Although this is actually a two-part series made up of “One Up on Wall Street” and “Beating the Street”, the two books essentially split into a theoretical part and a practical one. Rather than offering general information about the stock market and markets, One Up on Wall Street focuses on how to analyze individual stocks, and it reads like a rulebook meant to be built into the investment thesis you prepare before investing in any stock. I am sharing the passages I underlined in the book. Instead of writing up my own takeaways, the right thing to do is to integrate these key points into the process of writing an investment thesis. Soon I will publish a post titled “How to Write an Investment Thesis”, and I will fold the key points from this book into that topic. In the coming weeks I will also write theses for one or two stocks I currently hold; my monthly portfolio has changed a great deal, and starting next month I will return to the monthly portfolio series. Until then:

• But rule number one, in my book, is: Stop listening to professionals! Twenty years in this business convinces me that any normal person using the customary three percent of the brain can pick stocks just as well, if not better, than the average Wall Street expert. I know you don’t expect the plastic surgeon to advise you to do your own facelift, nor the plumber to tell you to install your own hot-water tank, nor the hairdresser to recommend that you trim your own bangs, but this isn’t surgery or plumbing or hairdressing. This is investing, where the smart money isn’t so smart, and the dumb money isn’t really as dumb as it thinks. Dumb money is only dumb when it listens to the smart money.
• There are at least three good reasons to ignore what Peter Lynch is buying: (1) he might be wrong! (A long list of losers from my own portfolio constantly reminds me that the so-called smart money is exceedingly dumb about 40 percent of the time); (2) even if he’s right, you’ll never know when he’s changed his mind about a stock and sold; and (3) you’ve got better sources, and they’re all around you. What makes them better is that you can keep tabs on them, just as I keep tabs on mine.
• You may have thought that a tenbagger can only happen with some wild penny stock in some weird company like Braino Biofeedback or Cosmic R and D, the kind of stock that sensible investors avoid. Actually there are numerous tenbaggers in companies you’ll recognize: Dunkin’ Donuts, Wal-Mart, Toys “R” Us, Stop & Shop, and Subaru, to mention a few. These are companies whose products you’ve admired and enjoyed, but who would have suspected that if you’d bought the Subaru stock along with the Subaru car, you’d be a millionaire today?
• There seems to be an unwritten rule on Wall Street: If you don’t understand it, then put your life savings into it. Shun the enterprise around the corner, which can at least be observed, and seek out the one that manufactures an incomprehensible product. I heard about one such opportunity just the other day. According to a report somebody left on my desk, this was a fantastic chance to invest in a company that makes the “one megabit S-Ram, C-mos (complementary metal oxide semiconductor); bipolar risc (reduced instructive set computer), floating point, data I/O array processor, optimizing compiler, 16-bytes dual port memory, unix operating system, whetstone megaflop polysilicon emitter, high band width, six gigahertz, double metalization communication protocol, asynchronous backward compatibility, peripheral bus architecture, four-way interleaved memory and 15 nanoseconds capability.” Gig my gigahertz and whetstone my megaflop, if you couldn’t tell if that was a racehorse or a memory chip you should stay away from it, even though your broker will be calling to recommend it as the opportunity of the decade to make countless nanobucks.
• Finding the promising company is only the first step. The next step is doing the research. The research is what helps you to sort out Toys “R” Us from Coleco, Apple Computer from Televideo, or Piedmont Airlines from People Express. Now that I mention it, I wish I’d done more checking into what was happening at People Express. Maybe then I wouldn’t have bought that one, either. All my failures notwithstanding, during the twelve years I’ve managed Fidelity Magellan, it has risen over twentyfold per share—partly thanks to some of the little-known and out-of-favor stocks I’ve been able to discover and then research on my own. I’m confident that any investor can benefit from the same tactics. It doesn’t take much to outsmart the smart money, which, as I’ve said, isn’t always very smart.
• Before you think about buying stocks, you ought to have made some basic decisions about the market, about how much you trust corporate America, about whether you need to invest in stocks and what you expect to get out of them, about whether you are a short-or long-term investor, and about how you will react to sudden, unexpected, and severe drops in price. It’s best to define your objectives and clarify your attitudes (do I really think stocks are riskier than bonds?) beforehand, because if you are undecided and lack conviction, then you are a potential market victim, who abandons all hope and reason at the worst moment and sells out at a loss. It is personal preparation, as much as knowledge and research, that distinguishes the successful stockpicker from the chronic loser. Ultimately it is not the stock market nor even the companies themselves that determine an investor’s fate. It is the investor.
• Distrust of stocks was the prevailing American attitude throughout the 1950s and into the 1960s, when the market tripled and then doubled again. This period of my childhood, and not the recent 1980s, was truly the greatest bull market in history, but to hear it from my uncles, you’d have thought it was the craps game behind the pool hall. “Never get involved in the market,” people warned. “It’s too risky. You’ll lose all your money.” Looking back on it, I realize there was less risk of losing all one’s money in the stock market of the 1950s than at any time before or since. This taught me not only that it’s difficult to predict markets, but also that small investors tend to be pessimistic and optimistic at precisely the wrong times, so it’s self-defeating to try to invest in good markets and get out of bad ones.
• As I look back on it now, it’s obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics. Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage. If stockpicking could be quantified, you could rent time on the nearest Cray computer and make a fortune. But it doesn’t work that way. All the math you need in the stock market (Chrysler’s got $1 billion in cash, $500 million in long-term debt, etc.) you get in the fourth grade. Logic is the subject that’s helped me the most in picking stocks, if only because it taught me to identify the peculiar illogic of Wall Street. Actually Wall Street thinks just as the Greeks did. The early Greeks used to sit around for days and debate how many teeth a horse has. They thought they could figure it out by just 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. In centuries past, people hearing the rooster crow as the sun came up decided that the crowing caused the sunrise. It sounds silly now, but every day the experts confuse cause and effect on Wall Street in offering some new explanation for why the market goes up: hemlines are up, a certain conference wins the Super Bowl, the Japanese are unhappy, a trendline has been broken, Republicans will win the election, stocks are “oversold,” etc. When I hear theories like these, I always remember the rooster.
• Fidelity had done such a good job selling America on mutual funds that even my mother was putting $100 a month into Fidelity Capital. That fund, run by Gerry Tsai, was one of the two famous go-go funds of this famous go-go era. The other was Fidelity Trend, run by Edward C. Johnson III, also known as Ned. Ned Johnson was the son of the fabled Edward C. Johnson II, also known as Mister Johnson, who founded the company. Ned Johnson’s Fidelity Trend and Gerry Tsai’s Fidelity Capital outperformed the competition by a big margin and were the envy of the industry over the period from 1958 to 1965. With these sorts of people training and supporting me, I felt as if I understood what Isaac Newton was talking about when he said: “If I have seen further . . . it is by standing upon the shoulders of Giants.”
• Fidelity Magellan had $20 million in assets. There were only 40 stocks in the portfolio, and Ned Johnson, Fidelity’s head man, recommended that I reduce the number to 25. I listened politely and then went out and raised the number to 60 stocks, six months later to 100 stocks, and soon after that, to 150 stocks. I didn’t do it to be contrary. I did it because when I saw a bargain I couldn’t resist buying it, and in those days there were bargains everywhere.
• STREET LAG With every spectacular stock I’ve managed to ferret out, the virtues seemed so obvious that if 100 professionals had been free to add it to their portfolios, I’m convinced that 99 would have done so. But for reasons I’m about to describe, they couldn’t. There are simply too many obstacles between them and the tenbaggers. Under the current system, a stock isn’t truly attractive until a number of large institutions have recognized its suitability and an equal number of respected Wall Street analysts (the researchers who track the various industries and companies) have put it on the recommended list. With so many people waiting for others to make the first move, it’s amazing that anything gets bought. The Limited is a good example of what I call Street lag. When the company went public in 1969, it was all but unknown to the large institutions and the big-time analysts. The underwriter of the offering was a small firm called Vercoe & Co., located in Columbus, Ohio, where the headquarters of The Limited can also be found. Peter Halliday, a high school classmate of Limited chairman Leslie Wexner, was Vercoe’s sales manager back then. Halliday attributed the disinterest of Wall Street to the fact that Columbus, Ohio, was not exactly a corporate Mecca at the time. A lone analyst (Susie Holmes of White, Weld) followed the company for a couple of years before a second analyst, Maggie Gilliam for First Boston, took official notice of The Limited in 1974. Even Maggie Gilliam might not have discovered it if she hadn’t stumbled onto the Limited store at Chicago’s Woodfield Mall during a snow emergency at O’Hare airport. To her credit, she paid attention to her amateur’s edge. The first institution which bought shares in The Limited was T. Rowe Price New Horizons Fund, and that was in the summer of 1975. By then there were one hundred Limited stores open for business across the country. Thousands of observant shoppers could have initiated their own coverage during this period. Still, by 1979, only two institutions owned Limited stock, accounting for 0.6 percent of the outstanding shares. Employees and executives in the company were heavy owners—usually a good sign, as we’ll discuss later. In 1981 there were four hundred Limited stores doing a thriving business and only six analysts followed the stock. This was seven years after Ms. Gilliam’s discovery. By 1983, when the stock hit its intermittent high of $9, long-term investors were up eighteenfold from 1979, when the shares had sold for 50 cents, adjusted for splits. Yes, I know that the price fell nearly in half, to $5 a share in 1984, but the company was still doing well, so that gave investors another chance to buy in. (As I’ll explain in later chapters, if a stock is down but the fundamentals are positive, it’s best to hold on and even better to buy more.) It wasn’t until 1985, with the stock back up to $15, that analysts joined the celebration. In fact, they were falling all over one another to put The Limited on their buy lists, and aggressive institutional buying helped send the shares on a ride all the way up to $527/8—way beyond what the fundamentals would have justified. By then, there were more than thirty analysts on the trail (thirty-seven as of this writing), and many had arrived just in time to see The Limited drop off the edge.
• INSPECTED BY 4 Whoever imagines that the average Wall Street professional is looking for reasons to buy exciting stocks hasn’t spent much time on Wall Street. The fund manager most likely is looking for reasons not to buy exciting stocks, so that he can offer the proper excuses if those exciting stocks happen to go up. “It was too small for me to buy” heads a long list, followed by “there was no track record,” “it was in a nongrowth industry,” “unproven management,” “the employees belong to a union,” and “the competition will kill them,” as in “Stop & Shop will never work, the 7-Elevens will kill them,” or “Pic ’N’ Save will never work, Sears will kill them,” or “Agency Rent-A-Car hasn’t got a chance against Hertz and Avis.” These may be reasonable concerns that merit investigation, but often they’re used to fortify snap judgments and wholesale taboos.
• There’s an unwritten rule on Wall Street: “You’ll never lose your job losing your client’s money in IBM.” If IBM goes bad and you bought it, the clients and the bosses will ask: “What’s wrong with that damn IBM lately?” But if La Quinta Motor Inns goes bad, they’ll ask: “What’s wrong with you?” That’s why security-conscious portfolio managers don’t buy La Quinta Motor Inns when two analysts cover the stock and it sells for $3 a share. They don’t buy Wal-Mart when the stock sells for $4, and it’s a dinky store in a dinky little town in Arkansas, but soon to expand. They buy Wal-Mart when there’s an outlet in every large population center in America, fifty analysts follow the company, and the chairman of Wal-Mart is featured in People magazine as the eccentric billionaire who drives a pickup truck to work. By then the stock sells for $40.
• Then Flint moves along to Seven Oaks International, which happens to be one of my all-time favorite picks. Ever wonder what happens to all those discount coupons—fifteen cents off Heinz ketchup, twenty-five cents off Windex, etc.—after you clip them from the newspapers and then turn them in at your supermarket checkout counter? Your supermarket wraps them up and sends them off to the Seven Oaks plant in Mexico, where piles of coupons are collated, processed, and cleared for payment, much as a check is cleared through the Federal Reserve banks. Seven Oaks makes a lot of money doing this boring job, and the shareholders are well-rewarded. It’s exactly the kind of obscure, boring, and highly profitable company with an inscrutable name that I like to own.
• Reverting to “group think,” and reminding himself that it’s safer to pick companies in a crowd, he ignores the words of wisdom that came either from Aeschylus the playwright, Goethe the author, or Alf, the TV star from outer space: Two’s a company, three’s a crowd Four is two companies Five is a company and a crowd Six is two crowds Seven is one crowd and two companies Eight is either four companies or two crowds and a company Nine is three crowds Ten is either five companies or two companies and two crowds
• If it’s not the bank or the mutual fund making up rules, then it’s the SEC. For instance, the SEC says a mutual fund such as mine cannot own more than ten percent of the shares in any given company, nor can we invest more than five percent of the fund’s assets in any given stock. The various restrictions are well-intentioned, and they protect against a fund’s putting all its eggs in one basket (more on this later) and also against a fund’s taking over a company à la Carl Icahn (more on that later, too). The secondary result is that the bigger funds are forced to limit themselves to the top 90 to 100 companies, out of the 10,000 or so that are publicly traded. Let’s say you manage a $1-billion pension fund, and to guard against diverse performance, you’re required to choose from a list of 40 approved stocks, via the Inspected by 4 method. Since you’re only allowed to invest five percent of your total stake in each stock, you’ve got to buy at least 20 stocks, with $50 million in each. The most you can have is 40 stocks, with $25 million in each. In that case you have to find companies where $25 million will buy less than ten percent of the outstanding shares. That cuts out a lot of opportunities, especially in the small fast-growing enterprises that tend to be the tenbaggers. For instance, you couldn’t have bought Seven Oaks International or Dunkin’ Donuts under these rules. Some funds are further restricted with a market-capitalization rule: they don’t own a stock in any company below, say, a $100-million size.
• In other words, I continue to think like an amateur as frequently as possible. GOING IT ALONE You don’t have to invest like an institution. If you invest like an institution, you’re doomed to perform like one, which in many cases isn’t very well. Nor do you have to force yourself to think like an amateur if you already are one. If you’re a surfer, a trucker, a high school dropout, or an eccentric retiree, then you’ve got an edge already. That’s where the tenbaggers come from, beyond the boundaries of accepted Wall Street cogitation. When you invest, there’s no Flint around to criticize your quarterly results or your semiannual results, or to grill you as to why you bought Agency Rent-A-Car instead of IBM. Well, maybe there’s a spouse and perhaps a stockbroker with whom you are forced to converse, but a stockbroker will be quite sympathetic to your odd choices and certainly isn’t going to fire you for picking Seven Oaks—as long as you’re paying the commissions. And hasn’t the spouse (the Person Who Doesn’t Understand the Serious Business of Money) already proven a faith in your investment schemes by allowing you to continue to make mistakes?
• “Is General Electric a good investment?” isn’t the first thing I’d inquire about a stock. Even if General Electric is a good investment, it still doesn’t mean you ought to own it. There’s no point in studying the financial section until you’ve looked into the nearest mirror. Before you buy a share of anything, there are three personal issues that ought to be addressed: (1) Do I own a house? (2) Do I need the money? and (3) Do I have the personal qualities that will bring me success in stocks? Whether stocks make good or bad investments depends more on your responses to these three questions than on anything you’ll read in The Wall Street Journal.
• No wonder people make money in the real estate market and lose money in the stock market. They spend months choosing their houses, and minutes choosing their stocks. In fact, they spend more time shopping for a good microwave oven than shopping for a good investment.
• Only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future. (3) DO I HAVE THE PERSONAL QUALITIES IT TAKES TO SUCCEED? This is the most important question of all. It seems to me the list of qualities ought to include patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit to mistakes, and the ability to ignore general panic. In terms of IQ, probably the best investors fall somewhere above the bottom ten percent but also below the top three percent. The true geniuses, it seems to me, get too enamored of theoretical cogitations and are forever betrayed by the actual behavior of stocks, which is more simple-minded than they can imagine. It’s also important to be able to make decisions without complete or perfect 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. And finally, it’s crucial to be able to resist your human nature and your “gut feelings.” It’s the rare investor who doesn’t secretly harbor the conviction that he or she has a knack for divining stock prices or gold prices or interest rates, in spite of the fact that most of us have been proven wrong again and again. It’s uncanny how often people feel most strongly that stocks are going to go up or the economy is going to improve just when the opposite occurs. This is borne out by the popular investment-advisory newsletter services, which themselves tend to turn bullish and bearish at inopportune moments. According to information published by Investor’s Intelligence, which tracks investor sentiment via the newsletters, at the end of 1972, when stocks were about to tumble, optimism was at an all-time high, with only 15 percent of the advisors bearish. At the beginning of the stock market rebound in 1974, investor sentiment was at an all-time low, with 65 percent of the advisors fearing the worst was yet to come. Before the market turned downward in 1977, once again the newsletter writers were optimistic, with only 10 percent bears. At the start of the 1982 sendoff into a great bull market, 55 percent of the advisors were bears, and just prior to the big gulp of October 19, 1987, 80 percent of the advisors were bulls again.
