Peter Lynch is considered one of the best investors in history, and in his book “One Up On Wall Street,” (download this document in pdf) he distills much of his knowledge and methods of choosing stocks. As a private investor, this is one of the first books that one should read.
Magellan Fund, Peter Lynch‘s fund under Fidelity Investments, achieved average annual profitability of 29.2% between 1977 and 1990. He started the fund with $18 million under management, and by the beginning of the 90s, he was managing $14 billion.
Unlike The Intelligent Investor or Security Analysis from Benjamin Graham, it is a book that is very easy to read and understand. With an entertaining style, Lynch leads the reader through different aspects to consider before buying a share.
Even acknowledging how much the world has changed since this book was published in 1989, I think it is an excellent read for any beginning investor.
Anyone Can Invest in the Stock Exchange
“Anyone can invest in the stock market.” That’s Peter Lynch’s mantra. He recommends paying more attention to the knowledge we have as consumers or industry insiders than to Wall Street’s recommendations.
Paying attention to businesses doing well in our daily lives could generate more insight and help us stay one step ahead of Wall Street.
Main Advice From Lynch in “One Up On Wall Street” (pdf)
Ok, so this book is a great way to start investing. Lynch gives general advice and a detailed checklist to revise any time we make an investment decision.
So to begin with, let’s see which is some of the general advice that Lynch gives to the individual investor:
- First, pay attention to the businesses you are surrounded by, as a consumer but as a professional as well. It’s better to invest in the industry you work in than in an industry that you don’t know anything about. You have to lever the knowledge that you already have.
- Once you’ve chosen the industry, Lynch says, focus on finding companies that Wall Street hasn’t yet discovered. Look for zero or no analysts coverage and no institutional money.
- When you buy a stock, you have to remember that you are purchasing a piece of a business. That’s why careful analysis of the fundamentals is due.
- Are you worried about the short-term fluctuations in the market? Lynch says to ignore them as they do not reflect fundamental changes in the structure of the business. It is already very usual that after analyzing a particular stock and making the purchase, the stock price continues to fall.
- Pay attention to the long-term. It is way more predictable than the random short-term movements of the markets.
- According to Lynch, trying to predict the economy’s performance is a futile task, and that together with the direction of the short-term market are two endeavors that the investor in companies should ignore.
So, how can I beat wall street?
Anyone can do it. Again that’s what Lynch tells us. He argues that anyone can find tenbaggers, that is, companies that will multiply their price by ten.
To find these tenbaggers, Lynch recommends:
- Understanding which businesses are growing and which companies offer better products than the competition and industry insiders also recommends.
- If you work in an industry and understand the complete value chain, you have an advantage over Wall Street’s analysts. Why does an engineer who works in the aeronautical sector end up buying shares in a biotech company? It doesn’t make sense to Lynch.
Lynch provides the example of the couple that spends the weekend looking for the cheapest airfare to fly to London but does not pay thought at all when investing a large part of their savings in KLM shares.
The simple truth is that most investors fail to analyze what they are buying.
Peter Lynch’s famous company classification
In this book, Peter Lynch shared for the first time his famous way of classifying companies. There are six buckets into where a company could be ranked:
These companies already had their moment of glory and no longer are growing rapidly but could be considered mature companies. Their growth rate is similar to the growth of the country’s GDP since they grow simultaneously with the general economy.
You would acquire this type of company with two objectives:
1) to reduce the risk of the equity portfolio since, in general, they are large and consolidated companies that have little risk of going bankrupt and
2) to collect the dividend.
No capital gains are expected relative to the share price.
Stalwarts or medium-growth
These are companies with an average annual growth of their profits of between 10% and 12%.
It is always advisable to have a good mix of these types of companies in the portfolio since these types of companies tend to provide some protection against the sharp drops that fast-growing companies can have in recessions.
Here is where the money is generally made, according to Lynch, since they are companies that are in frank expansion and their profits grow between 20% and 25% annually.
