Investing Insights from the Book ‘Beating The Street’ by Peter Lynch
INVESTOPAPER
‘Beating The Street’ is one the important books on investing written by the legendary mutual fund manager Peter Lynch. In the book, Lynch explains his investing strategies and also offers advice on how to select stocks and mutual funds for investing. Here, we have compiled some of the important excerpts from the book. Hope it is helpful. Beyond these valuable lessons, the book offers some practical examples while selecting the stocks which Lynch himself used in his investment decision making.
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Important Excerpts From Beating The Street’
There’s a Tolstoy story that involves an ambitious farmer. A genie of some sort offers him all the land that he can encircle on foot in a day. After running at full speed for several hours, he acquires several square miles of valuable property, more soil than he could till in a lifetime, more than enough to make him and his family rich for generations. The poor fellow is drenched with sweat and gasping for breath. He thinks about stopping-for what’s the point of going any further?-but he can’t help himself. He races ahead to maximize his opportunity, until finally he drops dead of exhaustion.
As an average investor, you don’t have to own more than a handful of stocks and you can do the research in your spare time. If no company appeals to you at the moment, you can stay in cash and wait for a better opportunity.
People who are no good at picking stocks are the very ones who say that they are ‘playing the market’, as if it is a game. When you ‘play the market’ you’re looking for instant gratification, without having to do any work. You’re seeking the excitement that comes from owning one stock one week, and another the next, or from buying futures and options.
If you hope to have more money tomorrow than you have today, you’ve got to put a chunk of your assets into stocks. Maybe we’re going into a bear market and for the next two years or three years or even five years you’ll wish you’d never heard of stocks. But the 20th century has been full of bear markets, not to mention recessions, and in spite of that the results are indisputable: sooner or later, a portfolio of stocks will turn out to be a lot more valuable than a portfolio of bonds or CDs or money market funds.
Whatever method you use to pick stocks, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn’t the head but the stomach that determines the fate of the stock picker.
A good company usually increases its dividend every year.
You can lose money in a very short time but it takes a long time to make money.
The stock market really isn’t a gamble, as long as you pick good companies that you think will do well, and not just because of the stock price.
You can make a lot of money from the stock market, but then again you can also lose money, as we proved.
You have to research the company before you put your money into it.
When you invest in the stock market, you should always diversify.
You should invest in several stocks because out of every five you pick one will be very great, one will be really bad, and three will be OK.
Never fall in love with a stock, always have an open mind.
Just because a stock goes down doesn’t mean it can’t go lower.
Over the long term, it’s better to buy stocks in small companies.
Hold no more stocks than you can remain informed on.
You want to see, first, that sales and earnings per share are moving forward at an acceptable rate and, second, that you can buy the stock at a reasonable price.
It is well to consider the financial strength and debt structure to sell if a few bad years would hinder the company’s long-term progress.
The key to making money in stocks is not get scared out of them. In dieting and in stocks, it is the gut and not the head that determines the results.
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.
While catching up on the news is merely depressing to the citizen who has no stocks, it is a dangerous habit for the investor. Who wants to own shares in the Gap if the AIDs virus is going to kill half the consumers, and the hole in the ozone the other half, either before or after the rain forest disappears and turns the Western Hemisphere into the new Gobi Desert, an event that will likely be preceded, if not followed, by the collapse of the remaining savings and loans, the cities, and the suburbs?
The best way not to be scared out of stocks is to buy them on a regular schedule, month in and month out. If you don’t buy stocks with the discipline of adding so much money a month to your holdings, you’ve got to find some way to keep the faith.
Keeping the faith and stockpicking are normally are normally not discussed in the same paragraph, but success in the latter depends on the former. You can be the world’s greatest expert on balance sheets or p/e ratios, but without faith, you’ll tend to believe the negative headlines. You can put your assets in a good mutual fund, but without faith you’ll sell when you fear the worst, which undoubtedly will be when the prices are their lowest.
What sort of faith am I talking about? Faith that America will survive, that people will continue to get up in the morning and put their pants on one leg at a time, and that the corporations that make the pants will turn a profit for the shareholders. Faith that as old enterprises lose momentum and disappear, exciting new ones such as Wal-Mart, Federal Express, and Apple Computer will emerge to take their place. Faith that America is a nation of hardworking and inventive people, and that even yuppies have gotten a bad rap for being lazy.