• There’s another theory that we have recessions every five years, but it hasn’t happened that way so far. I’ve looked in the Constitution, and nowhere is it written that every fifth year we have to have one. Of course, I’d love to be warned before we do go into a recession, so I could adjust my portfolio. But the odds of my figuring it out are nil. Some people wait for these bells to go off, to signal the end of a recession or the beginning of an exciting new bull market. The trouble is the bells never go off. Remember, things are never clear until it’s too late.
• What I hope you’ll remember most from this section are the following points: • Don’t overestimate the skill and wisdom of professionals. • Take advantage of what you already know. • Look for opportunities that haven’t yet 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 tenbagger is close to home—if not in the backyard then down at the shopping mall, and especially wherever you happen to work. With most of the tenbaggers already mentioned—Dunkin’ Donuts, The Limited, Subaru, Dreyfus, McDonald’s, Tambrands, and Pep Boys—the first sips of success were apparent at hundreds of locations across the country. The fireman in New England, the customers in central Ohio where Kentucky Fried Chicken first opened up, the mob down at Pic ’N’ Save, all had a chance to say, “This is great; I wonder about the stock,” long before Wall Street got its original clue. The average person comes across a likely prospect two or three times a year—sometimes more. Executives at Pep Boys, clerks at Pep Boys, lawyers and accountants, suppliers of Pep Boys, the firm that did the advertising, sign painters, building contractors for the new stores, and even the people who washed the floors all must have observed Pep Boys’ success. Thousands of potential investors got this “tip,” and that doesn’t even count the hundreds of thousands of customers.
• True, true. You don’t necessarily have to know anything about a company for its stock to go up. But the important point is that (1) the oil experts, on average, are in a better position than doctors to decide when to buy or to sell Schlumberger; and (2) the doctors, on average, know better than oil experts when to invest in a successful drug. The person with the edge is always in a position to outguess the person without an edge—who after all will be the last to learn of important changes in a given industry.
• Every time I look at the Dreyfus chart, it reminds me of the advice I’ve been trying to give you all along: Invest in things you know about.
• However a stock has come to your attention, whether via the office, the shopping mall, something you ate, something you bought, or something you heard from your broker, your mother-in-law, or even from Ivan Boesky’s parole officer, the discovery is not a buy signal. Just because Dunkin’ Donuts is always crowded or Reynolds Metals has more aluminum orders than it can handle doesn’t mean you ought to own the stock. Not yet. What you’ve got so far is simply a lead to a story that has to be developed. In fact, you ought to treat the initial information (whatever brought this company to your attention) as if it were an anonymous and intriguing tip, mysteriously shoved into your mailbox. This will keep you from buying a stock just because you’ve seen something you like, or worse, because of the reputation of the tipper, as in: “Uncle Harry’s buying it, and he’s rich, so he must know what he’s talking about.” Or: “Uncle Harry’s buying it, and so am I, because his last stock tip doubled.”
• The size of a company has a great deal to do with what you can expect to get out of the stock. How big is this company in which you’ve taken an interest? Specific products aside, big companies don’t have big stock moves. In certain markets they perform well, but you’ll get your biggest moves in smaller companies. You don’t buy stock in a giant such as Coca-Cola expecting to quadruple your money in two years. If you buy Coca-Cola at the right price, you might triple your money in six years, but you’re not going to hit the jackpot in two. There’s nothing wrong with Procter and Gamble or Coca-Cola, and recently both have been excellent performers. But you just have to know these are big companies so you won’t have false hopes or unrealistic expectations. Sometimes a series of misfortunes will drive a big company into desperate straits, and, as it recovers, the stock will make a big move. Chrysler had a big move, as did Ford and Bethlehem Steel. When Burlington Northern got depressed, the stock dropped from $12 to $6 and then climbed back to $70. But these are extraordinary situations that fall into the category of turnarounds. In the normal course of business, multibillion-dollar enterprises such as Chrysler or Burlington Northern, DuPont or Dow Chemical, Procter and Gamble or Coca-Cola, simply cannot grow fast enough to become tenbaggers. For a General Electric to double or triple in size in the foreseeable future is mathematically impossible. GE already has gotten so big that it represents nearly one percent of the entire U.S. gross national product. Every time you spend a dollar, GE gets almost a penny of it. Think of that. In all the trillions spent annually by American consumers, nearly a penny of every dollar goes to goods or services (light bulbs, appliances, insurance, the National Broadcasting Corporation [NBC], etc.) provided by GE. Here is a company that has done everything right—made sensible acquisitions; cut costs; developed successful new products; rid itself of bumbling subsidiaries; avoided getting suckered into the computer business (after selling its mistake to Honeywell)—and still the stock inches along. That’s not GE’s fault. The stock can’t help but inch along since it’s attached to such a huge enterprise. GE has 900 million shares outstanding, and a total market value of $39 billion. The annual profit, more than $3 billion, is enough to qualify as a Fortune 500 company on its own. There is simply no way that GE could accelerate its growth very much without taking over the world. And since fast growth propels stock prices, it’s no surprise that GE moves slowly as La Quinta soars. Everything else being equal, you’ll do better with the smaller companies. In the last decade you’d have made more money on Pic ’N’ Save than on Sears, although both are retail chains. Now that Waste Management is a multibillion-dollar conglomerate, it will probably lag behind the speedy new entries in the waste-removal field. In the recent comeback of the steel industry, shareholders in the smaller Nucor have fared better than shareholders in U.S. Steel (now USX). In the earlier comeback of the drug industry, the smaller SmithKline Beckman outperformed the larger American Home Products. THE SIX CATEGORIES Once I’ve established the size of the company relative to others in a particular industry, next I place it into one of six general categories: slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds. There are almost as many ways to classify stocks as there are stockbrokers—but I’ve found that these six categories cover all of the useful distinctions that any investor has to make. Countries have a growth rate (the GNP), industries have a growth rate, and so does an individual company. Whatever the entity, “growth” means that it does more of whatever it does this year (make cars, shine shoes, sell hamburgers) than it did last year. President Eisenhower once said that “things are more like they are now than they ever were before.” That’s a pretty good definition of economic growth. Keeping track of the growth rates of industry is an industry in itself. There are endless charts, tables, and comparisons. With individual companies it’s a little trickier, since growth can be measured in various ways: growth in sales, growth in profits, growth in earnings, etc. But when you hear about a “growth company,” you can assume that it’s expanding. There are more sales, more production, and more profits in each successive year. The growth of an individual company is measured against the growth of the economy at large. Slow-growing companies, as you might have guessed, grow very slowly—more or less in line with the nation’s GNP, which lately has averaged about three percent a year. Fast-growing companies grow very fast, sometimes as much as 20 to 30 percent a year or more. That’s where you find the most explosive stocks. Three of my six categories have to do with growth stocks. I separate the growth stocks into slow growers (sluggards), medium growers (stalwarts), and then the fast growers—the superstocks that deserve the most attention.
• Another sure sign of a slow grower is that it pays a generous and regular dividend. As I’ll discuss more fully in Chapter 13, companies pay generous dividends when they can’t dream up new ways to use the money to expand the business. Corporate managers would much prefer to expand the business, an effort that always enhances their prestige, than to pay a dividend, an effort that is mechanical and requires no imagination.
• In the market we’ve had since 1980 the stalwarts have been good performers, but not the star performers. Most of these are huge companies, and it’s unusual to get a tenbagger out of a Bristol-Myers or a Coca-Cola. So if you own a stalwart like Bristol-Myers and the stock’s gone up 50 percent in a year or two, you have to wonder if maybe that’s enough and begin to think about selling. How much can you expect to squeeze out of Colgate-Palmolive? You aren’t going to become a millionaire off it the way you could have with Subaru, unless there is some startling new development you would have heard about by now. Fifty percent in two years is what you’d be delighted to get from Colgate-Palmolive in most normal situations. With the stalwarts you have to consider taking profits more readily than you would with a Shoney’s, or a Service Corporation International. Stalwarts are stocks that I generally buy for a 30 to 50 percent gain, then sell and repeat the process with similar issues that haven’t yet appreciated. I always keep some stalwarts in my portfolio because they offer pretty good protection during recessions and hard times. You can see here that during the 1981–82 period, when the country seemed to be falling apart and the stock market fell apart with it, Bristol-Myers went sideways (see chart). It didn’t do that well in the 1973–74 washout as we’ve already seen, but nothing escaped that bath, and besides, the stock was grossly overpriced at the time. In general, Bristol-Myers and Kellogg, Coca-Cola and MMM, Ralston Purina and Procter and Gamble, are good friends in a crisis. You know they won’t go bankrupt, and soon enough they will be reassessed and their value will be restored.
• THE FAST GROWERS These are among my favorite investments: small, aggressive new enterprises that grow at 20 to 25 percent a year. If you choose wisely, this is the land of the 10- to 40-baggers, and even the 200-baggers. With a small portfolio, one or two of these can make a career. A fast-growing company doesn’t necessarily have to belong to a fast-growing industry. As a matter of fact, I’d rather it didn’t, as you’ll see in Chapter 8. All it needs is the room to expand within a slow-growing industry. Beer is a slow-growing industry, but Anheuser-Busch has been a fast grower by taking over market share, and enticing drinkers of rival brands to switch to theirs. The hotel business grows at only 2 percent a year, but Marriott was able to grow 20 percent by capturing a larger segment of that market over the last decade.
• There’s plenty of risk in fast growers, especially in the younger companies that tend to be overzealous and underfinanced. When an underfinanced company has headaches, it usually ends up in Chapter 11. Also, Wall Street does not look kindly on fast growers that run out of stamina and turn into slow growers, and when that happens, the stocks are beaten down accordingly. I’ve already mentioned how electric utilities, especially the ones in the Sunbelt, went from being fast growers to being slow growers. In the 1960s plastics was a high-growth industry. Plastics were so much on people’s minds that when the word “plastics” was whispered to Dustin Hoffman in the movie The Graduate, the word itself became a famous line. Dow Chemical got into plastics, enjoyed a vigorous growth spurt, and was beloved as a fast grower for several years. Then the growth slowed down and Dow became a sober chemical company, a sort of plodder with cyclical overtones. Aluminum was a great growth industry even into the 1960s and so was carpets, but when these industries matured, the companies within them became GNP-type growers, and the stock market yawned. So while the smaller fast growers risk extinction, the larger fast growers risk a rapid devaluation when they begin to falter. Once a fast grower gets too big, it faces the same dilemma as Gulliver in Lilliput. There’s simply no place for it to stretch out. But for as long as they can keep it up, fast growers are the big winners in the stock market. I look for the ones that have good balance sheets and are making substantial profits. The trick is figuring out when they’ll stop growing, and how much to pay for the growth. THE CYCLICALS A cyclical is a company whose sales and profits rise and fall in regular if not completely predictable fashion. In a growth industry, business just keeps expanding, but in a cyclical industry it expands and contracts, then expands and contracts again. The autos and the airlines, the tire companies, steel companies, and chemical companies are all cyclicals. Even defense companies behave like cyclicals, since their profits’ rise and fall depends on the policies of various administrations. AMR Corporation, the parent of American Airlines, is a cyclical, and so is Ford Motor, as you can see by the chart. Charts of the cyclicals look like the polygraphs of liars, or the maps of the Alps, as opposed to the maps of Delaware you get with the slow growers. Coming out of a recession and into a vigorous economy, the cyclicals flourish, and their stock prices tend to rise much faster than the prices of the stalwarts. This is understandable, since people buy new cars and take more airplane trips in a vigorous economy, and there’s greater demand for steel, chemicals, etc. But going the other direction, the cyclicals suffer, and so do the pocketbooks of the shareholders. You can lose more than fifty percent of your investment very quickly if you buy cyclicals in the wrong part of the cycle, and it may be years before you’ll see another upswing. Cyclicals are the most misunderstood of all the types of stocks. It is here that the unwary stockpicker is most easily parted from his money, and in stocks that he considers safe. Because the major cyclicals are large and well-known companies, they are naturally lumped together with the trusty stalwarts. Since Ford is a blue chip, one might assume that it will behave the same as Bristol-Myers, another blue chip (see charts). But this is far from the truth. Ford’s stock fluctuates wildly as the company alternately loses billions of dollars in recessions and makes billions of dollars in prosperous stretches. If a stalwart such as Bristol-Myers can lose half its value in a sorry market and/or a national economic slump, a cyclical such as Ford can lose 80 percent. That’s just what happened to Ford in the early 1980s. You have to know that owning Ford is different from owning Bristol-Myers. Timing is everything in cyclicals, and you have to be able to detect the early signs that business is falling off or picking up. If you work in some profession that’s connected to steel, aluminum, airlines, automobiles, etc., then you’ve got your edge, and nowhere is it more important than in this kind of investment. TURNAROUNDS Turnaround candidates have been battered, depressed, and often can barely drag themselves into Chapter 11. These aren’t slow growers; these are no growers. These aren’t cyclicals that rebound; these are potential fatalities, such as Chrysler. Actually Chrysler once was a cyclical that went so far down in a down cycle that people thought it would never come back up. A poorly managed cyclical is always a potential candidate for the kind of trouble that befell Chrysler and, to a slightly lesser extent, Ford. The Penn Central bankruptcy was one of the most traumatic events that ever happened to Wall Street. That this blue chip, this grand old company, this solid enterprise, could collapse was as startling and as unexpected as the collapse of the George Washington Bridge would be. An entire generation of investors had its faith shaken—and yet once again there was opportunity in this crisis. Penn Central has been a marvelous turnaround play. Turnaround stocks make up lost ground very quickly, as Chrysler, Ford, Penn Central, General Public Utilities, and numerous others have proven. The best thing about investing in successful turnarounds is that of all the categories of stocks, their ups and downs are least related to the general market. I made a lot of money for my shareholders by buying Chrysler. I started buying at $6 (unadjusted for later splits) in early 1982 and watched it go up fivefold in less than two years and fifteenfold in five years. At one point I had 5% of my fund invested in Chrysler. While other stocks that I owned have risen higher, no single stock ever had the impact of Chrysler because none ever represented such a large percentage of the fund while it rose. And I didn’t even buy Chrysler at the bottom! Other more daring Chrysler fans bought in at $1.50 and made a 32-bagger out of it. Either way, Chrysler was a happy occurrence. So was Lockheed, which sold for $1 in 1973, and even after the government bailed out the company you could have bought the stock for $4 in 1977 and sold it for $60 in 1986. Lockheed was one I missed. In absolute dollars I get my greatest profits from the revival of the Chryslers and the Penn Centrals, bigger companies in which I can buy enough shares to have a meaningful impact on my fund. It’s not easy to compile lists of failed turnarounds except from memory, because their existence is wiped out of the S&P books, the chart books, and the stockbrokers’ records, and these companies are never heard from again. I could attempt to reconstruct the rather long list of the failed turnarounds I wish I hadn’t bought, except the mere idea of it gives me a headache. In spite of this, the occasional major success makes the turnaround business very exciting, and very rewarding overall. There are several different types of turnarounds, and I’ve owned all of them at one time or another. There’s the bail-us-out-or-else kind of turnaround such as Chrysler or Lockheed, where the whole thing depended on a government loan guarantee. There’s the who-would-have-thunk-it kind of turnaround, such as Con Edison. Who would ever have believed you could lose this much money in a utility, as the stock price fell from $10 to $3 by 1974; and who would have believed you could make this much, as the price rebounded from $3 to $52 by 1987? There’s the little-problem-we-didn’t-anticipate kind of turnaround, such as Three Mile Island. This was a minor tragedy perceived to be worse than it was, and in minor tragedy there’s major opportunity. I made a lot of money in General Public Utilities, the owner of Three Mile Island. Anybody could have. You just had to be patient, keep up with the news, and read it with dispassion. After the original meltdown of the nuclear unit in 1979 the situation eventually stabilized. In 1985 GPU announced it was going to start up the sister reactor that had been turned off for years after the crisis but was unaffected by it. It was a good sign for the stock that they got that sister plant back on line, and an even better sign when other utilities agreed to share in the costs of the Three Mile Island cleanup. You had almost seven years to buy the stock after the place calmed down and all this good news had come out. The low of 33/8 was reached in 1980, but you could still have gotten in for $15 a share in late 1985 and watched the stock hit $38 in October, 1988. I try to stay away from the tragedies where the outcome is unmeasurable, such as the Bhopal disaster at the Union Carbide plant in India. This was a terrible gas leak that resulted in thousands of deaths, and how much the families would get out of Union Carbide in damages was an open question. I invested in the Johns-Manville turnaround but sold at a modest loss after realizing there was no way to predict the extent of that company’s liability, either.
• THE ASSET PLAYS An asset play is any company that’s sitting on something valuable that you know about, but that the Wall Street crowd has overlooked. With so many analysts and corporate raiders snooping around, it doesn’t seem possible that there are any assets that Wall Street hasn’t noticed, but believe me, there are. The asset play is where the local edge can be used to greatest advantage. The asset may be as simple as a pile of cash. Sometimes it’s real estate. I’ve already mentioned Pebble Beach as a great asset play. Here’s why: At the end of 1976 the stock was selling for 141/2 per share, which, with 1.7 million shares outstanding, meant that the whole company was valued at only $25 million. Less than three years later (May, 1979), Twentieth Century-Fox bought out Pebble Beach for $72 million, or 421/2 per share. What’s more, a day after buying the company, Twentieth Century turned around and sold Pebble Beach’s gravel pit—just one of the company’s many assets—for $30 million. In other words, the gravel pit alone was worth more than what investors in 1976 paid for the whole company. Those investors got all the adjacent land, the 2,700 acres in Del Monte Forest and the Monterey Peninsula, the 300-year-old trees, the hotel, and the two golf courses for nothing.