They are generally smaller and more aggressive companies.
These are companies whose sales and profits expand and contract with some regularity.
These companies shine out of a recession, but on the other hand, they can lose up to 50% of value.
These companies with zero growth are about to go bankrupt but are good because their movements have nothing to do with market cycles.
In general, a new manager or a change in the company’s strategy allows better forecasting of future results.
These companies have a hidden asset that the market has not fully valued: they can be TV rights, real estate, a tax credit that allows you not to pay taxes in the future, game royalties.
Which Companies to Avoid According to Peter Lynch
In general, the companies to avoid are the hottest stocks in the market, those stocks that Wall Street analysts talk about, and in the industry where there is the most growth.
Some other companies to avoid:
- Avoid companies that promote themselves as “the next Facebook,” “the next Netflix.” Surely you had the opportunity to hear someone on television or in some medium say precisely that phrase.
- Avoid companies that start to buy businesses in areas in which they do not have experience or that are not directly related to the central business where they can obtain results above the cost of capital. Lynch calls these types of companies “diworsifications.”
- Avoid “whisper stocks,” those recommended stocks that no one knows about, but because they are a “tip,” they have a particular attraction. They come to you recommended by a relative or friend in the form of “whisper stock,” as Lynch says.
- Finally, it is also advisable to avoid companies concentrating a large part of their sales on a single customer.
Watch the Profits, Always the Profits
This chapter is probably one of the most interesting of the book. Lynch makes a particular emphasis on earnings, of course. Companies are worth what they earn; if they earn more in the future than expected, they should be worth more.
To analyze a company’s profits, you have to forecast what could happen in 5 dimensions to which Lynch pays particular attention.
Profits can increase or decrease depending on:
- Cost reduction: can the company reduce the cost of materials, the cost of labor, or the fixed costs incurred each year?
- Increase prices: does the company have enough power to increase its prices year after year and not lose customers? This would be one of the signs that the company has a MOAT that protects its source of profit.
- Expand to new markets: can the company enter new markets with its current product?
- Expand in current markets: can the company continue to grow in existing markets as a result of an increase in its market share?
- Revitalize, close, or dispose of an operation that is losing money: can the company close an operation that is losing money and thus improve its profits?
Lynch makes a hilarious comparison between a stock and how we would value a human being: everything a person owns (golf clubs, a car, a house, etc.) minus what they owe (poker debts, credit cards, etc.) is the net worth or book value of the person.
In addition to that, there is also the ability to generate profit in the future.
How to Analyze a Balance in 10 Minutes
How to analyze a balance in 10 minutes according to Peter Lynch:
- In current assets, look at the position of cash and marketable securities; add them together to see how much cash you have available. See if it is increasing or decreasing from previous years.
- In liabilities, see the amount of long-term debt and see if it is increasing or decreasing (if cash has been growing and this type of debt is decreasing, then the balance is getting stronger and stronger); then view the total and calculate the net cash position.
- Current or short-term debt can be ignored or assumed to be paid with the rest of current assets.
- Look at the summary of the last ten years to analyze trends and see what happened to the number of shares; if it decreases because the company is buying back stock, it is a good sign.
- Divide the net cash position by the number of shares to see how much cash there is per share.
Do you have more than 10 minutes? Follow up with these.
Other metrics to observe in a balance:
- Percentage of sales: what percentage of total sales does the flagship product of the company represent?
- Price/earnings: The price is fair if the P/E equals the annual growth rate of earnings. If the P/E is less than the growth rate, then we have a bargain. If it is higher, we have a rather expensive company. Of course, the whole process should require more detailed analysis; in short, the PEG Ratio compares the P/E of a company with its most recent annual growth rate in earnings. If a company has been growing at 20% per year and has a P/E of 20, it would have a PEG ratio of 1, indicating that its price is within normal parameters.
- Cash position: subtract long-term debt from net cash position and calculate per share cash compared to the share price.