In 39 out of the 40 stock-market corrections in modern history, I would have sold all my stocks and been sorry. Even from the Big One, stocks eventually came back. A decline in stocks is not a surprising event, it’s 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.
A successful stockpicker has the same relationship with a drop in the market as a Minnesotan has with freezing weather. You know it’s coming, and you’re ready to ride it out, and when your favorite stocks go down with the rest, you jump at the chance to buy more. The story of the 40 declines continues to comfort me during gloomy periods when you and I have another chance in a long string of chances to buy great companies at bargain prices.
The reason that stocks do better than bonds is not hard to fathom. As companies grow larger and more profitable, their stockholders share in the increased profits. The dividends are raised. The dividend is such an important factor in the success of many stocks that you could hardly go wrong by making an entire portfolio of companies that have raised their dividends for 10 or 20 years in a row.
How much should invest in stocks depends on how much you can afford to invest in stocks and how quickly you’re going to need to spend this money.
People who sleep better at night because they own bonds and not stocks are susceptible to rude awakenings. A 30-year Treasury bond that pays 8 percent interest is safe only if we have 30 years of low inflation. If inflation returns to double digits, the resale value of an 8 percent bond will fall by 20-30 percent, if not more. In such a case, if you sell the bond, you lose money. If you hold on to it for the entire 30 years you’re guaranteed to get your money back, but that money (the principal) will be worth only a fraction of what it’s worth today. Unlike wine and baseball cards, money is cheapened with age.
The lesson here is: don’t spend a lot of time poring over the past performance charts. That’s not to say you shouldn’t pick a fund with a good long-term record. But it’s better to stick with a steady and consistent performer than to move in and out of funds, trying to catch the waves.
The stock market is a fickle business, although it’s difficult to believe that today, after so many years of exciting gains. Severe corrections lead to long stretches when nothing happens, Wall Street is shuned by the magazine editors, nobody is bragging about stocks at cocktail parties, and the investor’s patience is sorely tested. Dedicated stockpickers begin to feel as lonely as vacationers at off-season resorts.
The extravagance of any corporate office is directly proportional to management’s reluctance to reward the shareholders.
Rather than being constantly on the defensive, buying stocks and then thinking of new excuses for holding on to them if they weren’t doing well, I tried to stay on the offensive, searching for better opportunities in companies that were more undervalued than the ones I’d chosen.
Fortunately, I never invested much money in things I didn’t understand, which included most of the technology companies.
I realize that many stocks that I held for a few months I should have held a lot longer. This wouldn’t have been unconditional loyalty, it would have been sticking to companies that were getting more and more attractive.
Many of my favourite picks were the so-called secondary stocks, small or mid-sized companies including the retailers, banks etc. The big blue chips did not have exciting stories to tell, and they were twice as expensive as the secondaries. Small is not only beautiful, it also can be lucrative.
This is one of the keys to successful investing: focus on the companies, not on the stocks.
90 seconds is plenty of time to tell the story of a stock. If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won’t get bored.
I was progressively more impressed with the long range potential of restaurant chains and retailers. By expanding across the country, these companies could keep up a 20 percent growth rate for 10 to 15 years. The math was, and continues to be, very favorable. If earnings increase 20 percent per annum, they double in 3.5 years and quadruple in 7. The stock price follows suit, and often outpaces the earnings, as investors are willing to pay a considerable premium for the company’s future prospects.
When yields on long-term government bonds exceed the dividend yield of the S&P 500 by 6 percent or more, sell your stocks and buy bonds.
Bargains are the holy grail of the true stockpicker. The fact that 10-30 percent of our net worth is lost in a market sell-off is of little consequence. We see the latest correction not as a disaster but as an opportunity to acquire more shares at low prices. This is how great fortunes are made over time.
In stocks as in romance, ease of divorce is not a sound basis for commitment. If you’ve chosen wisely to begin with, you won’t want a divorce. And if you haven’t, you’re in a mess no matter what. All the liquidity in the world isn’t going to save you from pain, suffering, and probably a loss of money.