• Asset opportunities are everywhere. Sure they require a working knowledge of the company that owns the assets, but once that’s understood, all you need is patience.
• Companies don’t stay in the same category forever. Over my years of watching stocks I’ve seen hundreds of them start out fitting one description and end up fitting another.
• Putting stocks in categories is the first step in developing the story. Now at least you know what kind of story it’s supposed to be. The next step is filling in the details that will help you guess how the story is going to turn out.
• Getting the story on a company is a lot easier if you understand the basic business. That’s why I’d rather invest in panty hose than in communications satellites, or in motel chains than in fiber optics. The simpler it is, the better I like it. When somebody says, “Any idiot could run this joint,” that’s a plus as far as I’m concerned, because sooner or later any idiot probably is going to be running it. If it’s a choice between owning stock in a fine company with excellent management in a highly competitive and complex industry, or a humdrum company with mediocre management in a simpleminded industry with no competition, I’d take the latter. For one thing, it’s easier to follow. During a lifetime of eating donuts or buying tires, I’ve developed a feel for the product line that I’ll never have with laser beams or microprocessors. “Any idiot can run this business” is one characteristic of the perfect company, the kind of stock I dream about. You never find the perfect company, but if you can imagine it, then you’ll know how to recognize favorable attributes, the most important thirteen of which are as follows: (1) IT SOUNDS DULL—OR, EVEN BETTER, RIDICULOUS The perfect stock would be attached to the perfect company, and the perfect company has to be engaged in a perfectly simple business, and the perfectly simple business ought to have a perfectly boring name. The more boring it is, the better. Automatic Data Processing is a good start.
• (2) IT DOES SOMETHING DULL I get even more excited when a company with a boring name also does something boring. Crown, Cork, and Seal makes cans and bottle caps. What could be duller than that? You won’t see an interview with the CEO of Crown, Cork, and Seal in Time magazine alongside an interview with Lee Iacocca, but that’s a plus. There’s nothing boring about what’s happened to the shares of Crown, Cork, and Seal.
• A company that does boring things is almost as good as a company that has a boring name, and both together is terrific. Both together is guaranteed to keep the oxymorons away until finally the good news compels them to buy in, thus sending the stock price even higher. If a company with terrific earnings and a strong balance sheet also does dull things, it gives you a lot of time to purchase the stock at a discount. Then when it becomes trendy and overpriced, you can sell your shares to the trend-followers.
• (5) THE INSTITUTIONS DON’T OWN IT, AND THE ANALYSTS DON’T FOLLOW IT If you find a stock with little or no institutional ownership, you’ve found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner. When I talk to a company that tells me the last analyst showed up three years ago, I can hardly contain my enthusiasm. It frequently happens with banks, savings-and-loans, and insurance companies, since there are thousands of these and Wall Street only keeps up with fifty to one hundred.
• (7) THERE’S SOMETHING DEPRESSING ABOUT IT In this category my favorite all-time pick is Service Corporation International (SCI), which also has a boring name. I got this pick from George Vanderheiden, the onetime Fidelity electronics analyst who’s done a great job running the Fidelity Destiny Fund. Now, if there’s anything Wall Street would rather ignore besides toxic waste, it’s mortality. And SCI does burials.
• (8) IT’S A NO-GROWTH INDUSTRY Many people prefer to invest in a high-growth industry, where there’s a lot of sound and fury. Not me. I prefer to invest in a low-growth industry like plastic knives and forks, but only if I can’t find a no-growth industry like funerals. That’s where the biggest winners are developed. There’s nothing thrilling about a thrilling high-growth industry, except watching the stocks go down. Carpets in the 1950s, electronics in the 1960s, computers in the 1980s, were all exciting high-growth industries, in which numerous major and minor companies unerringly failed to prosper for long. That’s because for every single product in a hot industry, there are a thousand MIT graduates trying to figure out how to make it cheaper in Taiwan. As soon as a computer company designs the best word-processor in the world, ten other competitors are spending $100 million to design a better one, and it will be on the market in eight months. This doesn’t happen with bottle caps, coupon-clipping services, oil-drum retrieval, or motel chains. SCI was helped by the fact that there’s almost no growth in the funeral industry. Growth in the burial business in this country limps along at one percent a year, too slow for the action-seekers who’ve gone into computers. But it’s a steady business with as reliable a customer base as you could ever find. In a no-growth industry, especially one that’s boring and upsets people, there’s no problem with competition. You don’t have to protect your flanks from potential rivals because nobody else is going to be interested. This gives you the leeway to continue to grow, to gain market share, as SCI has done with burials. SCI already owns 5 percent of the nation’s funeral homes, and there’s nothing stopping them from owning 10 percent or 15 percent. The graduating class of Wharton isn’t going to want to challenge SCI, and you can’t tell your friends in the investment banking firms that you’ve decided to specialize in picking up dirty oil from the gas stations.
• I always look for niches. The perfect company would have to have one. Warren Buffett started out by acquiring a textile mill in New Bedford, Massachusetts, which he quickly realized was not a niche business. He did poorly in textiles but went on to make billions for his shareholders by investing in niches. He was one of the first to see the value in newspapers and TV stations that dominated major markets, beginning with the Washington Post. Thinking along the same lines, I bought as much stock as I could in Affiliated Publications, which owns the local Boston Globe. Since the Globe gets over 90 percent of the print ad revenues in Boston, how could the Globe lose?
• (10) PEOPLE HAVE TO KEEP BUYING IT I’d rather invest in a company that makes drugs, soft drinks, razor blades, or cigarettes than in a company that makes toys. In the toy industry somebody can make a wonderful doll that every child has to have, but every child gets only one each. Eight months later that product is taken off the shelves to make room for the newest doll the children have to have—manufactured by somebody else. Why take chances on fickle purchases when there’s so much steady business around? (11) IT’S A USER OF TECHNOLOGY Instead of investing in computer companies that struggle to survive in an endless price war, why not invest in a company that benefits from the price war—such as Automatic Data Processing? As computers get cheaper, Automatic Data can do its job cheaper and thus increase its own profits. Or instead of investing in a company that makes automatic scanners, why not invest in the supermarkets that install the scanners? If a scanner helps a supermarket company cut costs just three percent, that alone might double the company’s earnings. (12) THE INSIDERS ARE BUYERS There’s no better tip-off to the probable success of a stock than that people in the company are putting their own money into it. In general, corporate insiders are net sellers, and they normally sell 2.3 shares to every one share that they buy. After the 1,000-point drop from August to October, 1987, it was reassuring to discover that there were four shares bought to every one share sold by insiders across the board. At least they hadn’t lost their faith. When insiders are buying like crazy, you can be certain that, at a minimum, the company will not go bankrupt in the next six months. When insiders are buying, I’d bet there aren’t three companies in history that have gone bankrupt near term.
• Although it’s a nice gesture for the CEO or the corporate president with the million-dollar salary to buy a few thousand shares of the company stock, it’s more significant when employees at the lower echelons add to their positions. If you see someone with a $45,000 annual salary buying $10,000 worth of stock, you can be sure it’s a meaningful vote of confidence. That’s why I’d rather find seven vice presidents buying 1,000 shares apiece than the president buying 5,000. If the stock price drops after the insiders have bought, so that you have a chance to buy it cheaper than they did, so much the better for you. It’s simple to keep track of insider purchases. Every time an officer or a director buys or sells shares, he or she has to declare it on Form 4 and send the form to the Securities and Exchange Commission advising them of the fact. Several newsletter services, including Vicker’s Weekly Insider Report and The Insiders, keep track of these filings. Barron’s, The Wall Street Journal, and Investor’s Daily also carry the information. Many local business newspapers report on insider trading on local companies—I know the Boston Business Journal has such a column. Your broker may also be able to provide the information, or you may find that your local library subscribes to the newsletters. There’s also a tabulation of insider buying and selling in the Value Line publication. (Insider selling usually means nothing, and it’s silly to react to it. If a stock had gone from $3 to $12 and nine officers were selling, I’d take notice, particularly if they were selling a majority of their shares. But in normal situations insider selling is not an automatic sign of trouble within a company. There are many reasons that officers might sell. They may need the money to pay their children’s tuition or to buy a new house or to satisfy a debt. They may have decided to diversify into other stocks. But there’s only one reason that insiders buy: They think the stock price is undervalued and will eventually go up.) (13) THE COMPANY IS BUYING BACK SHARES Buying back shares is the simplest and best way a company can reward its investors. If a company has faith in its own future, then why shouldn’t it invest in itself, just as the shareholders do? The announcement of massive share buybacks by company after company broke on October 20, 1987 the fall of many stocks, and stabilized the market at the height of its panic. Long term, these buybacks can’t help but reward investors. When stock is bought in by the company, it is taken out of circulation, therefore shrinking the number of outstanding shares. This can have a magical effect on earnings per share, which in turn has a magical effect on the stock price. If a company buys back half its shares and its overall earnings stay the same, the earnings per share have just doubled. Few companies could get that kind of result by cutting costs or selling more widgets.
• The common alternatives to buying back shares are (1) raising the dividend, (2) developing new products, (3) starting new operations, and (4) making acquisitions. Gillette tried to do all four, with emphasis on the final three. Gillette has a spectacularly profitable razor business, which it gradually reduced in relative size as it acquired less profitable operations. If the company had regularly bought back its shares and raised its dividend instead of diverting its capital to cosmetics, toiletries, ballpoint pens, cigarette lighters, curlers, blenders, office products, toothbrushes, hair care, digital watches, and lots of other diversions, the stock might well be worth over $100 instead of the current $35. In the last five years, Gillette has gotten back on track by eliminating losing operations and emphasizing its core shaving business, where it dominates the market. The reverse of buying back shares is adding more shares, also called diluting. International Harvester, now Navistar, sold millions of additional shares to raise cash to help it survive a financial crisis brought about by the collapse of the farm-equipment business (see chart). Chrysler, remember, did just the opposite—buying back stock and stock warrants and shrinking the number of outstanding shares as the business improved (see chart). Navistar is once again a profitable company, but because of the extraordinary dilution, the earnings have a minimal impact, and shareholders have yet to benefit from the recovery to any significant degree.
• If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train—and succumbing to the social pressure, often buys. Hot stocks can go up fast, usually out of sight of any of the known landmarks of value, but since there’s nothing but hope and thin air to support them, they fall just as quickly. If you aren’t clever at selling hot stocks (and the fact that you’ve bought them is a clue that you won’t be), you’ll soon see your profits turn into losses, because when the price falls, it’s not going to fall slowly, nor is it likely to stop at the level where you jumped on.
• Wood floors were once cheaper than carpets, but now carpets were cheaper, so the upper classes switched from carpets to wood floors and the masses switched from wood floors to carpets. Carpet sales rose dramatically, and the five or six major producers were earning more money than they knew how to spend, and growing at an astonishing pace. That’s when the analysts started telling the stockbrokers that the carpet boom would last forever, and the brokers told their clients, and the clients bought the carpet stocks. At the same time, the five or six major producers were joined by two hundred new competitors, and they all fought for customers by dropping their prices, and nobody made another dime in the carpet business.
• Contrast the sorry stock performance of Xerox to that of Philip Morris, a company that sells cigarettes—a negative-growth industry in the U.S. Over the past fifteen years Xerox dropped from $160 to $60, while Philip Morris rose from $14 to $90. Year after year Philip Morris increases its earnings by expanding its market share abroad, by raising prices, and by cutting costs. Because of its brand names—Marlboro, Virginia Slims, Benson & Hedges, Merit, etc.—Philip Morris has found its niche. Negative-growth industries do not attract flocks of competitors. BEWARE THE NEXT SOMETHING Another stock I’d avoid is a stock in a company that’s been touted as the next IBM, the next McDonald’s, the next Intel, or the next Disney, etc. In my experience the next of something almost never is—on Broadway, the best-seller list, the National Basketball Association, or Wall Street. How many times have you heard that some player is supposed to be the next Willie Mays, or that some novel is supposed to be the next Moby Dick, only to find that the first is cut from the team, and the second is quietly remaindered? In stocks there’s a similar curse. In fact, when people tout a stock as the next of something, it often marks the end of prosperity not only for the imitator but also for the original to which it is being compared. When other computer companies were called the “next IBM,” you could have guessed that IBM would go through some terrible times, and it has. Today most computer companies are trying not to become the next IBM, which may mean better times ahead for that beleaguered firm.
• That’s not to say it’s always foolish to make acquisitions. It’s a very good strategy in situations where the basic business is terrible. We would never have heard of Warren Buffett or his Berkshire Hathaway if Buffett had stuck to textiles. The same might be said of the Tisches, who started out with a chain of movie theaters (Loew’s) and used the proceeds to buy a tobacco company (Lorillard), which in turn helped them acquire an insurance company (CNA), which led to their taking a huge position in CBS. The trick is that you have to know how to make the right acquisitions and then manage them successfully.
• Why did Melville succeed while Genesco failed? The answer has a lot to do with a concept called synergy. “Synergy” is a fancy name for the two-plus-two-equals-five theory of putting together related businesses and making the whole thing work. The synergy theory suggests, for example, that since Marriott already operates hotels and restaurants, it made sense for them to acquire the Big Boy restaurant chain, and also to acquire the subsidiary that provides meal service to prisons and colleges. (College students will tell you there’s a lot of synergy between prison food and college food.) But what would Marriott know about auto parts or video games? In practice, sometimes acquisitions produce synergy, and sometimes they don’t. Gillette, the leading manufacturer of razor blades, got some synergy when it acquired the Foamy shaving cream line. However, that didn’t extend to shampoo, lotion, and all the other toiletry items that Gillette brought under its control. Buffett’s Berkshire Hathaway has bought everything from candy stores to furniture stores to newspapers, with spectacular results. Then again, Buffett’s company is devoted to acquisitions. If a company must acquire something, I’d prefer it to be a related business, but acquisitions in general make me nervous. There’s a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them. I’d rather see a vigorous buyback of shares, which is the purest synergy of all.
• Whisper stocks have a hypnotic effect, and usually the stories have emotional appeal. This is where the sizzle is so delectable that you forget to notice there’s no steak. If you or I regularly invested in these stocks, we both would need part-time jobs to offset the losses. They may go up before they come down, but as a long-term proposition I’ve lost money on every single one I’ve ever bought.
• What all these longshots had in common besides the fact that you lost money on them was that the great story had no substance. That’s the essence of a whisper stock.
• What I try to remind myself (and obviously I’m not always successful) is that if the prospects are so phenomenal, then this will be a fine investment next year and the year after that. Why not put off buying the stock until later, when the company has established a record? Wait for the earnings. You can get tenbaggers in companies that have already proven themselves. When in doubt, tune in later.
• BEWARE THE MIDDLEMAN The company that sells 25 to 50 percent of its wares to a single customer is in a precarious situation. SCI Systems (not to be confused with the funeral-home firm) is a well-managed company and a major supplier of computer parts to IBM, but you never know when IBM will decide that it can make its own parts, or that it can do without the parts, and then cancel the SCI contract. If the loss of one customer would be catastrophic to a supplier, I’d be wary of investing in the supplier. Disk-drive companies such as Tandon were always on the brink of disaster because they were too dependent on a few clients.
• Let’s say you noticed Sensormatic, the company that invented the clever tag and buzzer system for foiling shoplifters, and whose stock rose from $2 to $42 as the business expanded between 1979 and 1983. Your broker tells you it’s a small company and a fast grower. Or perhaps you’ve reviewed your portfolio and you’ve found two stalwarts and three cyclicals. What possible assurance do you have that Sensormatic, or any of the stocks you own already, will go up in price? And if you’re buying, how much should you pay? What you’re asking here is what makes a company valuable, and why it will be more valuable tomorrow than it is today. There are many theories, but to me, it always comes down to earnings and assets. Especially earnings. Sometimes it takes years for the stock price to catch up to a company’s value, and the down periods last so long that investors begin to doubt that will ever happen. But value always wins out—or at least in enough cases that it’s worthwhile to believe it.
• Here’s another way of thinking about earnings and assets. If you were a stock, your earnings and assets would determine how much an investor would be willing to pay for a percentage of your action. Evaluating yourself as you might evaluate General Motors is an instructive exercise, and it helps you get the hang of this phase of the investigation.
