where people think they can turn up and get rich without doing any work. People who will spend half a day trying to save £50 on an American style fridge freezer will lump their life savings into a stock because some anonymous pseudonym on a bulletin board told them it was going to the moon. To make money in stocks, leads need to be chased and developed into a story. There’s a story behind every stock – learn what it is doing and follow it. You never know when its fortunes may change.
The Two Minute Drill
If you can’t give a two minute monologue on the stock, its fundamentals, its challenges, and its story, then you don’t deserve to own the stock. Remember, a stock isn’t a lottery ticket. It’s part ownership in a business.
The six categories of stocks
- Lost momentum because they became too big
- Started out as fast growers but eventually slowed down
- Likely to pay a generous and regular dividend
- Income investors would prefer this company but not for capital growth
When investing in slow growers for the dividends (no other reason to buy them) check what percentage of the earnings are being paid out as dividends. If it’s a low percentage then the company has a cushion in hard times, but if it it’s a high percentage the dividend could be at risk.
- Good defensive stocks that do well in corrections and recessions
- Tend to be established brands that will be around for a long time
- Stable and predictable cash flows
As these companies aren’t likely to go out of business, check the P/E ratio to tell whether you’re paying too much. Look for diworseifications (diversifications that are bad for the business) that may reduce earnings in future.
- Lynch’s favourite investments – the land of the ten baggers
- One or two of these can make a career
- Look for good balance sheets and how much to pay for growth
- The trick is to figure out when they’ll stop growing
Growth stocks that are speeding up their rate of growth get the market excited the most and have the biggest potential for capital growth. Stocks that still have room to grow are the best – there’s no point buying a national roll-out story if the brand is in every part of the country!
- Sales and profits rise in regular if not completely predictable fashion
- Automobile and airline industry, tyre companies, commodities, are all examples
- Cyclicals flourish coming into a vigorous economy as they’ve been beaten down
- Also works the other way – be careful not to mistake a cyclical with a stalwart
The key here is to keep an eye on the inventories and the supply-demand relationship. New entrants into the market pose a threat too.
- Battered, depressed, and often barely able to drag themselves into bankruptcy
- Price smashed so much that anything positive is exaggerated
- Investing in turnarounds has more to do with the stock than the general market
Most important here is can the company survive a raid by its creditors? If it’s going to go bankrupt – what would even be left for the shareholders? How does the company intend to turn around? Costs being cut is often a good sign, but check how much those costs will be cut by and what the effect on the business will be.
- A stock that is sitting on something valuable that the market has overlooked
- Can be tangible and intangible that is sat on the balance sheet
- Negative Enterprise Value means more cash than the market cap and debt
Check for the value of the assets and for any hidden assets. Look for debt too because creditors are always first in line to be paid in front of shareholders. If the company is taking on new debt, this makes the assets less valuable, so check if this debt is necessary and good for the business.
The twelve silliest (and most dangerous) things people say about stock prices
You can always tell when a stock’s hit the bottom
Bottom fishing is a popular private investor pastime, but it’s usually the private investor who is hooked and not the stock. Catching falling knives is gambling, and gamblers don’t win.
It’s possible to spot turnarounds, as you may see that the business is now priced at £9 per share yet has £11 per share in cash and no debt, but that stock can still fall lower. I believe it’s best for the price action to confirm this.
If it’s gone this high already, how can it possibly go higher?
There is no limit to how high a stock can go. Stocks don’t care who owns them and what price you bought and sold it for. When owning shares, your potential gain is infinity.
It’s only $3 a share: what can I lose?
Many people succumb to the fallacy that buying a $3 stock is a lot safer than buying a $50 stock. I’m not sure why, because if they both go to zero then you lose 100%. Whenever you buy a stock, you can lose 100% of your money.
Interestingly, many shorters tend to short harder when a stock is so obviously going up the wall, and bankruptcy is almost a certainty. They like to take their positions nearer to the bottom than the top. It doesn’t bother them if they get involved at $8 or $6 because if the stock goes to zero they make exactly the same!
Eventually they always come back
How many people bought Kodak thinking that they would come back? How many people bought Blockbuster thinking they would go back up again? How many people bought Northern Rock because it was “too big to fail”? How many people bought Carillion because it was cheap at 20p?