There’s no shame in losing money on a stock. Everybody does it. What is shameful is to hold on to a stock, or, worse, to buy more of it,, when the fundamentals are deteriorating. That’s what I tried to avoid doing. Although I had more stocks that lost money than I had 10-baggers, I didn’t keep adding to the losers.
If a company turns out to be solvent, its bonds will be worth 100 cents on the dollar. So when the bonds sell for only 20 cents, the bond market is trying to tell us something. The bond market is dominated by conservative investors who keep rather close taps on a company’s ability to repay the principal. Since bonds come before stocks in the lineup of claimants on the company’s assets, you can be sure that when bonds sell for next to nothing, the stock will be worth even less.
I’ve always believed that searching for companies is like looking for grubs under rocks: if you turn over 10 rocks you’ll likely find one grub; if you turn over 20 rocks you’ll find two. I had to turn over thousands of rocks a year to find enough new grubs.
The part-time stockpicker doesn’t need to find 50 or 100 winning stocks. It only takes a couple of big winners in a decade to make the effort worthwhile. The smallest investor can follow the Rule of Five and limit the portfolio to five issues. If just one of those is a 10-bagger and the other four combined go nowhere, you’ve still tripled your money.
Recessions will always end sooner or later, and in a beaten-down market there are bargains everywhere you look, but in an overpriced market it’s hard to find anything worth buying. Ergo, the devoted stockpicker is happier when the market drops 300 points than when it rises the same amount.
Getting involved with a manageable number of companies and confining your buying and selling to these is not a bad strategy. Once you’ve bought a stock, presumably you’ve learned something about the industry and the company’s place within it, how it behaves in recessions., what factors affect the earnings, etc. Inevitably, some gloomy scenario will cause a general retreat in the stock market, your old favorites will once again become bargains, and you can add to your investment.
Just because a stock is cheaper than before is no reason to buy it, and just because it’s more expensive is no reason to sell.
If anybody ever tells you that a stock that’s already gone up 10-fold or 50-fold cannot possibly go higher, show that person the Wal-Mart chart. Twenty-three years ago, in 1970, Wal-Mart went public with 38 stores, most of them in Arkansas. Five years after the initial offering, in 1975, Wal-Mart had 104 stores and the stock price had quadrupled. Ten years after the initial offering, in 1980, Wal-Mart had 276 sores, and the stock was up nearly 20-fold. Many lucky residents of Bentonville, Arkansas, the hometown of Wal-Mart’s founder, Sam Walton, invested at the earliest opportunity and made 20 times their money in the first decade. Was it time to sell and not be greedy and put the money into computers? Not if they believed in making a profit. A stock doesn’t care who owns it, and questions of greed are best resolved in church or in the psychiatrist’s office, not in the retirement account.
The important issue to analyse was not whether Wal-Mart stock would punish the greed of its shareholders, but whether the company had saturated its market. The answer was simple: even in the 1970s, after all the gains in the stock and in the earnings, there were Wal-Mart stores in only 15 percent of the country. That left 85 percent in which the company could still grow.
You could have bought Wal-Mart stock in 1980, a decade after it came public, after the 20-fold gain was already achieved, and after Sam Walton had become famous as the billionaire who drove a pickup truck. If you held the stock from 1980 through 1990, you would have made a 30-fold gain, and in 1991, you would have made another 60 percent on your money on Wal-Mart, giving you a 50-bagger in 11 years. The patient shareholders have that to feel greedy about, on top of the original 20-fold gain. They have no problem paying their psychiatrists.
Digging where the surroundings are tranquil and pleasurable may prove to be as unrewarding as doing detective work from a stuffed chair. You’ve got to go into places where other investors fear to tread, or more to the point, to invest.
When an industry gets too popular, nobody makes money there anymore. As a place to invest, I’ll take a lousy industry over a great industry anytime. In a lousy industry, one that’s growing slowly if at all, the weak drop out and the survivors get a bigger share of the market. A company that can capture an ever-increasing share of a stagnant market is a lot better off than one that has to struggle to protect a dwindling share of an exciting market. In business, competition is never as healthy as total domination.