• Now that you’re thinking about it, you might want to put yourself in one of the six categories of stocks we’ve already gone over. This could be a halfway decent party game: People who work in secure jobs that pay low salaries and modest raises are slow growers, the human equivalents of the electric utilities such as American Electric Power. Librarians, schoolteachers, and policemen are slow growers. People who command good salaries and get predictable raises, such as the middle-level managers of corporations, are stalwarts: the Coca-Colas and Ralston Purinas of the work force. Farmers, hotel and resort employees, jai alai players, summer-camp operators, and Christmas tree sales-lot operators who make all their money in short bursts and then try to budget it through long, unprofitable stretches are cyclicals. Writers and actors may also be cyclicals, but the possibility of sudden increases in fortune makes them potential fast growers. Ne’er-do-wells, trust-fund men and women, squires, bon vivants, and others, who live off family fortunes but contribute nothing from their own labor are asset plays, the gold-mining stocks and railroads of our analogy. The issue with asset plays is always what will be left after all the debts are run up, and the creditors at the liquor store and the travel agency paid off. Guttersnipes, drifters, down-and-outers, bankrupts, workers who’ve been laid off, and others in the unemployment lines are all potential turnarounds, as long as there’s any energy and enterprise left in them. Actors, inventors, real estate developers, small businessmen, athletes, musicians, and criminals are all potential fast growers. In this group there’s a higher failure rate than there is among stalwarts, but if and when a fast grower succeeds, he or she may boost income tenfold, twentyfold, or even a hundredfold overnight, making him or her the human equivalent of Taco Bell or Stop & Shop.
• During the last decade we’ve seen recessions and inflation, oil prices going up and oil prices going down, and all along, these stocks have followed earnings. Look at the chart of Dow Chemical. When earnings are up the stock is up. That’s what happened during the period from 1971 to 1975 and again from 1985 through 1988. In between, from 1975 through 1985, earnings were erratic and so was the stock price. Look at Avon, a stock that jumped from $3 in 1958 to $140 in 1972 as earnings continued to rise. Optimism abounded, and the stock price became inflated relative to earnings. Then, in 1973, the fantasy ended. The stock price collapsed because earnings collapsed, and you could have seen it coming. Forbes magazine warned us all in a cover article ten months before the collapse began.
• Look at Shoney’s, a restaurant chain that has had 116 consecutive quarters (twenty-nine years) of higher revenues—a record few companies could match. Sure enough, the stock price has steadily moved up. In those few spots where the price got ahead of the earnings, it promptly fell back to reality, as you can see in the chart. The chart for Marriott, another great growth stock, tells the same story. And look at The Limited. When earnings stumbled in the late seventies, so did the stock. When earnings then soared, the stock soared as well. But when the stock got way ahead of earnings, as it did in 1983 and again in 1987, the result was a short-term disaster. The same was true for countless other stocks in the October, 1987 market decline. (A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies—such as Shoney’s, The Limited, or Marriott—when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well. [It sure would have worked with Avon!] I’m not necessarily advocating this practice, but I can think of worse strategies.) THE FAMOUS P/E RATIO Any serious discussion of earnings involves the price/earnings ratio—also known as the p/e ratio, the price-earnings multiple, or simply, the multiple. This ratio is a numerical shorthand for the relationship between the stock price and the earnings of the company. The p/e ratio for each stock is listed in the daily stock tables of most major newspapers, as shown here. THE WALL STREET JOURNAL TUESDAY, SEPTEMBER 13, 1988 73 52 Weeks Yld P-E Sales Net. High Low Stock Div. % Ratio 100s High Low Close Chg. 431/4 215/8 K mart 1.32 3.8 10 4696 351/8 341/2 35 +3/8 Like the earnings line, the p/e ratio is often a useful measure of whether any stock is overpriced, fairly priced, or underpriced relative to a company’s money-making potential. (In a few cases the p/e ratio listed in the newspaper may be abnormally high, often because a company has written off some long-term losses against the current short-term earnings, thus “punishing” those earnings. If the p/e seems out of line, you can ask your broker to provide you with an explanation.) In today’s Wall Street Journal, for instance, I see that K mart has a p/e ratio of 10. This was derived by taking the current price of the stock ($35 a share) and dividing it by the company’s earnings for the prior 12 months or fiscal year (in this case, $3.50 a share). The $35 divided by the $3.50 results in the p/e of 10. The p/e ratio can be thought of as the number of years it will take the company to earn back the amount of your initial investment—assuming, of course, that the company’s earnings stay constant. Let’s say you buy 100 shares of K mart for $3,500. Current earnings are $3.50 per share, so your 100 shares will earn $350 in one year, and the original investment of $3,500 will be earned back in ten years. However, you don’t have to go through this exercise because the p/e ratio of 10 tells you it’s ten years. If you buy shares in a company selling at two times earnings (a p/e of 2), you will earn back your initial investment in two years, but in a company selling at 40 times earnings (a p/e of 40) it would take forty years to accomplish the same thing. Cher might be a great-grandmother by then. With all the low p/e opportunities around, why then would anybody buy a stock with a high p/e? Because they’re looking for Harrison Ford at the lumber yard. Corporate earnings do not stay constant any more than human earnings do. The fact that some stocks have p/e’s of 40 and others have p/e’s of 3 tells you that investors are willing to take substantial gambles on the improved future earnings of some companies, while they’re quite skeptical about the future of others. Look in the newspaper and you’ll be amazed at the range of p/e’s that you see. You’ll also find that the p/e levels tend to be lowest for the slow growers and highest for the fast growers, with the cyclicals vacillating in between. That’s as it should be, if you follow the logic of the discussion above. An average p/e for a utility (7 to 9 these days) will be lower than the average p/e for a stalwart (10 to 14 these days), and that in turn will be lower than the average p/e of a fast grower (14–20). Some bargain hunters believe in buying any and all stocks with low p/e’s, but that strategy makes no sense to me. We shouldn’t compare apples to oranges. What’s a bargain p/e for a Dow Chemical isn’t necessarily the same as a bargain p/e for a Wal-Mart. MORE ON THE P/E A full discussion of p/e ratios of various industries and different types of companies would take an entire book that nobody would want to read. It’s silly to get bogged down in p/e’s, but you don’t want to ignore them. Once again, your broker may be your best source for p/e analysis. You might begin by asking whether the p/e ratios of various stocks you own are low, high, or average, relative to the industry norms. Sometimes you’ll hear things like “this company is selling at a discount to the industry”—meaning that its p/e is at a bargain level. A broker can also give you the historical record of a company’s p/e—and the same information can be found on the S&P reports also available from the brokerage firm. Before you buy a stock, you might want to track its p/e ratio back through several years to get a sense of its normal levels. (New companies, of course, haven’t been around long enough to have such records.)
• (The Value Line Investment Survey, available in most large libraries and also from most brokers, is another good source for p/e histories. In fact, Value Line is a good source for all the pertinent data that amateur investors need to know. It’s the next best thing to having your own private securities analyst.) If you remember nothing else about p/e ratios, remember to avoid stocks with excessively high ones. You’ll save yourself a lot of grief and a lot of money if you do. With few exceptions, an extremely high p/e ratio is a handicap to a stock, in the same way that extra weight in the saddle is a handicap to a racehorse. A company with a high p/e must have incredible earnings growth to justify the high price that’s been put on the stock.
• THE P/E OF THE MARKET Company p/e ratios do not exist in a vacuum. The stock market as a whole has its own collective p/e ratio, which is a good indicator of whether the market at large is overvalued or undervalued. I know I’ve already advised you to ignore the market, but when you find that a few stocks are selling at inflated prices relative to earnings, it’s likely that most stocks are selling at inflated prices relative to earnings. That’s what happened before the big drop in 1973–74, and once again (although not to the same extent) before the big drop of 1987. During the five years of the latest bull market, from 1982 to 1987, you could see the market’s overall p/e ratio creep gradually higher, from about 8 to 16. This meant that investors in 1987 were willing to pay twice what they paid in 1982 for the same corporate earnings—which should have been a warning that most stocks were overvalued. Interest rates have a large effect on the prevailing p/e ratios, since investors pay more for stocks when interest rates are low and bonds are less attractive. But interest rates aside, the incredible optimism that develops in bull markets can drive p/e ratios to ridiculous levels, as it did in the cases of EDS, Avon, and Polaroid. In that period, the fast growers commanded p/e ratios that belonged somewhere in Wonderland, the slow growers were commanding p/e ratios normally reserved for fast growers, and the p/e of the market itself hit a peak of 20 in 1971. Any student of the p/e ratio could have seen that this was lunacy, and I wish one of them had told me. In 1973–74 the market had its most brutal correction since the 1930s.
• There are five basic ways a company can increase earnings*: reduce costs; raise prices; expand into new markets; sell more of its product in the old markets; or revitalize, close, or otherwise dispose of a losing operation. These are the factors to investigate as you develop the story. If you have an edge, this is where it’s going to be most helpful.
• The Two-Minute Drill Already you’ve found out whether you’re dealing with a slow grower, a stalwart, a fast grower, a turnaround, an asset play, or a cyclical. The p/e ratio has given you a rough idea of whether the stock, as currently priced, is undervalued or overvalued relative to its immediate prospects. The next step is to learn as much as possible about what the company is doing to bring about the added prosperity, the growth spurt, or whatever happy event is expected to occur. This is known as the “story.” With the possible exception of the asset play (where you can sit back and wait for the value of the real estate or the oil reserves or the TV stations to be recognized by others), something dynamic has to happen to keep the earnings moving along. The more certain you are about what that something is, the better you’ll be able to follow the script. The analyst’s reports on the company you get from your broker, and the short essays in the Value Line give you the professional version of the story, but if you’ve got an edge in the company or in the industry, you’ll be able to develop your own script in useful detail. Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. The two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot. Once you’re able to tell the story of a stock to your family, your friends, or the dog (and I don’t mean “a guy on the bus says Caesars World is a takeover”), and so that even a child could understand it, then you have a proper grasp of the situation. Here are some of the topics that might be addressed in the monologue: If it’s a slow-growing company you’re thinking about, then presumably you’re in it for the dividend, (Why else own this kind of stock?) Therefore, the important elements of the script would be: “This company has increased earnings every year for the last ten, it offers an attractive yield; it’s never reduced or suspended a dividend, and in fact it’s raised the dividend during good times and bad, including the last three recessions. It’s a telephone utility, and the new cellular operations may add a substantial kicker to the growth rate.” If it’s a cyclical company you’re thinking about, then your script revolves around business conditions, inventories, and prices. “There has been a three-year business slump in the auto industry, but this year things have turned around. I know that because car sales are up across the board for the first time in recent memory. I notice that GM’s new models are selling well, and in the last eighteen months the company has closed five inefficient plants, cut twenty percent off labor costs, and earnings are about to turn sharply higher.” If it’s an asset play, then what are the assets, how much are they worth? “The stock sells for $8, but the videocassette division alone is worth $4 a share and the real estate is worth $7. That’s a bargain in itself, and I’m getting the rest of the company for a minus $3. Insiders are buying, and the company has steady earnings, and there’s no debt to speak of.” If it’s a turnaround, then has the company gone about improving its fortunes, and is the plan working so far? “General Mills has made great progress in curing its diworseification. It’s gone from eleven basic businesses to two. By selling off Eddie Bauer, Talbot’s, Kenner, and Parker Brothers and getting top dollar for these excellent companies, General Mills has returned to doing what it does best: restaurants and packaged foods. The company has been buying back millions of its shares. The seafood subsidiary, Gortons, has grown from 7 percent of the seafood market to 25 percent. They are coming out with low-cal yogurt, no-cholesterol Bisquick, and microwave brownies. Earnings are up sharply.” If it’s a stalwart, then the key issues are the p/e ratio, whether the stock already has had a dramatic run-up in price in recent months, and what, if anything, is happening to accelerate the growth rate. You might say to yourself: “Coca-Cola is selling at the low end of its p/e range. The stock hasn’t gone anywhere for two years. The company has improved itself in several ways. It sold half its interest in Columbia Pictures to the public. Diet drinks have sped up the growth rate dramatically. Last year the Japanese drank 36 percent more Cokes than they did the year before, and the Spanish upped their consumption by 26 percent. That’s phenomenal progress. Foreign sales are excellent in general. Through a separate stock offering, Coca-Cola Enterprises, the company has bought out many of its independent regional distributors. Now the company has better control over distribution and domestic sales. Because of these factors, Coca-Cola may do better than people think.” If it is a fast grower, then where and how can it continue to grow fast? “La Quinta is a motel chain that started out in Texas. It was very profitable there. The company successfully duplicated its successful formula in Arkansas and Louisiana. Last year it added 20 percent more motel units than the year before. Earnings have increased every quarter. The company plans rapid future expansion. The debt is not excessive. Motels are a low-growth industry, and very competitive, but La Quinta has found something of a niche. It has a long way to go before it has saturated the market.” Those are some basic themes for the story, and you can fill in as much detail as you want. The more you know the better. I often devote several hours to developing a script, though that’s not always necessary. Let me give you two examples, one a situation that I checked out properly, and the other where there was something I forgot to ask. The first was La Quinta, which has been a fifteenbagger, and the second was Bildner’s, a fifteenbagger in reverse. CHECKING OUT LA QUINTA At one point I’d decided the motel industry was due for a cyclical turnaround. I’d already invested in United Inns, the largest franchiser of Holiday Inns, and I was keeping my ears open for other opportunities. During a telephone interview with a vice president at United Inns, I asked which company was Holiday Inn’s most successful competitor. Asking about the competition is one of my favorite techniques for finding promising new stocks. Muckamucks speak negatively about the competition ninety-five percent of the time, and it doesn’t mean much. But when an executive of one company admits he’s impressed by another company, you can bet that company is doing something right. Nothing could be more bullish than begrudging admiration from a rival.
• That’s one reason I prefer hotel and restaurant stocks to technology stocks—the minute you invest in an exciting new technology, a more exciting and newer technology is brought out of somebody else’s lab. But the prototypes of would-be hotel and restaurant chains have to show up someplace—you simply can’t build 100 of them overnight, and if they are in a different part of the country, they wouldn’t affect you anyway.
• That the stock had doubled in the previous year wasn’t bothersome—the p/e ratio relative to the growth rate still made it a bargain. What bothered me was that one of the important insiders had sold his shares at half the price I was staring at in the newspaper. (I found out later that this insider, a member of the founding family of La Quinta, was simply diversifying his portfolio.) Fortunately I reminded myself that insider selling is a terrible reason to dislike a stock, and then I bought as much La Quinta as possible for Magellan fund. I made elevenfold on it over a ten-year period before it suffered a downturn due to declining fortunes in the energy-producing states. Recently the company has become an exciting combination of asset play and turnaround.
• You know what Mark Twain says: ‘October is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.’ ”
• In the unlikely event that investor relations gives you the cold shoulder, you can tell them that you own 20,000 shares and are trying to decide whether to double your position. Then casually mention that your shares are held in “street name.” That ought to warm things up. Actually I’m not recommending this, but fibbing is something that some people would think of, and the odds of your being caught in it here are nil. The company has to take your word for the 20,000 shares, because shares held in street name are lumped together by the brokerage firms and stored in an undifferentiated mass. Before you call the company, it’s advisable to prepare your questions, and you needn’t lead off with “Why is the stock going down?” Asking why the stock is going down immediately brands you as a neophyte and undeserving of serious response. In most cases a company has no idea why the stock is going down. Earnings are a good topic, but for some reason it’s not regarded as proper etiquette to ask the company “How much are you going to make?” any more than it’s proper etiquette for strangers to ask you your annual salary. The accepted form of the question is subtle and indirect: “What are the Wall Street estimates of your company’s earnings for the upcoming year?”
• I flip past all that and turn directly to the Consolidated Balance Sheet printed on the cheaper paper on page 27 of the report (see charts). (That’s a rule with annuals and perhaps with publications in general—the cheaper the paper the more valuable the information.) The balance sheet lists the assets and then the liabilities. That’s critical to me. In the top column marked Current Assets, I notice that the company has $5.672 billion in cash and cash items, plus $4.424 billion in marketable securities. Adding these two items together, I get the company’s current overall-cash position, which I round off to $10.1 billion. Comparing the 1987 cash to the 1986 cash in the right-hand column, I see that Ford is socking away more and more cash. This is a sure sign of prosperity. Then I go to the other half of the balance sheet, down to the entry that says “long-term debt.” Here I see that the 1987 long-term debt is $1.75 billion, considerably reduced from last year’s long-term debt. Debt reduction is another sign of prosperity. When cash increases relative to debt, it’s an improving balance sheet. When it’s the other way around, it’s a deteriorating balance sheet. Subtracting the long-term debt from the cash, I arrive at $8.35 billion, Ford’s “net cash” position. The cash and cash assets alone exceed the debt by $8.35 billion. When cash exceeds debt it’s very favorable. No matter what happens, Ford isn’t about to go out of business. (You may have noticed Ford’s short-term debt of $1.8 billion. I ignore short-term debt in my calculations. The purists can fret all they want about this, but why complicate matters unnecessarily? I simply assume that the company’s other assets [inventories and so forth] are valuable enough to cover the short-term debt, and I leave it at that.)