- Debt factor: here, we compare debt with equity. An average balance has 75% equity and 25% debt (that would be a strong balance); a weak balance, on the other hand, would be 80% debt and 20% equity. This is especially risky in young companies. These ratios, in any case, are indicative and are not a rule that must be strictly adhered to.
- Dividends: The good thing about companies that pay dividends is that it protects free cash flow from being spent on diworsifications. In addition, the presence of the dividend may cause the price not to fall as much when there is a downturn since the return of the stock would increase dramatically, and other investors would end up buying the stock just for that.
- Book value: the book value of debt is always almost the real value. On the other hand, you have to be careful with the value of assets because they are carried on the books with different criteria depending on the asset.
- Hidden assets: companies that own natural resources, such as land, oil, or precious metals, record these assets at a book value that is a fraction of their real value. Other assets such as trademarks, patents, and licenses are also carried to book value and continue to depreciate until they disappear from the balance sheet. Tax breaks can also be a hidden asset.
- Free-cashflows: it is the cash with which the company keeps to do business. The best companies are the ones that can generate cash without spending much cash. For some companies, it is easier to generate cash than for others. It always refers to the free-cashflow, which is what remains after investments in CAPEX. 10% is fine; 20% is fantastic.
- Inventories: when inventories grow more than sales, it is a bad sign, especially in retailers and manufacturing companies. Look at the “management discussion on earnings” notes. If inventories begin to empty, it is the first sign that there is a turnaround.
- Pension plans: these are obligations the companies agree to pay; therefore, they should be seen as debt. Pay attention specifically to it on turnarounds.
- Growth rate: the only growth that matters is growth in earnings. If the business can increase prices year after year without losing customers, we have a tremendous investment. A company growing at 20% selling at a P/E of 20 is a much better investment than a company selling at a P/E of 10 growing at 10%.
- The bottom line: earnings after taxes. It is only helpful to compare these margins for companies in the same industry. The company with the highest profit margin is, by definition, the one with the lowest costs in the entire industry. These are the ones that have the best chance of survival.
Final Tips for Investing in the Stock Market
Near the end of the book, Peter Lynch ends with some conclusions and final tips for anyone who wants to embark on the adventure of buying individual stocks:
- At some point in the next three months or the next year or the next three years, the market will have a sharp fall, that is almost certain. These falls are great opportunities to buy good companies at auction prices.
- To get ahead of the market, you don’t have to be right all the time, just a small number of times.
- Different categories of companies have various risks and rewards. You can make much money by building a portfolio with stalwarts with a yield of 20 or 30% per year.
- In the short term, the price of the shares typically moves in the opposite direction to the fundamentals. In the long term, the market follows the fundamentals.
- Just because a company is having bad results does not mean that it can perform even worse.
- Just because the price of a company’s share goes up does not mean that we are right.
- Just because the price of a company’s share goes down does not mean that we are wrong.
- Buying a stock with a poor forecast just because the stock is cheap is a futile technique.
- Selling the stock of a fast-growing company just because the stock appears to be slightly overvalued is a losing technique.
- You don’t lose anything by not buying a share that later became a tenbagger.
- When good cards come out, then add to the position and vice versa.
- Our position will not improve if we cut the flowers and water the weeds.
- You don’t have to “kiss all the girls.” You do not have to buy all the stocks that you think are going to rise, only those in which a careful analysis has been made on whether it is a good investment or not.
Conclusion on “One Up On Wall Street”
Each book has a different impact on each person, so it’s challenging to make recommendations. But if you are beginning your path in finance, then I think this book is an excellent first step.
While some of the tips and strategies Lynch shares have become outdated over the years, it is still an excellent read written in clear, easy-to-understand language.
Lynch, P. (1989). One Up On Wall Street: How to Use What You Already Know to Make Money in the Market. First Fireside Edition. New York: Simon & Schuster.
Peter Lynch. (nd). In Wikipedia. Retrieved November 18, 2020, from https://en.wikipedia.org/wiki/Peter_Lynch#cite_note-3