How many of these people lost all of their money? All of them.
The problem with unprofitable companies – especially on AIM – is that investors tend to get diluted so much that for the share price to get back to breakeven for them, the company would need to increase in value several hundred times. It’s hard enough hitting a hundred-bagger – what is the likelihood a piece of trash with spivvy management is going to be that stock?
It’s always darkest before the dawn
Whilst this is technically true, it is not true for stocks. That’s because nobody knows when the dawn is. In 2014 when the oil price was crashing, many thought it couldn’t get any worse, only for it to get plenty worse. It’s much better (for your wealth, and possibly health) to wait for the dawn.
Sometimes it’s darkest before the dawn. Other times it’s always darkest before pitch black.
When it rebounds to $10, I’ll sell
We’ve all been guilty of this before, and there’s no shame in that. However, there is shame in repeating this mistake as it is loss aversion. Remember, stocks don’t care what price we bought them.
Peter says that whenever he is tempted to fall for that one, he reminds himself that unless he is confident enough in the company to buy more shares, he should be selling immediately.
What me worry? Conservative stocks don’t fluctuate much
There isn’t a simple stock you can own then afford to ignore. You can win and lose big in every stock.
It’s taking too long for anything to ever happen
Something that is certain to occur: if you give up on a stock out of boredom then something will happen the day after you sell it. Peter calls this “postdivestiture flourish”.
Peter says that he makes most of his money in the third of fourth year of owning something (that tells me personally he is too early, but I suppose when you’re running a multi-billion dollar fund you might have problems in where to park your cash). He remarks that it takes patience to hold onto stock in a company that excites you but everyone else seems to ignore. You begin to question your research. But where fundamentals shine through, patience is often rewarded.
Look at all the money I’ve lost: I didn’t buy it!
This one needs no explanation. Not buying anything didn’t lose anyone any money ever. Missed out? Yes. But there’s always another stock.
Thinking about someone else’s gains as your own personal loss is not healthy thinking in the stock market. There is enough money to go around for everyone who deserves it, and so we should try to think abundantly.
I missed that one; I’ll catch the next one
The problem here is that the next one is rarely as good, and the reason the first one is so good is because ut’s the first. If you missed the first one, you’ve not lost a single penny. But if you buy the second one on account of it being exactly like the first one, then you may end up losing more than pennies!
In most cases it’s better to buy the original good company at a high price than it is to jump onto the next one at a bargain price (unless you have good fundamental analysis that says otherwise).
The stock’s gone up so I must be right, or the stock’s gone down so I must be wrong
The price has absolutely nothing to do with you being right. If your stock is up 20% in two months then all that it tells you is that people are willing to pay 20% more for the company two months down the line. Maybe the company has not even issued any news, in which case the person who paid 20% more is investing in the same business with the exact same information available as you did. How could you possibly be right from that?
Checklist for investing in stocks
- P/E ratio – is this high or low for this specific company and for similar companies in the industry?
- What is the percentage of institutional ownership? The lower, the better
- If insiders are buying then this is positive, so is the company buying back shares
- Check the record of earnings to date and if these are sporadic or consistent
- Look for a strong balance sheet (debt to equity ratio) and how it is rated for financial strength
- Check the cash position – sometimes companies can have well over half their market cap in cash with no debt meaning you get the business for a steal
Peter believes that the market will always correct and that these declines are great opportunities to buy stocks in companies you like. These corrections push outstanding companies to bargain prices.
To come out ahead, you don’t need to be right all of the time, or even the majority of the time. By running winners these can pay for a lot of losers. Do not water the weeds – that is cutting your winners to add to your losers.
Understand what the company you hold does and the specific reason for holding the stock.
Long shots almost never pay off. It’s better to miss the first move in a stock and wait to see if the company’s plans work out.
People get incredibly valuable fundamental information from their jobs and everyday lives that may not reach the professionals for months or even years.
Look for companies with niches (and companies with moats).
Companies in which management have significant personal investments should be chosen over companies ran by people who only benefit from their salary (all things being equal).
Spend at least an hour a week on investment research. You’ll thank yourself in years to come.
Be patient. Watched stock never boils.
When choosing a new stock, spend at least the amount of time that you would when choosing a new fridge-freezer.