• PERCENT OF SALES When I’m interested in a company because of a particular product—such as L’eggs, Pampers, Bufferin, or Lexan plastic—the first thing I want to know is what that product means to the company in question. What percent of sales does it represent? L’eggs sent Hanes stock soaring because Hanes was a relatively small company. Pampers was more profitable than L’eggs, but it didn’t mean as much to the huge Procter and Gamble. Let’s say you’ve gotten excited about Lexan plastic, and you find out that General Electric makes Lexan. Next, you discover from your broker (or from the annual report if you can follow it) that the plastics division is part of the materials division, and that entire division contributes only 6.8 percent to GE’s total revenues. So what if Lexan is the next Pampers—it’s not going to mean much to the shareholders of GE. You look at this and ask yourself who else makes Lexan, or you forget about Lexan. THE PRICE/EARNINGS RATIO We’ve gone on about this already, but here’s a useful refinement: The p/e ratio of any company that’s fairly priced will equal its growth rate. I’m talking about growth rate of earnings here. How do you find that out? Ask your broker what’s the growth rate, as compared to the p/e ratio. If the p/e of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year (also known as a “12-percent grower”) and a p/e ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown. In general, a p/e ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative. We use this measure all the time in analyzing stocks for the mutual funds.
• A slightly more complicated formula enables us to compare growth rates to earnings, while also taking the dividends into account. Find the long-term growth rate (say, Company X’s is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the p/e ratio (Company X’s is 10). 12 plus 3 divided by 10 is 1.5. Less than a 1 is poor, and 1.5 is okay, but what you’re really looking for is a 2 or better. A company with a 15 percent growth rate, a 3 percent dividend, and a p/e of 6 would have a fabulous 3. THE CASH POSITION We just went over Ford’s $8.35 billion in cash net of long-term debt. When a company is sitting on billions in cash, it’s definitely something you want to know about. Here’s why: Ford’s stock had moved from $4 a share in 1982 to $38 a share in early 1988 (adjusted for splits). Along the way I’d bought my 5 million shares. At $38 a share I’d already made a huge profit in Ford, and the Wall Street chorus had been sounding off for almost two years about Ford’s being overvalued. Numerous advisors said that this cyclical auto company had had its last hurrah and the next move was down. I almost cashed in the stock on several occasions. But by glancing at the annual report I’d noticed that Ford had accumulated the $16.30 a share in cash beyond debt—as mentioned in the previous chapter. For every share of Ford I owned, there was this $16.30 bonus sitting there on paper like some delightful hidden rebate. The $16.30 bonus changed everything. It meant that I was buying the auto company not for $38 a share, the stock price at the time, but for $21.70 a share ($38 minus the $16.30 in cash). Analysts were expecting Ford to earn $7 a share from its auto operations, which at the $38 price gave it a p/e of 5.4, but at the $21.70 price it had a p/e of 3.1. A p/e of 3.1 is a tantalizing number, cycles or no cycles. Maybe I wouldn’t have been impressed if Ford were a lousy company or if people were turned off by its latest cars. But Ford is a great company, and people loved the latest Ford cars and trucks. The cash factor helped convince me to hold on to Ford, and it rose more than 40 percent after I made the decision not to sell. I also knew (and you could have found out on page 5 of the annual report—still in the readable glossy section) that Ford’s financial services group—Ford Credit, First Nationwide, U. S. Leasing, and others—earned $1.66 per share on their own in 1987. For Ford Credit, which alone contributed $1.33 per share, it was “its 13th consecutive year of earnings growth.” Assigning a hypothetical p/e ratio of 10 to the earnings of Ford’s financial businesses (finance companies commonly have p/e ratios of 10) I estimated the value of these subsidiaries to be 10 times the $1.66, or $16.60 per share. So with Ford selling for $38, you were getting the $16.30 in net cash and another $16.60 in the value of the finance companies, so the automobile business was costing you a grand total of $5.10 per share. And this same automobile business was expected to earn $7 a share. Was Ford a risky pick? At $5.10 per share it was an absolute steal, in spite of the fact that the stock was up almost tenfold already since 1982. Boeing is another cash-rich stock. In early 1987 it sold in the low $40s, but with $27 in cash, you were buying the company for $15. I tuned in to Boeing with a small position in early 1988, then built it up to a major one—partly because of the cash and partly because Boeing had a record backlog of commercial orders yet to be filled. Cash doesn’t always make a difference, of course. More often than not, there isn’t enough of it to worry about. Schlumberger has a lot of cash, but not an impressive amount per share. Bristol-Myers has $1.6 billion in cash and only $200 million in long-term debt, which produces an impressive ratio, but with 280 million shares outstanding, $1.4 billion net cash (after subtracting debt) works out to $5 per share. The $5 doesn’t count for much with the stock selling for over $40. If the stock dropped to $15, it would be a big deal. Nevertheless, it’s always advisable to check the cash position (and the value of related businesses) as part of your research. You never know when you’ll stumble across a Ford.
• BOOK VALUE Book value gets a lot of attention these days—perhaps because it’s such an easy number to find. You see it reported everywhere. Popular computer programs can tell you instantly how many stocks are selling for less than the stated book value. People invest in these on the theory that if the book value is $20 a share and the stock sells for $10, they’re getting something for half price. The flaw is that the stated book value often bears little relationship to the actual worth of the company. It often understates or overstates reality by a large margin. Penn Central had a book value of more than $60 a share when it went bankrupt!
• Overvalued assets on the left side of the balance sheet are especially treacherous when there’s a lot of debt on the right. Let’s say that a company shows $400 million in assets and $300 million in debts, resulting in a positive book value of $100 million. You know the debt part is a real number. But if the $400 million in assets will bring only $200 million in a bankruptcy sale, then the actual book value is a negative $100 million. The company is less than worthless.
• When you buy a stock for its book value, you have to have a detailed understanding of what those values really are. At Penn Central, tunnels through mountains and useless rail cars counted as assets. MORE HIDDEN ASSETS Just as often as book value overstates true worth, it can understate true worth. This is where you get the greatest asset plays. Companies that own natural resources—such as land, timber, oil, or precious metals—carry those assets on their book at a fraction of the true value. For instance, in 1987, Handy and Harman, a manufacturer of precious metals products, had a book value of $7.83 per share, including its rather large inventories of gold, silver, and platinum. But these inventories are carried on the books at the prices Handy and Harman originally paid for the metals—and that could have been thirty years ago. At today’s prices ($6.40 an ounce for silver and $415 for gold) the metals are worth over $19 per share.
• A lot of people use the cash flow numbers to evaluate stocks. For instance, a $20 stock with $2 per share in annual cash flow has a 10-to-1 ratio, which is standard. A ten percent return on cash corresponds nicely with the ten percent that one expects as a minimum reward for owning stocks long term. A $20 stock with a $4-per-share cash flow gives you a 20 percent return on cash, which is terrific. And if you find a $20 stock with a sustainable $10-per-share cash flow, mortgage your house and buy all the shares you can find. There’s no point getting bogged down in these calculations. But if cash flow is ever mentioned as a reason you’re supposed to buy a stock, make sure that it’s free cash flow that they’re talking about. Free cash flow is what’s left over after the normal capital spending is taken out. It’s the cash you’ve taken in that you don’t have to spend. Pig Iron, Inc. will have a lot less free cash flow than Philip Morris.
• GROWTH RATE That “growth” is synonymous with “expansion” is one of the most popular misconceptions on Wall Street, leading people to overlook the really great growth companies
• That’s the only growth rate that really counts: earnings.
• If you find a business that can get away with raising prices year after year without losing customers (an addictive product such as cigarettes fills the bill), you’ve got a terrific investment.
• THE BOTTOM LINE Everywhere you turn these days you hear some reference to the “bottom line.” “What’s the bottom line?” is a common refrain in sports, business deals, and even courtship. So what is the real bottom line? It’s the final number at the end of an income statement: profit after taxes. Corporate profitability tends to be misunderstood by many in our society. In a survey I once saw, college students and other young adults were asked to guess the average profit margin on the corporate dollar. Most guessed 20–40 percent. In the last few decades the actual answer has been closer to 5 percent. Profit before taxes, also known as the pretax profit margin, is a tool I use in analyzing companies. That’s what’s left of a company’s annual sales dollar after all the costs, including depreciation and interest expenses, have been deducted. In 1987, Ford Motor had sales of $71.6 billion and earned $7.38 billion pretax, for a pretax profit margin of 10.3 percent. Retailers have lower profit margins than manufacturers—an outstanding supermarket and drugstore chain such as Albertson’s still earns only 3.6 percent pretax. On the other hand, companies that make highly profitable drugs, such as Merck, routinely make 25 percent pretax or better. There’s not much to be gained in comparing pretax profit margins across industries, since the generic numbers vary so widely. Where it comes in handy is in comparing companies within the same industry. The company with the highest profit margin is by definition the lowest-cost operator, and the low-cost operator has a better chance of surviving if business conditions deteriorate.
• What you want, then, is a relatively high profit-margin in a long-term stock that you plan to hold through good times and bad, and a relatively low profit-margin in a successful turnaround.
• Rechecking the Story Every few months it’s worthwhile to recheck the company story. This may involve reading the latest Value Line, or the quarterly report, and inquiring about the earnings and whether the earnings are holding up as expected. It may involve checking the stores to see that the merchandise is still attractive, and that there’s an aura of prosperity. Have any new cards turned over? With fast growers, especially, you have to ask yourself what will keep them growing. There are three phases to a growth company’s life: the start-up phase, during which it works out the kinks in the basic business; the rapid expansion phase, during which it moves into new markets; and the mature phase, also known as the saturation phase, when it begins to prepare for the fact that there’s no easy way to continue to expand. Each of these phases may last several years. The first phase is the riskiest for the investor, because the success of the enterprise isn’t yet established. The second phase is the safest, and also where the most money is made, because the company is growing simply by duplicating its successful formula. The third phase is the most problematic, because the company runs into its limitations. Other ways must be found to increase earnings. As you periodically recheck the stock, you’ll want to determine whether the company seems to be moving from one phase into another.
• The Final Checklist All of this research I’ve been talking about takes a couple of hours, at most, for each stock. The more you know the better, but it isn’t imperative that you call the company. Nor do you have to study the annual report with the concentration of a Dead Sea scroll scholar. Some of the “famous numbers” apply only to specific categories of stocks and otherwise can be ignored altogether. What follows is a summary of the things you’d like to learn about stocks in each of the six categories: STOCKS IN GENERAL • The p/e ratio. Is it high or low for this particular company and for similar companies in the same industry. • The percentage of institutional ownership. The lower the better. • Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs. • The record of earnings growth to date and whether the earnings are sporadic or consistent. (The only category where earnings may not be important is in the asset play.) • Whether the company has a strong balance sheet or a weak balance sheet (debt-to-equity ratio) and how it’s rated for financial strength. • The cash position. With $16 in net cash, I know Ford is unlikely to drop below $16 a share. That’s the floor on the stock. SLOW GROWERS • Since you buy these for the dividends (why else would you own them?) you want to check to see if dividends have always been paid, and whether they are routinely raised. • When possible, find out 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. It can earn less money and still retain the dividend. If it’s a high percentage, then the dividend is riskier. STALWARTS • These are big companies that aren’t likely to go out of business. The key issue is price, and the p/e ratio will tell you whether you are paying too much. • Check for possible diworseifications that may reduce earnings in the future. • Check the company’s long-term growth rate, and whether it has kept up the same momentum in recent years. • If you plan to hold the stock forever, see how the company has fared during previous recessions and market drops. (McDonald’s did well in the 1977 break, and in the 1984 break it went sideways. In the big Sneeze of 1987, it got blown away with the rest. Overall it’s been a good defensive stock. Bristol-Myers got clobbered in the 1973–74 break, primarily because it was so overpriced. It did well in 1982, 1984, and 1987. Kellogg has survived all the recent debacles, except for ’73–’74, in relatively healthy fashion.) CYCLICALS • Keep a close watch on inventories, and the supply-demand relationship. Watch for new entrants into the market, which is usually a dangerous development. • Anticipate a shrinking p/e multiple over time as business recovers and investors look ahead to the end of the cycle, when peak earnings are achieved. • If you know your cyclical, you have an advantage in figuring out the cycles. (For instance, everyone knows there are cycles in the auto industry. Eventually there are going to be three or four up years to follow three or four down years. There always are. Cars get older and they have to be replaced. People can put off replacing cars for a year or two longer than expected, but sooner or later they are back in the dealerships. The worse the slump in the auto industry, the better the recovery. Sometimes I root for an extra year of bad sales, because I know it will bring a longer and more sustainable upside. Lately we’ve had five years of good car sales, so I know we are in the middle, and perhaps somewhere close to the end, of a prosperous cycle. But it’s much easier to predict an upturn in a cyclical industry than it is to predict a downturn.) FAST GROWERS • Investigate whether the product that’s supposed to enrich the company is a major part of the company’s business. It was with L’eggs, but not with Lexan. • What the growth rate in earnings has been in recent years. (My favorites are the ones in the 20 to 25 percent range. I’m wary of companies that seem to be growing faster than 25 percent. Those 50 percenters usually are found in hot industries, and you know what that means.) • That the company has duplicated its successes in more than one city or town, to prove that expansion will work. • That the company still has room to grow. When I first visited Pic ’N’ Save, they were established in southern California and were just beginning to talk about expanding into northern California. There were forty-nine other states to go. Sears, on the other hand, is everywhere. • Whether the stock is selling at a p/e ratio at or near the growth rate. • Whether the expansion is speeding up (three new motels last year and five new motels this year) or slowing down (five last year and three this year). For stocks of companies such as Sensormatic Electronics, whose sales are primarily “one-shot” deals—as opposed to razor blades, which customers have to keep on buying—a slowdown in growth can be devastating. Sensormatic’s growth rate was spectacular in the late seventies and early eighties, but to increase earnings they had to sell more new systems each year than they had sold the year before. The revenue from the basic electronic surveillance system (the one-time purchase) far overshadowed whatever they got from selling those little white tags to their established customers. So, in 1983, when the rate of growth slowed, earnings didn’t just slow, they dived. And so did the stock, from $42 to $6 in twelve months. • That few institutions own the stock and only a handful of analysts have ever heard of it. With fast growers on the rise this is a big plus. TURNAROUNDS • Most important, can the company survive a raid by its creditors? How much cash does the company have? How much debt? (Apple Computer had $200 million in cash and no debt at the time of its crisis, so once again you knew it wasn’t going out of business.) What is the debt structure, and how long can it operate in the red while working out its problems without going bankrupt? (International Harvester—now Navistar—was a potential turnaround that has disappointed investors, because the company printed and sold millions of new shares to raise capital. This dilution resulted in the company’s having turned around, but not the stock.) • If it’s bankrupt already, then what’s left for the shareholders? • How is the company supposed to be turning around? Has it rid itself of unprofitable divisions? This can make a big difference in earnings. For example, in 1980 Lockheed earned $8.04 per share from its defense business, but it lost $6.54 per share in its commercial aviation division because of its L-1011 TriStar passenger jet. The L-1011 was a great airplane, but it suffered from competition with McDonnell Douglas’s DC10 in a relatively small market. And in the long-distance market, it was getting killed by the 747. These losses were persistent, and in December, 1981, the company announced that it would phase out the L-1011. This resulted in a large write-off in 1981 ($26 per share), but it was a one-time loss. In 1982, when Lockheed earned $10.78 per share from defense, there were no more losses to deal with. Earnings had gone from $1.50 to $10.78 per share in two years! You could have bought Lockheed for $15 at the time of the L-1011 announcement. Within four years it hit $60, for a fourbagger. Texas Instruments was another classic turnaround. In October, 1983, the company announced it would leave the home-computer business (another hot industry with too many competitors). It had lost over $500 million from home computers in that year alone. Again, the decision made for big write-offs, but it meant that the company could concentrate on its strong semiconductor and defense-electronics businesses. The day after the announcement, TI stock spurted from $101 to $124. And four months later it was $176. Time also has sold off divisions and dramatically cut costs. It is one of my favorite recent turnarounds. Actually it’s an asset play as well. The cable-TV part of the business is potentially worth $60 a share, so if the stock sells for $100, you’re buying the rest of the company for $40. • Is business coming back? (This is what’s happening at Eastman Kodak, which has benefited from the new boom in film sales.) • Are costs being cut? If so, what will the effect be? (Chrysler cut costs drastically by closing plants. It also began to farm out the making of a lot of the parts it used to make itself, saving hundreds of millions in the process. It went from being one of the highest-cost producers of automobiles to one of the lowest. The turnaround in Apple Computer was harder to predict. However, if you’d been close to the company, you might have noticed the surge in sales, the cost-cutting, and the appeal of the new products, which all came at once.) ASSET PLAYS • What’s the value of the assets? Are there any hidden assets? • How much debt is there to detract from these assets? (Creditors are first in line.) • Is the company taking on new debt, making the assets less valuable? • Is there a raider in the wings to help shareholders reap the benefits of the assets? Here are some pointers from this section: • Understand the nature of the companies you own and the specific reasons for holding the stock. (“It is really going up!” doesn’t count.) • By putting your stocks into categories you’ll have a better idea of what to expect from them. • Big companies have small moves, small companies have big moves. • Consider the size of a company if you expect it to profit from a specific product. • Look for small companies that are already profitable and have proven that their concept can be replicated. • Be suspicious of companies with growth rates of 50 to 100 percent a year. • Avoid hot stocks in hot industries. • Distrust diversifications, which usually turn out to be diworseifications. • Long shots almost never pay off. • It’s better to miss the first move in a stock and wait to see if a company’s plans are working out. • People get incredibly valuable fundamental information from their jobs that may not reach the professionals for months or even years. • Separate all stock tips from the tipper, even if the tipper is very smart, very rich, and his or her last tip went up. • Some stock tips, especially from an expert in the field, may turn out to be quite valuable. However, people in the paper industry normally give out tips on drug stocks, and people in the health care field never run out of tips on the coming takeovers in the paper industry. • Invest in simple companies that appear dull, mundane, out of favor, and haven’t caught the fancy of Wall Street. • Moderately fast growers (20 to 25 percent) in nongrowth industries are ideal investments. • Look for companies with niches. • When purchasing depressed stocks in troubled companies, seek out the ones with the superior financial positions and avoid the ones with loads of bank debt. • Companies that have no debt can’t go bankrupt. • Managerial ability may be important, but it’s quite difficult to assess. Base your purchases on the company’s prospects, not on the president’s resume or speaking ability. • A lot of money can be made when a troubled company turns around. • Carefully consider the price-earnings ratio. If the stock is grossly overpriced, even if everything else goes right, you won’t make any money. • Find a story line to follow as a way of monitoring a company’s progress. • Look for companies that consistently buy back their own shares. • Study the dividend record of a company over the years and also how its earnings have fared in past recessions. • Look for companies with little or no institutional ownership. • All else being equal, favor companies in which management has a significant personal investment over companies run by people that benefit only from their salaries. • Insider buying is a positive sign, especially when several individuals are buying at once. • Devote at least an hour a week to investment research. Adding up your dividends and figuring out your gains and losses doesn’t count. • Be patient. Watched stock never boils. • Buying stocks based on stated book value alone is dangerous and illusory. It’s real value that counts. • When in doubt, tune in later. • Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.
