You think you’ve found a good company in which to invest. It’s in the right category and has a decent valuation, based on the price-earnings ratio. What now? In chapter 11 of "One Up on Wall Street," author and legendary investor Peter Lynch explained:
“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.'”
He said something “dynamic” has to happen to keep the earnings coming, and the more you know about that “something” the better.
The two-minute monologue
No, Lynch was not doing comedy routines. Rather, he had to be able to know and articulate the story behind a stock before he would buy it. He would mutter the monologue under his breath, speak it out loud to a colleague or even explain it to his dog. And articulating it so a child could understand would ensure he properly understood the story behind the stock.
What should one address in the monologue? That would usually depend on the category of stock.
Slow growers (sluggards)
If you own a slow grower, it’s likely because you want the dividend, which in Lynch’s perspective is the only reason to own a sluggard. In this case, Lynch said a monologue might discuss the dividend this way:
“This company has increased earnings every year for the last 10, 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.”
This was a partial monologue: The average English-speaking American speaks at a rate of about 150 words per minute, so a full two-minute monologue would be around 300 words (adjust for you own speaking rate, as needed).
Cyclicals
If you are considering a cyclical company, then you would focus on issues such as business conditions, inventories and prices. Lynch offered this typical monologue, in part, to illustrate:
“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.”
Asset plays
What are the component assets of this company, and what is each worth? Lynch typically dealt with each aspect of asset plays this way:
- The stock was selling for $8 per share.
- One division’s assets alone were worth $4 per share.
- Its real estate is worth $7 per share.
- Total value: $11, providing a $3 margin of safety (although he doesn’t use that term).
In addition, prospective investors might also check whether insiders are buying, whether earnings are steady and whether the long-term debt is level.
Turnarounds
The time to consider turnarounds is when the company has made progress at improving itself. For example, Lynch cited the case of General Mills (GIS, Financial), which at that time had given up on being a conglomerate and was refocusing. The company had slimmed down from 11 basic businesses to just two. It was also buying back millions of shares, which is a practice Lynch liked to see (it pushes up earnings per share).
Medium growers
When it comes to stalwarts, he checked out three key aspects for his two-minute monologue:
- The price-earnings ratio.
- Was there a “dramatic” price gain in recent months?
- Is something happening that is speeding up the growth rate?
An example of the latter point, he used the example of Coca Cola (KO, Financial), which in the late 1980s had bought out many independent regional distributors. That gave the company greater control over distribution and domestic sales, which might accelerate the growth rate.
Fast growers
His example for fast growers was the La Quinta (LQ, Financial), the upstart motel chain that created a unique business model in Texas, then rolled it out into two adjacent states. At the time the book was published, earnings had increased every quarter, and the company planned to keep growing quickly. It was also a fast grower in a slow-growth industry, thanks to finding a niche of its own, and it had operations in only three states at the time.
As you may recall, fast growers in slow-growth industries were also situations Lynch liked.
A good example
Lynch reported he spent several hours developing each script after he had done his fundamental research.
An example of where he did his thinking correctly was La Quinta. That started with a phone call to a competitor, a franchiser of Holiday Inns, who named the then little-known La Quinta as the most successful competitor of Holiday Inn.
Lynch then spoke with the head of La Quinta, who described the business model as offering Holiday Inn quality but charging 30% less. The new chain’s secret was in eliminating wedding areas, conference rooms, large reception areas, kitchens and restaurants. These all added to the cost of building and maintenance but added little if anything to earnings.
As a result, the chain was able to build its facilities for 30% less than Holiday Inn. La Quinta also found an attractive niche: small business people who did not like budget motels but did like the luxury at a discount price. There more attractions for Lynch, but these, at least provided a good monologue.
The sad example
In this case, Lynch said he got so “caught up in the euphoria of an enterprise that you ask all the questions except a most important one, and that turns out to be the fatal flaw.”
J. Bildner and Sons operated a specialty food store across the street from his office, and Lynch loved its gourmet sandwiches and prepared hot meals. In his words, “They had the best bread and the best sandwiches in Boston.” Because of its initial success, the company decided to go public and expand to other cities.
After learning how profitable the stores were and that it planned to avoid bank debt by leasing rather than buying and building new stores, Lynch became excited and bought shares for $13 in the initial public offering. Two new outlets in Boston department stores were added, and both failed. It next launched three stores in Manhattan, but they could not compete with delis and failed as well. Expansion to other cities also proved difficult, while piling up costs.
“One or two mistakes at a time might not have been so damaging, but instead of moving cautiously, Bildner’s suffered multiple and simultaneous failures. The company no doubt learned from these mistakes, and Jim Bildner was a bright, hardworking, and dedicated man, but after the money ran out, there was no second chance.”
Lynch reported that he lost from 50-95% on the tranches he bought. Nevertheless, he continued to eat at the Bildner’s across the street.
Conclusion
Once more, Peter Lynch took readers through the six product categories, this time to illustrate the importance of preparing a two-minute monologue in which investors would make the case for the stock they proposed to buy.
By going through such an exercise, investors are more likely to know the advantages and disadvantages of a company and its stock. By reading the monologue aloud, to someone else, or even just to themselves, they push themselves even harder to see the pros and the cons.
Peter Lynch charts
GuruFocus provides the Peter Lynch Screen 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.