The greatest companies in lousy industries share certain characteristics. They are low-cost operators, and penny-pinchers in the executive suite. They avoid going into debt. They reject the corporate caste system that creates white-collar Brahmins and blue collar untouchables. Their workers are well paid and have a stake in the companies’ future. They find niches, parts of the market that bigger companies have overlooked.
One way to judge a company’s commitment to frugality is by visiting the headquarters. “The fact that a company you put your money in has a big building doesn’t mean that the people in it are smart, but it does mean that you’ve helped pay for the building.”
All else being equal, invest in the company with the fewest color photographs in the annual report.
I like companies that stick to business and let the images take of themselves.
I examine the earnings report to see if any unusual factors might be giving investors a false impression. You don’t want to be fooled into buying a stock after a company reports a gain in earnings, only to discover that the gain was an aberration, caused by some onetime event such as the sale of investment securities.
I find general gloom in an industry far less bothersome than if a specific company struggles while its competitors thrive.
The popular prescription “Buy at the sound of cannons, sell at the sound of trumpets” can be misguided advice. Buying on the bad news can be a very costly strategy, especially since bad news has a habit of getting worse. How many people lost substantial amounts of investment capital when they bought o the bad news coming out of the Bank of New England after the stock had already dropped from $40 to $20, or from $20 to $10, or from $10 to $5, or from $5 to $1, only to see it sink to zero and wipe out 100 percent of their investment?
Buying on the good news is healthier in the long run, and you improve your odds considerably by waiting for the proof. Maybe you lose a dollar a share or so by waiting for the announcement of a signed contract, as opposed to buying the rumor, but if there’s a real deal it will add many more dollars to the stock price in the future. And if there isn’t a real deal, you’ve protected yourself by waiting.
A healthy free cash flow gives a company the flexibility to change course in good and bad times.
Corporations, like people, change their names for one of two reasons: either they’ve gotten married or they’ve been involved in some fiasco that the hope the public will forget.
For a stock to do better than expected, the company has to be widely underestimated. Otherwise, it would sell for a higher price to begin with. When the prevailing opinion is more negative than yours, you have to constantly check and recheck the facts, to reassure yourself that you’re not being foolishly optimistic. The story keeps changing, for either better or worse, and you have to follow those changes and act accordingly.
Here’s the key question to ask about a risky yet promising stock. If things go right, how much can I earn? What is the reward side of the equation.
During periods when mutual funds are popular, investing in the companies that sell the funds is likely to be more rewarding that investing in their products. I’m reminded that in the Gold Rush the people who sold picks and shovels did better than the prospectors.
I learned long ago that if you make 10 different companies, you are going to discover at least 1 unexpected development. Unexpected developments are what make stocks go up can down.
As a stockpicker, you can’t assume anything. You’ve got to follow the stories. You are trying to get answers to two basic questions: (1) is the stock still attractively priced relative to earnings, and (2) what is happening in the company to make the earnings go up. Here you can reach one of three conclusions: (1) the story has gotten better, in which case you might want to increase your investment, or (2) the story has gotten worse, in which case you can decrease your investment, or (3) the story’s unchanged, in which case you can either stick with your investment or put the money into another company with more exciting prospects.
Take the industry that’s surrounded with the most doom and gloom, and if the fundamentals are positive, you’ll find some big winners.
Rejecting a stock because the price has doubled, tripled, or even quadrupled in the recent past can be a big mistake. Whether a million investors made or lost money on Chrysler last month has no bearing on what will happen next month. I try to treat each potential investment as if it had no history- the “be here now” approach. Whatever occurred earlier is irrelevant.
In my experience, the price of a stock, the “p” in the p/e equation, cannot run too far ahead of the earnings, the “e” in the equation, without something having to give.
With so much attention given to the ups and downs of stock prices, it’s easy to forget that owning a stock is owning a piece of a company. You wouldn’t own a rental building without checking every once in a while to see that the units are well maintained and the place isn’t falling apart, and likewise, when you own a piece of a company you must stay in tune and watch for new developments.
The stock market can test our patience, but if you believe in a company, you hold on until your patience is rewarded.
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