• In my view it’s best to own as many stocks as there are situations in which: (a) you’ve got an edge; and (b) you’ve uncovered an exciting prospect that passes all the tests of research. Maybe that’s a single stock, or maybe it’s a dozen stocks. Maybe you’ve decided to specialize in turnarounds or asset plays and you buy several of those; or perhaps you happen to know something special about a single turnaround or a single asset play. There’s no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors.
• WATERING THE WEEDS In the next chapter I’ll explain what I know about when to sell a stock, but here I want to discuss selling as it relates to portfolio management. I’m constantly rechecking stocks and rechecking stories, adding and subtracting to my investments as things change. But I don’t go into cash—except to have enough of it around to cover anticipated redemptions. Going into cash would be getting out of the market. My idea is to stay in the market forever, and to rotate stocks depending on the fundamental situations. I think if you decide that a certain amount you’ve invested in the stock market will always be invested in the stock market, you’ll save yourself a lot of mistimed moves and general agony.
• A better strategy, it seems to me, is to rotate in and out of stocks depending on what has happened to the price as it relates to the story. For instance, if a stalwart has gone up 40 percent—which is all I expected to get out of it—and nothing wonderful has happened with the company to make me think there are pleasant surprises ahead, I sell the stock and replace it with another stalwart I find attractive that hasn’t gone up. In the same situation, if you didn’t want to sell all of it, you could sell some of it.
• If you can’t convince yourself “When I’m down 25 percent, I’m a buyer” and banish forever the fatal thought “When I’m down 25 percent, I’m a seller,” then you’ll never make a decent profit in stocks.
• After all that’s been said, I don’t want to sound like a market timer and tell you that there’s a certain best time to buy stocks. The best time to buy stocks will always be the day you’ve convinced yourself you’ve found solid merchandise at a good price—the same as at the department store. However, there are two particular periods when great bargains are likely to be found.
• If you have a list of companies that you’d like to own if only the stock price were reduced, the end of the year is a likely time to find the deals you’ve been waiting for.
• Not buying because an insider has started selling can be as big a mistake as selling because an outsider (Petrie) has stopped buying.
• WHEN TO SELL A SLOW GROWER I can’t really help you with this one, because I don’t own many slow growers in the first place. The ones I do buy, I sell when there’s been a 30–50 percent appreciation or when the fundamentals have deteriorated, even if the stock has declined in price. Here are some other signs: • The company has lost market share for two consecutive years and is hiring another advertising agency. • No new products are being developed, spending on research and development is curtailed, and the company appears to be resting on its laurels. • Two recent acquisitions of unrelated businesses look like diworseifications, and the company announces it is looking for further acquisitions “at the leading edge of technology.” • The company has paid so much for its acquisitions that the balance sheet has deteriorated from no debt and millions in cash to no cash and millions in debt. There are no surplus funds to buy back stock, even if the price falls sharply. • Even at a lower stock price the dividend yield will not be high enough to attract much interest from investors. WHEN TO SELL A STALWART These are the stocks that I frequently replace with others in the category. There’s no point expecting a quick tenbagger in a stalwart, and if the stock price gets above the earnings line, or if the p/e strays too far beyond the normal range, you might think about selling it and waiting to buy it back later at a lower price—or buying something else, as I do. Other sell signs: • New products introduced in the last two years have had mixed results, and others still in the testing stage are a year away from the marketplace. • The stock has a p/e of 15, while similar-quality companies in the industry have p/e’s of 11–12. • No officers or directors have bought shares in the last year. • A major division that contributes 25 percent of earnings is vulnerable to an economic slump that’s taking place (in housing starts, oil drilling, etc.). • The company’s growth rate has been slowing down, and though it’s been maintaining profits by cutting costs, future cost-cutting opportunities are limited. WHEN TO SELL A CYCLICAL The best time to sell is toward the end of the cycle, but who knows when that is? Who even knows what cycles they’re talking about? Sometimes the knowledgeable vanguard begins to sell cyclicals a year before there’s a single sign of a company’s decline. The stock price starts to fall for apparently no earthly reason. To play this game successfully you have to understand the strange rules. That’s what makes cyclicals so tricky. In the defense business, which behaves like a cyclical, the price of General Dynamics once fell 50 percent on higher earnings. Farsighted cycle-watchers were selling in advance to avoid the rush. Other than at the end of the cycle, the best time to sell a cyclical is when something has actually started to go wrong. Costs have started to rise. Existing plants are operating at full capacity, and the company begins to spend money to add to capacity. Whatever inspired you to buy XYZ between the last bust and latest boom ought to clue you in that the latest boom is over. One obvious sell signal is that inventories are building up and the company can’t get rid of them, which means lower prices and lower profits down the road. I always pay attention to rising inventories. When the parking lot is full of ingots, it’s certainly time to sell the cyclical. In fact, you may be a little late. Falling commodity prices is another harbinger. Usually prices of oil, steel, etc., will turn down several months before the troubles show up in the earnings. Another useful sign is when the future price of a commodity is lower than the current, or spot, price. If you had enough of an edge to know when to buy the cyclical in the first place, then you’ll notice the price changes. Competition businesses are also a bad sign for cyclicals. The outsider will have to win customers by cutting prices, which forces everyone else to cut prices and leads to lower earnings for all the producers. As long as there’s strong demand for nickel and nobody to challenge Inco, Inco will do fine, but as soon as demand slackens or rival nickel producers begin to sell nickel, Inco’s got problems. Other signs: • Two key union contracts expire in the next twelve months, and labor leaders are asking for a full restoration of the wages and benefits they gave up in the last contract. • Final demand for the product is slowing down. • The company has doubled its capital spending budget to build a fancy new plant, as opposed to modernizing the old plants at low cost. • The company has tried to cut costs but still can’t compete with foreign producers. WHEN TO SELL A FAST GROWER Here, the trick is not to lose the potential tenbagger. On the other hand, if the company falls apart and the earnings shrink, then so will the p/e multiple that investors have bid up on the stock. This is a very expensive double whammy for the loyal shareholders. The main thing to watch for is the end of the second phase of rapid growth, as explained earlier. If The Gap has stopped building new stores, and the old stores are beginning to look shabby, and your children complain that The Gap doesn’t carry acid-washed denim apparel, which is the current rage, then it’s probably time to think about selling. If forty Wall Street analysts are giving the stock their highest recommendation, 60 percent of the shares are held by institutions, and three national magazines have fawned over the CEO, then it’s definitely time to think about selling. All the characteristics of the Stock You’d Avoid (see Chapter 9) are characteristics of the Stock You’d Want to Sell. Unlike the cyclical where the p/e ratio gets smaller near the end, in a growth company the p/e usually gets bigger, and it may reach absurd and illogical dimensions. Remember Polaroid and Avon Products. P/e’s of 50 for companies of their size? Any astute fourth-grader could have figured it was time to sell those. Was Avon going to sell a billion bottles of perfume? How could it, when every other housewife in America was an Avon representative? You could have sold Holiday Inn when it hit 40 times earnings and been confident that the party was over there, and you were right. When you saw a Holiday Inn franchise every twenty miles along every major U.S. highway, and then you traveled to Gibraltar and saw a Holiday Inn at the base of the rock, it had to be time to worry. Where else could they expand? Mars? Other signs: • Same store sales are down 3 percent in the last quarter. • New store results are disappointing. • Two top executives and several key employees leave to join a rival firm. • The company recently returned from a “dog and pony” show, telling an extremely positive story to institutional investors in twelve cities in two weeks. • The stock is selling at a p/e of 30, while the most optimistic projections of earnings growth are 15–20 percent for the next two years. WHEN TO SELL A TURNAROUND The best time to sell a turnaround is after it’s turned around. All the troubles are over and everybody knows it. The company has become the old self it was before it fell apart: growth company or cyclical or whatever. The shareholders aren’t embarrassed to own it again. If the turnaround has been successful, you have to reclassify the stock. Chrysler was a turnaround play at $2 a share, at $5, and even at $10 (adjusted for splits), but not at $48 in mid-1987. By then the debt was paid and the rot was cleaned out, and Chrysler was back to being a solid, cyclical auto company. The stock may go higher, but it’s unlikely to see a tenfold rise. It has to be judged the same way that General Motors, Ford, or other prosperous companies are judged. If you like the autos, keep Chrysler. It’s doing well in all divisions, and the acquisition of American Motors gives it some extra long-term potential, along with some extra short-term problems. But if you specialize in turnarounds, sell Chrysler and look for something else. General Public Utilities was a turnaround at $4 a share, at $8, and at $12, but after the second nuclear unit was returned to service, and other utilities agreed to help pay the costs of the Three Mile Island cleanup, GPU became a quality electric utility again. Nobody thinks GPU is going out of business anymore. The stock, now at $38, may hit $45, but it certainly isn’t going to hit $400. Other signs: • Debt, which has declined for five straight quarters, just rose by $25 million in the latest quarterly report. • Inventories are rising at twice the rate of sales growth. • The p/e is inflated relative to earnings prospects. • The company’s strongest division sells 50 percent of its output to one leading customer, and that leading customer is suffering from a slowdown in its own sales. WHEN TO SELL AN ASSET PLAY Lately, the best idea is to wait for the raider. If there are really hidden assets there, Saul Steinberg, the Hafts, or the Reichmanns will figure it out. As long as the company isn’t going on a debt binge, thus reducing the value of the assets, then you’ll want to hold on. Alexander and Baldwin owns 96,000 acres of Hawaiian real estate in addition to its exclusive shipping rights into the island plus other assets. A lot of people estimated that this $5 stock (adjusted for splits) was worth much more. They tried to be patient, but nothing happened for several years. Then a Mr. Harry Weinberg showed up and bought 5 percent, then 9 percent, and finally 15 percent of the shares. That inspired other investors to buy shares because Mr. Weinberg was buying, and the stock hit a high of $32 before it was marked down to $16 in the October, 1987, sell-off. Seven months later it was back up to $30. The same thing happened at Storer Broadcasting, and then at Disney. Disney was a sleepy company that didn’t know its own worth until Mr. Steinberg came along to goad management into “enhancing shareholder values.” The company was making progress anyway. It’s done a brilliant job moving away from animated movies to appeal to a broader and more adult audience. It’s been successful with the Disney channel and the Japanese theme park, and the upcoming European theme park is promising. With its irreplaceable film library and its Florida and California real estate, Disney is an asset play, a turnaround, and a growth company all at once. No longer do you have to wait until your children have children for hidden assets to be discovered. It used to be that you could sit on an undervalued situation your entire adult life and the stock wouldn’t budge a nickel. These days, the enhancement of shareholder values happens much quicker, thanks to the packs of well-heeled magnates roving around looking for every last example of an undervalued asset. (Boone Pickens came to our office a few years ago and told us exactly how a company such as Gulf Oil could hypothetically be taken over. I listened to his well-reasoned presentation, then promptly concluded that it couldn’t be done. I was convinced that Gulf Oil was too big to be taken over—right up to the day that Chevron did it. Now I’m ready to believe that anything could be taken over, including the larger continents.) With so many raiders around, it’s harder for the amateur to find a good asset stock, but it’s a cinch to know when to sell. You don’t sell until the Bass brothers show up, and if it’s not the Bass brothers, then it’s certain to be Steinberg, Icahn, the Belzbergs, the Pritzkers, Irwin Jacobs, Sir James Goldsmith, Donald Trump, Boone Pickens, or maybe even Merv Griffin. After that, there could be a takeover, a bidding war, or a leveraged buyout to double, triple or quadruple the stock price. Other sell signs: • Although the shares sell at a discount to real market value, management has announced it will issue 10 percent more shares to help finance a diversification program. • The division that was expected to be sold for $20 million only brings $12 million in the actual sale. • The reduction in the corporate tax rate considerably reduces the value of the company’s tax-loss carryforward. • Institutional ownership has risen from 25 percent five years ago to 60 percent today—with several Boston fund groups being major purchasers.
• The Twelve Silliest (and Most Dangerous) 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
• IF 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 THE DAWN
• WHEN IT REBOUNDS TO $10, I’LL SELL
• WHAT ME WORRY? CONSERVATIVE STOCKS DON’T FLUCTUATE MUCH
• IT’S TAKING TOO LONG FOR ANYTHINGTO 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
• If you take anything with you at all from this last section, I hope you’ll remember the following: • Sometime in the next month, year, or three years, the market will decline sharply. • Market declines are great opportunities to buy stocks in companies you like. Corrections—Wall Street’s definition of going down a lot—push outstanding companies to bargain prices. • Trying to predict the direction of the market over one year, or even two years, is impossible. • To come out ahead you don’t have to be right all the time, or even a majority of the time. • The biggest winners are surprises to me, and takeovers are even more surprising. It takes years, not months, to produce big results. • Different categories of stocks have different risks and rewards. • You can make serious money by compounding a series of 20–30 percent gains in stalwarts. • Stock prices often move in opposite directions from the fundamentals but long term, the direction and sustainability of profits will prevail. • Just because a company is doing poorly doesn’t mean it can’t do worse. • Just because the price goes up doesn’t mean you’re right. • Just because the price goes down doesn’t mean you’re wrong. • Stalwarts with heavy institutional ownership and lots of Wall Street coverage that have outperformed the market and are overpriced are due for a rest or a decline. • Buying a company with mediocre prospects just because the stock is cheap is a losing technique. • Selling an outstanding fast grower because its stock seems slightly overpriced is a losing technique. • Companies don’t grow for no reason, nor do fast growers stay that way forever. • You don’t lose anything by not owning a successful stock, even if it’s a tenbagger. • A stock does not know that you own it. • Don’t become so attached to a winner that complacency sets in and you stop monitoring the story. • If a stock goes to zero, you lose just as much money whether you bought it at $50, $25, $5, or $2—everything you invested. • By careful pruning and rotation based on fundamentals, you can improve your results. When stocks are out of line with reality and better alternatives exist, sell them and switch into something else. • When favorable cards turn up, add to your bet, and vice versa. • You won’t improve results by pulling out the flowers and watering the weeds. • If you don’t think you can beat the market, then buy a mutual fund and save yourself a lot of extra work and money. • There is always something to worry about. • Keep an open mind to new ideas. • You don’t have to “kiss all the girls.” I’ve missed my share of tenbaggers and it hasn’t kept me from beating the market.

I’ve also finished Reminiscences of a Stock Operator. Although the book is extremely detailed and recounts nearly every speculative move its protagonist makes, there are some very important things to take away from it.

The quotes below share a common backbone: the fact that speculation is a struggle far more with one’s own inner world than with the world outside. Throughout the book, the narrator shows again and again that the cause of losing is usually not a wrong forecast but wrong behavior. Clinging to a losing position, cutting profits short, taking refuge in someone else’s opinion, feeling “compelled to do something,” or holding on to hope… All of these are mistakes born not of failing to beat the market, but of failing to beat oneself. That is why the market neither delivers moral lessons nor offers consolation; it simply announces the result. Prices reward not the one who is right or well-intentioned, but the one who acts correctly at the right time. This is why the author learns not to be ashamed of his mistakes, but to see them as “tuition.” What is truly devastating is not losing money but being wrong, because being wrong gnaws away at a person’s ego, self-confidence, and judgment. In the book, speculation is separated from gambling by a sharp line: gambling rests on hope, while speculation rests on discipline, observation, and patience. Without recognizing one’s own weaknesses, without learning to swap fear for hope and hope for fear, a person is doomed to lose in the long run, no matter how intelligent they may be.

