Chapter nine of "One Up on Wall Street" provided Peter Lynch’s map of places to avoid if we want to preserve our capital. It’s the other side of the coin from chapter eight, where he guided us to the places he found potential multibaggers.
Beyond the “known landmarks of value”
Hot stocks in the hottest industries—the ones that get a lot of publicity and become must-buys among speculators—are the first on Lynch’s ire list:
“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.”
When the price of a hot stock falls, it is going to fall in a hurry and it is unlikely to do you the courtesy of stopping at the price you originally paid. As an example, he cited Home Shopping Network (now owned by Qurate Retail Group (QRTEA, Financial)), which shot up from $3 to $47 and back down to $3.50 in just 16 months. “Where were the earnings, the profits, the future prospects? This investment had all the underlying security of a roulette spin.”
The next whatever
How often have we heard of the next incarnation of a currently hot business. For Lynch, these were stocks being touted as the next McDonald’s (MCD, Financial), the next IBM (IBM, Financial) and the next Disney (DIS, Financial). Of course, the next big things are still being proclaimed in 2018 and will likely continue to flare up as long as stock markets exist. Lynch said:
“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.”
Diworsification
In Lynch’s recollection, corporations would go on rampant “diworsification” binges every second decade and then follow up with purges when the ill-advised acquisitions would be sold off for less than their original cost. Just as, “The same thing happens to people and their sailboats.”
What’s more, he sees these binges as “a form of transfer payment from the shareholders of the large and cash-rich corporation to the shareholders of the smaller entity being taken over, since the large corporations so often overpay.”
Two silver linings appear in these clouds. Lynch described them as owning shares in a company being taken over (and collecting a premium above fair valuation) and seeing turnaround opportunities when the “victims of diworsification” restructure themselves. He added that the “great acquisitive era” of his time had ended when the market collapsed in 1973-74.
Whisper stocks
The fourth category to avoid is whisper stocks, which Lynch also calls longshots and whiz-bang stories. Apparently, he had plenty whispered to him while he was at the helm of Fidelity’s Magellan Fund. He added there is a worrisome aspect to these stocks:
“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.”
He said he has bought plenty of these himself, enough to know that all these stocks had something in common: “the great story had no substance.” He also learned that if the prospects are so good, the stock will be a “fine investment” in a year or two, so why not wait until they can show some earnings.
Single-customer dependency
A brief section, in which Lynch recommended that investors avoid companies that are highly dependent on one customer.
He cites the case of SCI Systems (now a private company, also not the funeral home chain); it sold a quarter to a half of its computer parts to IBM and that set off warning lights for Lynch. He noted the company was well managed, but at the mercy of IBM, should it decide to make its own parts or do without them altogether. He added:
“Short of cancellation, the big customer has incredible leverage in extracting price cuts and other concessions that will reduce the supplier’s profits. It’s rare that a great investment could result from such an arrangement.”
Since Lynch published this book in 1988, Walmart (WMT, Financial) grew to be a giant that constantly pressured its suppliers, and management of those suppliers had to constantly decide how far they were willing to go to satisfy Walmart’s demands. That was great for consumers, but not necessarily for investors in those suppliers.
Flashy names for mediocre companies
Lynch lamented that Xerox (XRX, Financial) did not have a name such as David’s Dry Copies, which would have made investors more skeptical:
“A flashy name in a mediocre company attracts investors and gives them a false sense of security. As long as it has 'advanced,' 'leading,' 'micro' or something with an x in it, or it’s a mystifying acronym, people will fall in love with it.”
He also speculated that had Crown Cork and Seal (CCK) listened to corporate image consultants, it would have changed its name to CroCorSea and that would have guaranteed lots of institutional interest. From Lynch’s perspective, that would have eliminated one of his favorite stocks, from a company that focused on building the fundamentals rather than being trendy.
Conclusion
With apologies to Barton Malkiel, a random walk down Wall Street can be like a walk down the Las Vegas strip. Vast amounts of noise, bright and blinking lights and no end of temptations. Investors face that each time they step into the market.
Unfortunately, those bright lights and temptations can do damage galore to your portfolio, your capital or both. Peter Lynch spent more than two decades trying to step around those hazards; sometimes he, too, learned the hard way.
As a result, he was an excellent guide, helping others avoid the hazards, as demonstrated in chapter nine’s list of follies and failures waiting to happen.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
GuruFocus provides the Peter Lynch Screen tool for quickly finding companies that meet his criteria. Members can access the screener here, and non-members can get started here.
(This review is based on the Millennium Edition (2000) of “One Up on Wall Street”. More chapter-by-chapter reviews can be found here.)