Another strong theme of these quotes is the idea that the general trend always matters more than individual stories. The author chooses to look at what prices are doing rather than question why, because the market is always right and there is no arguing with it. The real money is made not from small fluctuations but from the big moves. And that requires patience, timing, and, more often than not, knowing how to “do nothing.” Tips, rumors, charismatic people, or fancy rationalizations are an investor’s greatest enemies, because they pull a person away from their own thinking. The successful speculator acts on his own plan rather than on someone else’s mind, and only adds to his position when prices confirm that he is right. And the moment he realizes he is wrong, he pulls back without stubbornness. This perspective turns Reminiscences of a Stock Operator from merely a book about the stock market into a harsh but honest text on human nature. The essence of the book is this: no one can beat the whole game in the market, but if a person learns to beat themselves, they can stay standing in the long run. And that is where the profit comes from anyway; from building one’s own inner discipline before turning to prices.

Before getting to everything I underlined in the book, I’m sharing the ones I personally consider the most important. After that, you can find every quote I found significant while reading:

• “People who can both make the right call and patiently sit tight are rare. It is not easy to learn. But the only way to make money in the market is to acquire this skill.”
• “Another lesson I learned at a young age is that on Wall Street, everything is always the same. It is the same because speculation is as old as the world. Whatever happens in the market today has happened before and will surely happen again in the future.”
• “A speculator’s greatest enemy lies within himself. Hope and fear are inseparable parts of human nature. (…) A successful trader must fight these two powerful emotions and be able to reverse what we call these two natural impulses. Instead of hoping, he must fear; instead of fearing, he must hope.”
• “In the market, it is not the small plays that bring the real profit, but the big general moves.”
• “There is the ordinary fool, who does everything in the wrong place at the wrong time; and then there is the Wall Street fool, who thinks he must always be buying or selling something. No one can have the luck or the knowledge to buy and sell stocks every single day without stopping.”
• “If I buy stocks on a tip from Smith, I have to sell those stocks on a tip from Smith too. Then I become dependent on Smith. (…) No one can get rich by relying on something they heard from someone else.”
• “Losing money doesn’t upset me. I forget it overnight. But being wrong—now that is the thing that eats a person alive.”
• “To put it simply, we can say that prices move in the direction where they will meet the least resistance. Whichever way is easiest for them, that is the way they will go.”
• “Regrets pay no dividends in the market.”

The passages I found most important from the book as a whole:

• “I did exactly the wrong thing. The cotton was showing a loss, and I didn’t sell it. The wheat was showing a profit, and I went and sold that.” “A man can make plenty of blunders in the market, but the greatest of all is to keep losing with your eyes wide open. Remember, cutting a loss at any point is a gain.”
• Another lesson I learned at a young age is that on Wall Street, everything is always the same. It is the same because speculation is as old as the world. Whatever happens in the market today has happened before and will surely happen again in the future. I have never let that slip from my mind.
• Of course, fluctuations don’t happen without reason, but the tape doesn’t ask why or how. It explains nothing. I never asked the reason for these ups and downs when I was fourteen, and I don’t ask today at forty either.
• To me, the most enjoyable part of the market is being proven right by using your head.
• If I have ten dollars in my pocket and I risk all of it, that means I am braver than the man who has millions in the bank and risks one million of it.
• I never do anything blindly. It’s not my nature. It never has been. Even as a child, I wanted to know the reason for everything I did.
• What caused me to lose was abandoning my original plan—that is, ceasing to check whether the market’s signals fit the situation. There is a time for everything, but back then I didn’t know that. This is exactly what separates the winners from the losers on Wall Street. There is the ordinary fool, who does everything in the wrong place at the wrong time, and then there is the Wall Street fool, who thinks he must always be buying or selling something. No one can have the luck or the knowledge to buy and sell stocks every single day without stopping. I am living proof of that. When I read the tape in the light of my experience, I made money; when I acted purely on my emotions, I lost. I was just like everyone else. The quotation board stood right in front of me; people were watching the prices coming off the tape and, in the meantime, witnessing the tickets in their hands turn into either money or a scrap of paper. Every now and then I got carried away by that excited atmosphere too.
• Remember, I was still just a kid. In those days I didn’t have the mind I have today, whereas fifteen years later I would watch a stock I felt was going to rise climb thirty points over the course of two weeks, and only then, believing the stock was safe, would I buy.
• I never lose my composure in the market. I never claim that what the tape tells me is wrong. You can’t get very far by being angry at the market.
• And then I would never have learned that stock speculation is not merely a matter of playing fluctuations of a few points.
• It takes a long time for a person to learn to draw lessons from painful experiences. Every coin has two sides. But the securities market has only one side; what matters is not whether the market rises or falls, what matters is being able to read the market correctly. For some reason, understanding this took me much longer than learning the more technical aspects of speculation.
• This reminds me of the story of a man who was going to fight a duel the next day. His second asked him, “Are you a good shot?” The man replied quite modestly: “I can hit the stem of a wineglass from twenty paces.” The other, without batting an eye, replied: “That’s all well and good, but can you still hit that wineglass while it’s holding a loaded pistol to your head?”
• The losses I have suffered so far have taught me not to go on the attack until I am sure I won’t be forced to retreat.
• If you intend to win this game, you must trust yourself and your ability to make decisions. That’s why I don’t believe in the thing called a tip. If I buy stocks on a tip from Smith, I have to sell those stocks on a tip from Smith too. Then I become dependent on Smith. What if Smith is on vacation when it’s time to sell? No! No one can get rich by relying on something they heard from someone else.
• Besides, even if someone had come and told me my method wouldn’t work here, I wouldn’t have listened; I would have tried it myself anyway. I only believe I’ve made a mistake when I lose money. And I’m only sure I’m right when I make money. That is what speculation is.
• Prices were going to tumble suddenly, and then we would be able to buy very solid stocks at very good prices. The market would recover before long, and in the meantime those who knew how to pick the right stock would make plenty of profit.
• If I think I should sell, I sell. If I think stocks are going to go up, I buy. What saved me was following this general principle of speculation. If I had been forced to buy within certain limits, everything would have been a bad copy of my old bucket-shop method adapted to a broker’s office. I would never have learned what stock speculation is; I would have just done whatever my gut told me on the strength of my brief experience.
• Still, what bothered me most was not giving up this life, but constantly being wrong in my predictions about the market.
• “He who makes his customers rich gets rich” is an old and very true saying, but these men seemed never to have heard it; they wouldn’t give up their lies and tricks.
• But now I knew the reason. It was because I kept making ill-timed trades; whenever my system, based on research and experience, didn’t work, I went and gambled blindly. I wasn’t sure of myself; I was leaving things to chance.
• There is something I call the behavior of a stock, and it has to do with whether a stock keeps up the behavior it has shown in the past. If a stock is behaving inconsistently, the best thing is to stay away from it, because since you don’t know what is wrong and where, you can’t know what price the stock will reach in the future either. If you can’t diagnose the stock’s illness, there can be no cure.
• But now I understand that the real mistake was that I had confused stock speculation with gambling.
• In a market that is expected to rise, greenhorns, not knowing the rules of the market, buy blindly and leave things to chance.
• “All right, I know as well as you do that the market is going up. But right now is exactly the time to sell the stock you’re holding and buy it back once the price drops. You’ll come out ahead.” “My boy,” said Partridge, and it was obvious how distressed he was—“my boy, if I sold that stock now, I’d lose my chance to make more profit.” Elmer Harwood shook his head and turned toward me. It was clear he expected sympathy from me. “What can I say?” he whispered in my ear. “What do you say to that?” I chose to keep quiet. He went on: “I gave him a tip on Climax Motors. He went and bought five hundred shares. He made seven points, and then, when I told him to sell the shares and get out ahead of the drop that was long overdue, what does he tell me? That if he sells now he can’t make a profit. What do you say to that?” “Excuse me, Mr. Harwood, I didn’t say I couldn’t make a profit. I said I’d lose my chance to make more profit,” old Turkey interjected. “When you reach my age and have been down the roads I’ve been down, through the panics I’ve weathered and the ups and downs, you’ll understand. Don’t miss the chance to make more profit; nobody can afford that, not even John D. Rockefeller. I hope the stock goes down and you buy back what you sold at a better price, but I have to act on years of experience. That experience has cost me a great deal, and I don’t want to start everything over from scratch one more time. But believe me, I’m very grateful to you. It’s a bull market, you know.” Then he turned and walked away, leaving Elmer staring after him with eyes full of astonishment. I couldn’t quite understand what Mr. Partridge said at the time, but when I couldn’t make enough money even though my predictions about the market came true, I thought about his words once more. The more I thought about it, the better I understood how clever that old man was. He, too, had made the same mistakes when he was young, and he knew himself very well. He didn’t easily give in to the weaknesses he knew were harmful to him, and so he steered clear of costly regrets. Understanding what Mr. Partridge meant by “It’s a bull market, you know” was a very important and instructive step for me. What he meant was that the real profit comes not from small fluctuations but from the fundamental movements of the market—in other words, that one must look not at the prices coming off the tape, but at the general conditions and the trend of the market.
• People who can both make the right call and patiently sit tight are rare. It is not easy to learn. But the only way to make money in the market is to acquire this skill.
• If the market is rising, you first buy stocks, and after a while, when the expectation of a decline sets in, you sell them. To do this, you need to pay attention to general conditions and ignore special factors concerning individual stocks, or tips. The moment you feel a general decline is coming in the market, sell every stock you hold and then wait for conditions to reverse. To be able to do this, you have to be intelligent and far-sighted; otherwise what I’m saying can be taken as a piece of simplistic advice like “buy low, sell high.”
• Someone who can’t trust his own decisions can’t succeed in the market. There is only one thing I’ve learned in all these years in the market: study the general conditions, buy certain stocks, and then don’t let go of them easily. I’ve now learned to wait without showing even a single sign of impatience. When I see a stock’s price drop, I don’t panic at all, because I know it’s temporary. Once, I had gone short a hundred thousand shares. I knew the market was going to start rising again very soon. I was also aware that this rally would bring me a million dollars in profit on paper. Still, I waited without flinching and watched half of my paper profit get wiped out. Meanwhile, it never even crossed my mind to get out of my short position and cover. I knew that if I did, I would lose my position, and that this would stand in the way of my future profits. In the market, it is not the small plays that bring the real profit, but the big general moves.
• I told some of these stories to my friends, and they told me that these feelings were not intuition but a manifestation of my constantly active subconscious, that is, the creative mind. It’s this subconscious that makes artists do certain things without realizing it. Perhaps in my case it was an accumulation, a combination of factors that were unimportant on their own but that affected me when they came together.
• Besides, when the market is high, the public never makes decisions based on news of disasters. If the market has a downward tendency, the situation changes; then disasters accelerate the decline.
• Not only did I learn to disregard tips and stand by my own thinking, but my self-confidence grew, and I shed the last remnants of my old trading method. The Saratoga experience was the last episode of arbitrary trial and error. From that day on, I started looking at the general climate of the market instead of at individual stocks. In this way, I moved up a grade in the school of trading. But it was a long and difficult stage for me.
• If there is a general decline in the market, the prices of all stocks fall; if there is a general rise, they go up. But let’s say there is a war going on and the market has fallen because of it; that doesn’t mean arms stocks will fall too. I’m talking about general situations. But the average investor isn’t interested in the general rises or declines of the market. This investor wants to know which stock he should sell or buy. His intention is to get something for nothing. He wants to lie back and take it easy. He doesn’t want to tax his brain too much. Even counting the money he finds on the ground feels like a chore to him.
• What matters is not being able to catch prices at their lowest point, but being able to buy or sell at the right moment. If I think the market is going to fall and I’ve started selling, every sale I make should go through at a lower price than the one before. If I’m going to buy, the opposite applies. Prices must keep rising. Buying as prices rise and selling as they fall is my method. Let’s say I’m going to buy a stock, and I bought two thousand shares at 110. If the stock’s price goes up to 111 after I buy, then, at least for the moment, I’m right in the trade I made; since the price has risen a point, I count as having a profit, and because I have a profit I go and buy two thousand more shares. If the market is still rising, I make another purchase of two thousand shares. Let’s say the price goes up to 114. For the moment I think that’s enough. Now I’ve got a base position in the stock. I’ve bought six thousand shares at an average of 111 3/4, and the price is currently 114. For the moment I don’t want to buy any more. I sit and wait. I figure the price will surely drop at some point. I’m curious to see how the market will recover the price after that drop. In all likelihood, this drop will come after the third purchase I made. Let’s say the price will drop from 114 to 112 1/4 and then rise again. The moment the price gets back up to 113 3/4, I place an order to buy four thousand shares. If I can get those four thousand shares at 113 3/4, I know something is wrong, and I decide to make a test sale—that is, I put a thousand shares up for sale and watch how the market reacts to it. But let’s say that after the four-thousand-share buy order I placed at 113 3/4, I’m able to get two thousand shares at 114, five hundred at 114 1/2, and the rest at higher prices, paying 115 1/2 for the last five hundred. Now I know for certain that I’m right. The conditions under which I buy the stock show me whether I’m right to be buying that stock at that moment—assuming, of course, that in the meantime I have thoroughly assessed the general state of the market and that the market is in an upward trend. I never want to buy any stock too cheaply or too easily.
• The president began to explain: “My friend, I never doubted for a moment that you were telling me the truth. But even if H. O. Havemeyer himself had given you this news, I would have done the same thing. There really is only one way to find out whether H. O. Havemeyer and his associates are buying those shares the way you say, and that is to do what I did. The first ten thousand shares sold quite easily. But that didn’t tell me much about the situation. The second ten thousand went instantly, and the market kept rising all the while. So somebody was ready to snap up every share that was sold. Who those buyers are doesn’t matter much right now. I’ve now covered my short position, I’m holding ten thousand shares, and I believe the information you gave me is correct.”
• If you are making large, long-term purchases, never let this slip your mind. An investor first studies the general conditions, then makes himself a plan, and then acts. Let’s say his plan works out and he makes a big profit—but on paper. This investor can’t sell his shares whenever he feels like it. It will be much harder for the market to absorb fifty thousand shares than a hundred. This investor has to wait until a market forms for him. Then he notices that a crowd of buyers has formed for his shares. He must reach that crowd immediately. He has already been waiting for a while anyway. He has to sell his shares not when he wants to, but when he can.
• But if you haven’t made a profit after the first trade, never enter a second one. Choose to wait. At this point, watch prices very closely; that’s how you’ll know when to start the next trade. Everything depends on the right timing. It took me many years to understand its importance. It also cost me hundreds of thousands of dollars.
• The Union Pacific incident I went through at Saratoga in the summer of 1906 thoroughly put me off tips and idle talk; that is, it taught me not to listen to other people’s opinions and predictions, no matter how well-meaning and experienced they may be.
• Getting angry at the market because it moved when you least expected it, and in a way that defies your logic on top of that, is like getting angry at your lungs because you caught pneumonia.
• Naturally, the best thing is to buy stocks in a rising market and sell as the market falls. It sounds all too simple, doesn’t it? But understanding this principle isn’t enough; when applying it, you have to take many possibilities into account. It took me a long time to learn to trade according to this basic principle.
• If a man never made a mistake, he could take over the world within a month. But if he doesn’t learn from the mistakes he makes, he won’t have a thing to his name.
• According to a theory I came up with long ago, when a stock crosses the 100, 200, or 300 mark for the first time, the price doesn’t stop at the round number but keeps going higher, so if you buy the stock as soon as it crosses that line, you’re sure to make a profit. Cautious investors don’t buy a stock after it has hit a record price. But in the past I made a lot of money by applying this theory of mine.
• Money is earned only through work. To make a lot of money, though, you need to be right at the right time.
• But my biggest gain was something money couldn’t buy: I had been right, I had known how to look ahead, and I had acted according to a detailed plan. I had learned what I needed to do to make big money; I was no longer at the gamblers’ stage. I had finally learned to play the market using my head. It was an unforgettable day for me.
• Let me tell you something interesting: a trader can make a mistake knowing full well that he’s making a mistake. After making these mistakes, he’ll ask himself why he did it. After thinking calmly for a while, he may understand how, when, and at what point in the trade he committed these mistakes, but he will never understand why. He’ll be angry at himself, and then he’ll never think about the matter again.
• Losing money doesn’t upset me. I forget it overnight. But being wrong—now that is the thing that eats a person alive.
• A young, normal person quickly forgets the days when he was poor. But it may take him a little longer to forget the days when he was rich. The reason is that money creates new needs and multiplies the old ones.
• He deliberates over buying a cheap car, yet doesn’t pause even for a moment when putting half his fortune into the market.
• When watching the market—and by the market I mean the prices coming off the tape—you should have a single aim: to determine the price trend. As you know, prices move up or down according to the resistance they meet. To put it simply, we can say that prices move in the direction where they will meet the least resistance. Whichever way is easiest for them, that is the way they will go; that is, if there is little resistance to a rise they will go up, and if there is little resistance to a fall they will go down.
• An open-minded person who can see a little way ahead can easily spot this trend, but if someone perceives everything through the preconceptions in their head, it can be a bit difficult.
• A speculator is not an investor. His aim is not to earn a high rate of return on the money he puts in, but to profit from the rises or falls in the prices of the stocks he speculates in.
• And in practice, if you trade using the method I’ve described, you will see that the important news that spreads between the market’s close and its opening will always tell you something about which way the price is going to move.
• In periods when the market is stagnant and prices move only within narrow limits, there is no point in trying to guess which direction the next big move will take. What needs to be done is to watch the market, determine the lower and upper limits of prices, and then decide not to buy or sell until prices break out of those limits. The speculator’s job is to make money from the market, not to lock horns with prices and force them to move in the direction he has in mind. Never fight with prices, and never try to question why prices are at this or that level. Regrets pay no dividends in the market.
• While wheat was fluctuating within certain limits, I couldn’t explain why it was behaving that way. Nor could I predict in advance whether, when it broke out of those limits, the price would go above $1.20 or below $1.10. Though deep down I thought the price would rise, because there hadn’t been a wheat harvest anywhere in the world abundant enough to push prices down. As it turned out later, Europe had been quietly buying wheat from us, and many traders had gone short at around $1.19. Because of the purchases from Europe and some other reasons, a large amount of wheat had been withdrawn from the market, and finally the expected big move began. So the price crossed the $1.20 mark. That was the signal I had been waiting for. When the price passed $1.20, I understood that the rise beyond the limit was finally beginning. In other words, when the price passed $1.20, the direction of least resistance was determined as well. And so the course of the market changed too.
• Interestingly, many experienced traders are surprised when I tell them that I don’t hesitate to buy at a high price when buying stock, or to sell at a low price when selling, and that if necessary I don’t sell at all. If everyone bought or sold according to the course of prices and waited until the last line of resistance was broken, there would be no losers in the market. A good trader doesn’t play all his cards at once. He buys gradually and sells gradually. First he buys a fifth of what he intends to buy. If he hasn’t made a profit, he shouldn’t keep buying; that shows he has made a wrong move—at least for the moment, he is mistaken.
• ‘Nobody knows the winner until the race is over!’
• I sometimes think that speculation is an unnatural business, because when speculating in the market, a person has to fight against his own nature. People’s weaknesses eat them alive in the market. These are the weaknesses that make them human, that make them liked by others, and that are not at all dangerous outside the securities or commodity markets. A speculator’s greatest enemy lies within himself. Hope and fear are inseparable parts of human nature. When the market starts going against you, you always hope that each day will be the last, and because of that hope you lose a little more. Yet many a nation has survived thanks to hope, and hope has always brought statesmen the successes they achieved. And when the market starts going in your favor, you start to fear; you think, what if I lose tomorrow, and you sell your stocks before their time. Fear limits the gains you could have made. A successful trader must fight these two powerful emotions and be able to reverse what we call these two natural impulses. Instead of hoping, he must fear; instead of fearing, he must hope. He must fear that his loss may grow even larger, and hope that his profits may grow even more. The average person does exactly the opposite, and playing the market with that approach resembles a dangerous gamble.
• A man can beat a stock or a group of stocks at a given time, but never the whole market! A man can make a profit buying cotton or grain, but no one can beat the cotton or grain market. It’s like horse racing. A man can win a horse race, but never every horse race! I don’t know how to explain this to you any better. Don’t believe those who say otherwise. I know very well that what I’m saying is true and that no one can prove the opposite.
• When a person spends years in a business, he picks up certain habits of his own, whereas for novices the situation is entirely different. That’s the difference between professionals and amateurs. What determines whether you make a profit or a loss in the market is your way of looking at things. The public evaluates its own efforts from a superficial point of view. A person’s ego steps in at the first opportunity and prevents deep, thorough thinking. Professionals, on the other hand, are concerned with doing the right thing without thinking about the money, because they know that the moment they act correctly, the money will come on its own. A trader plays the game like a professional billiard player—that is, instead of focusing his attention on the first shot, he thinks long-term. This style of play becomes a habit.
• In Palm Beach, everyone was talking about the collapse of Thomas’s position in March cotton. You know how rumors spread as they pass from mouth to mouth: they get exaggerated, the facts get distorted, the news gets altered. When a rumor that started about me came back to the person who first started it within twenty-four hours, it had been so inflated, with so many details added, that even he had trouble recognizing it as the same rumor.
• I’m so used to making money that when I make a mistake, the first thing that comes to mind isn’t the money I’ve lost. I’ve always been interested in the game itself, in the reasons. First of all, I’m a person who questions his own limitations and habits. Secondly, I don’t want to fall into the same mistake twice. The only mistakes a person can be forgiven for are the ones he turns into profit by learning from them.
• It’s not easy to make a person give up what he believes, but it is easy to drive him into a feeling of uncertainty and indecision. And that is a worse thing, because then a person can’t play the market with self-confidence and peace of mind.
• This was the most foolish move of my career. Instead of succeeding or failing on the strength of my own observations and conclusions, I started acting on someone else’s ideas. I more than deserved what was coming to me. I didn’t really believe the market would rise, but I bought anyway—and what’s more, I didn’t even buy according to the method my experience had taught me. I wasn’t playing right. By listening to Thomas, I had signed my own death warrant.
• A man can make plenty of blunders in the market, but the greatest of all is to keep losing with your eyes wide open.
• Another lesson that cost me millions was seeing that a charismatic person can sway anyone with persuasive talk, and that this is one of a trader’s greatest enemies. Unfortunately, I could have learned the same lesson by losing only a million dollars. But what can you do—sometimes fate sets the price of the lesson. Fate teaches you your lesson and then hands you the bill, and you have to pay it, whatever the amount.
• Most of those who are determined to make a living from the market gradually use up everything they have.
• On Wall Street, you won’t find a single person who played the market to buy a car, a bracelet, a motorboat, or a painting and didn’t lose.
• What does a person do when he tries to make money from the market for a sudden need? He gives himself over to hope. He gambles. So he takes risks he would never take when speculating with his intelligence, and he forgets that he needs to study the general conditions of the market with a cool head.
• If a person wants to make money in the market, he must know himself very well. Realizing how foolish I could be was a very important step for me. I sometimes think that, whatever the cost, every lesson that makes a person act more wisely in the future is useful. Many people make big mistakes because they are blinded by their own successes. Getting carried away by the spell of success is a very expensive disease for everyone, everywhere—and especially on Wall Street.
• Someone once told me that James Stillman, the former president of the National City Bank and also a very close friend of Williamson’s, would listen to anyone who brought him any proposal without saying a word, with an expressionless face. After the person finished speaking, Stillman would keep looking at him as if he hadn’t finished. So the other person, feeling he needed to say a bit more, would add something else. Just by listening to the person in front of him and looking at him, Stillman could get more than he had expected. In this way, he made very advantageous deals for his bank.
• A sensible person is grateful to those who do him favors, but doesn’t let that feeling tie his hands.
• The loss didn’t upset me. Whenever I lose money in the market, I consider that I’ve received a lesson in return. If I’ve taken a loss, I’ve gained experience in exchange; in other words, I’ve actually used the money I lost as tuition. A person keeps gaining experience and has to pay for it.
• I had learned that a trader’s weaknesses know no limit. My attitude toward Dan Williamson was conduct befitting a gentleman, but acting against one’s own decisions was not at all befitting a real trader. There is no room for obligatory courtesy in the market, because prices reward not noble behavior but sound decisions. Still, I knew I couldn’t have acted differently. I couldn’t trample over the person in front of me just so I could get into the market. But business is business, and my business as a speculator always depends on my own decisions.
• Besides studying the general conditions of the market, keeping the past performance of stocks in mind, and taking into account the psychology of the public and the limitations of his brokers, a trader must know himself very well and know how to resist his own weaknesses.
• Then, all of a sudden, while I was getting a little closer to a fortune with every passing day, the Lusitania incident happened and prices fell. Every now and then, events like this are good for bringing a person back to his senses. No one can know exactly what the market will bring; you always have to allow a margin for accidents. Some say the torpedoing of the Lusitania didn’t shake professional traders much, that they had heard the news long before it spread through Wall Street.
• sometimes a person can’t help making money, just as it’s impossible to go out in the rain without an umbrella and stay dry.
• During a general rise in the market, all prices keep climbing. So if a stock goes against the general trend, it’s assumed this stems from something negative specific to that stock. An experienced trader immediately senses that something is wrong. He draws conclusions from the way prices are moving, takes the warning before the market’s alarm bells ring, and sells the stock he holds.
• Another thing that must not be forgotten is this: never try to sell a stock when its price is at its highest. That’s not a wise move. Sell after waiting for the stock to fall back a few points.
• As I’ve said before, when the market starts falling and the public’s morale collapses completely, the best strategy is to buy stock as soon as possible and cover your shorts.
• After paying off all my debts, I put a sizable portion of my money into stocks that would provide me with a regular income. I was determined never to be broke again, never to live without any security or capital. Of course, after I got married I set up a fund for my wife. After our son was born, I did the same for him. The reason I did this wasn’t a fear of losing my money to the market, but knowing that a person can spend every last penny he has without batting an eye. By setting up these funds, I protected my wife and child from myself.
• Life is a gamble from the cradle to the grave, and since I have no sixth sense, I know I have to accept whatever happens to me. Still, during my life in the market, there were times when, despite making sound decisions and taking careful steps, I lost money because of the unfair play of some dishonest rivals.
• I look only and solely at the facts and plan my moves accordingly. That is also how Bernard M. Baruch gave his recipe for wealth.
• As I’ve said a thousand times before, no manipulation can push stock prices down and keep them down. This isn’t hard to understand at all. Anyone who bothers to think about it for half a minute can grasp the reason. Let’s say a trader pushes a stock’s price below its real value; what happens next? First of all, this person will be playing right into the hands of those who want to buy the stock. Those who know the stock’s value will certainly want to buy it while it’s selling at a low price. If no buyers show up, that means the general conditions of the market are negative and there is an expectation of a general decline. Deliberately holding a price down is frowned upon in the market; it’s viewed almost as a crime. But selling a stock at a price far below its real value is a dangerous business. If the price of a stock that is being deliberately held down—that is, one that has been unfairly sold short—isn’t rising, it means it can’t find buyers; when a buyer appears, the price rises right away. Let me say this much: in ninety-nine percent of the cases where prices are alleged to have been held down by unfair means, the decline happened naturally.
• People believe tips not because they are stupid, but because they let themselves get carried away by hope. Baron Rothschild supposedly had a secret that helped him profit in the market. Someone asked him whether it was hard to make money in the market, and he said it was very easy. The person who asked said, “It seems easy to you because you’re already very rich.” “Not at all. I found the easy way, and I don’t stray from it. It’s impossible not to make money this way. If you like, I’ll tell you my secret. My secret is this: I never buy a stock when the price is at its lowest, and I always sell early.”
• He also explained what had driven him to sell his shares. “While Reinhart was telling me about the state of the company, he pulled some letter paper out of his desk drawer to write down the figures. The paper he used was extremely high quality, with a two-color embossed letterhead. This paper was very, very expensive. He wrote a few figures on the paper and told me how much profit certain departments of the company were making and how they had cut expenses and operating costs. Then he crumpled up that beautiful sheet and threw it in the wastebasket. A moment later, to explain a new method they were implementing, he pulled out another fresh sheet with the two-color letterhead. After writing a few figures, that sheet ended up in the wastebasket too. So much money wasted without a moment’s thought. If the president is like this, I thought, who knows what the people working under him are like. So instead of believing the president, I decided to believe those who had told me how wasteful he was, and I sold all the Atchison I had. By coincidence, a few days later I had to go to the offices of Delaware, Lackawanna & Western. In those days the president was Sam Sloan. His office was the room right next to the entrance, and its door was wide open. His door was always open. Anyone who walked into D. L. & W.’s head office could see the president of the company sitting at his desk. Anyone who wanted to could go and take up their business directly with him. Financial reporters say they could talk to Sam Sloan directly, ask him questions without beating around the bush, and get a clear yes or no answer from him whatever the situation in the market. When I went into Sloan’s office, I saw that he was busy. At first I thought he was opening his mail, but when I got closer to his desk I realized what he was doing. I later learned that this was his daily habit. After the letters arriving at the office were sorted and opened, instead of being thrown away, the empty envelopes were brought to Sloan’s office. In his spare minutes, he would tear the edges off the envelopes. That way he would get two pieces of paper, blank on one side. He would collect these papers and then hand them out to the office staff, having them use them as notepaper in place of the letterhead Reinhart had used for me. Neither the empty envelopes nor the president’s time went to waste. You see, a use was found for everything. If D. L. & W.’s president is like this, I thought, every department of the company must surely be run economically; Sloan must be seeing to that. Of course, I knew the company paid regular dividends and had plenty of real estate. I bought as much D. L. & W. stock as I could get. Since then, the stock’s value has doubled and then quadrupled. Now I receive nearly as much in annual dividends as the money I first invested. I still hold my D. L. & W. today. As for the Atchison company, it changed hands shortly after its president tossed sheet after sheet of letterhead into the wastebasket to prove to me that he wasn’t wasteful.” This is a true story, and D. L. & W. is the best investment that Pennsylvanian made in his entire life in the market.
• The training of a trader resembles a medical education. The would-be doctor has to study for many years and learn many subjects such as anatomy, physiology, and pharmacology. First he grasps the theory, and then he devotes his life to putting it into practice. He observes every kind of pathological case and classifies them. He learns to make a diagnosis. If his diagnoses turn out right—which is only possible if his observations are complete—he will succeed in treatment as well. But he always has to keep in mind that a person can be wrong and that some unexpected events can affect the outcome. Then, little by little, he gains experience; he learns not only to do the right things but to do them in time, so much so that people who aren’t doctors start to believe he is acting on some sort of instinct. But the doctor doesn’t do this automatically. Because he has encountered and diagnosed the same illness many times over the years, he chooses whatever treatment is most suitable based on his experience. You can pass on your knowledge, that is, the things you learned from books, to others, but you can’t pass on your experience. An investor may know very well what he needs to do, but as long as he doesn’t apply what he knows in time, he won’t escape losing money.
• Thanks to years spent in the market, hard work, and a good memory, a trader will know how to act in the face of both what he expects and what he doesn’t.
• For instance, I should point out that my memory and mathematics are of enormous importance to me. On Wall Street, money is made mathematically. That is, the market runs on certain facts and figures.
• Experience is what pays a person the highest dividends in the market, and observation is the best tip. Sometimes the only information you need is the direction a certain stock’s price is taking. That has to be observed. Then your experience will show you how you can make money from departures from the normal—that is, from the probable. For example, we all know that stocks don’t all move together, but if there is a general rise or fall in the market, certain groups of stocks will move in that direction.
• Although it has been disproved hundreds of times in practice, in theory it is taken as certain that these stocks will eventually meet at the same place, and so when C. D. Steel and X. Y. Steel are rising and A. B. Steel hasn’t risen yet, the public rushes to buy the latter. Even if a general rise is expected in the market, I won’t buy a stock if it isn’t behaving as it should. Sometimes, when a rise in prices is only a matter of time, I buy a stock and then sell it because the prices of the other stocks in its group aren’t going up. Why? Because my experience has shown me that I shouldn’t go against group tendencies. One can’t always act on hard facts.
• I don’t need an overly complicated reason. I’m a trader, and for me a single sign is enough: is the company’s own management buying the stock? They weren’t. Why the management didn’t want to buy the stock as the price fell was of no concern to me. The fact that they were making no special effort to push the stock’s price up was enough for me.
• In his book Speculation as a Fine Art, the author writes that for a trader, being courageous means being able to stand firm on the decisions he makes. As for me, I’m not afraid of being wrong, because I don’t consider myself wrong until I’ve been proven wrong.
• If I’m going to succeed, it should be thanks to my own knowledge. If I’m going to fail, that too should be because of my own mistakes.
• Knowledge is power, and power need not fear lies, even when those lies are posted on the market’s quotation board. It will soon come out that they are lies anyway.
• The secret of success in the market rests on the principle that people will make the same mistakes in the future that they made in the past.
• He who sells what isn’t his own must buy it back or go to prison.
• He was one of those rare people who could change his position the moment he realized he was wrong.
• Take a look at the financial news the agencies put out; you’ll see that most of it consists of tips issued by semi-official mouths. Why didn’t he give his name?
• Knowing what not to do is as important as knowing what to do.
• In times of a general rise in the market, especially during boom periods, the public makes a profit, and then suffers losses because it doesn’t know how to sell its stocks in time.

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A successful trader must fight these two powerful emotions… Instead of hoping, he must fear; instead of fearing, he must hope. He must fear that his loss may grow even larger, and hope that his profits may grow even more.