Peter Lynch launched straight into chapter 13 of "One Up on Wall Street" with a series of ratios and data that are the “Famous Numbers,” but noted he was not presenting them in any particular order of importance.
Percent of sales
When a company has a successful product, such as L’eggs, Pampers or Bufferin, what percent of company-wide sales does it represent? Hanes (HBI, Financial) was a relatively small company, so the success of L’eggs dramatically boosted the corporate share price. Pampers was even more profitable than L’eggs but was part of Procter and Gamble (PG, Financial), a giant company, thus making Pampers less significant to share prices.
Price-earnings ratio
Lynch offered a wrinkle of the price-earnings ratio in this section:
“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.”
For example, he cited a hypothetical case, Coca-Cola (KO, Financial). If its price-earnings was 15, you would expect it to grow about 15% per year. However, if you could find it available when the price-earnings was less than the annual growth rate, you could be looking at a bargain. On the other hand, a company that has a growth rate below its price-earnings ratio is a company to avoid.
Cash position
Want to buy shares at a big discount, even if the market believes the shares are overvalued? That’s what Lynch did with shares of Ford (F, Financial). The reason he could do that was because he had studied the company’s net cash condition and found it had a net cash position of $16.30 per share; subtract that from the then-current $38 per share and his effective cost was $21.30 per share.
And he went even deeper in his research and found the company’s financing arm, Ford Credit, was worth another $16.60 per share. Subtracting that from the previously stated $21.30 per share, the net cost dropped to $5.10 per share—and the company was expected to earn $7 per share!
If a company has cash, factoring that position into the share price can have rewarding results.
Long-term debt
Looking at the two sides of the balance sheet quickly reveals a company’s equity and long-term debt. In studying the 1987 annual report of Ford, Lynch could see the company had equity of almost $18.5 billion and long-term debt of $1.7 billion. From that, he could calculate the equity-to-debt ratio, which was 91 to 9, which meant the company had relatively minor leveraging and a relatively strong balance sheet (Lynch referred to 75 to 25 as being the norm for this ratio).
He pointed out that debt was crucial when he considered turnarounds:
“More than anything else, it’s debt that determines which companies will survive and which will go bankrupt in a crisis. Young companies with heavy debts are always at risk.”
Lynch also made a distinction between types of debt:
- Bank debt (the worst kind) puts a (cash-strapped) borrower in the untenable position of holding a loan that be called at any time and exposed to forced bankruptcy.
- Funded debt (the best kind) cannot be called so long as the borrower continues its interest payments.
Dividends
Lynch said he liked dividends, but also saw dividends as a means to an end:
“But the real issue, as I see it, is how the dividend, or the lack of a dividend, affects the value of a company and the price of its stock over time.”
He refered to the basic conflict between a corporations’ board of directors and its shareholders. Dividends can be used to reinvest in the company, which is to everyone’s advantage. However, leaving the cash with management can also lead to “a string of stupid diworsifications”:
“I’ve seen this happen enough times to begin to believe in the bladder theory of corporate finance, as propounded by Hugh Liedtke of Pennzoil: The more cash that builds up in the treasury, the greater the pressure to piss it away.”
Dividends, then, were not always a good thing in Lynch’s eyes.
Is the dividend sustainable?
Lynch’ preference was for companies that had a 20 or 30-year record of regularly raising their dividends. He glowingly referenced Kellogg (K, Financial) and Ralston Purina (now a division of Nestle SA (NESN, Financial)). They had neither reduced nor eliminated their dividends through three wars and eight recessions.
He warned against the dividends of highly-indebted companies, which are highly vulnerable to external pressures.
The dividends of cyclical stocks cannot be depended upon either, since there will be down years when paying dividends may require too much financial stretching.
Book value
Beware of this simple but potentially misleading metric. Lynch said what you see is not necessarily what you get; he points to Penn Central Railroad, which carried a book value of $60 per share when it filed for bankruptcy.
The problem here is with the quality of the assets comprising the book value. He refered to a textile company with fabric carried on the books at $4 per yard, when the reality is that the company might not be able to sell it for even 10 cents a yard. Lynch adds that the further a product gets from being a raw material, and the closer to being a finished product, the riskier it becomes. “You know what you can get for a bar of metal, but what is it worth as a floor lamp?”
Hidden assets
Book value may overstate the true worth of book value—it may also open opportunities for great asset plays. For example, in 1987, Handy and Harman (HNH, Financial) carried precious metals inventory at a book value of $7.83 per share based on prices paid years or many years earlier. As of 1988, that gold, silver and platinum was worth more than $19 per share.
Brand names are another source of hidden value; Lynch says names such as Coca-Cola and Robitussin had “tremendous value” that was not reflected on the books. To that list he adds patented drugs, cable franchises, TV and radio stations (although necessarily so much in 2018).
Cash flow
First, a definition from Lynch:
“Cash flow is the amount of money a company takes in as a result of doing business. All companies take in cash, but some have to spend more than others to get it. This is a critical difference that makes a Philip Morris such a wonderfully reliable investment, and a steel company such a shaky one.”
The difference, he said, was the amount of capital needed to operate a business, and he preferred companies that do not depend on capital spending. He also urged investors to make a distinction between cash flow and free cash flow. The latter is the amount remaining after normal capital spending and, of course, if you have little or no capital spending, then you have healthy free cash flow.
Lynch’s example, and a favorite holding (for reasons that will become apparent), was Coastal Corp., now a unit of Kinder Morgan (KMI, Financial). He said the company was fairly priced at $20, had earnings of $2.50 per share and spent $2.45 billion to buy a major pipeline company. Maintenance of the existing pipeline required relatively little capital but continued to generate earnings. So, it collected $10 to $11 in total cash flow, capital spending took away about about $4 and that left $7 per share in free cash flow. Lynch liked that:
“On the books this company could earn nothing for the next ten years, and shareholders would get the benefit of the $7-a-share annual influx, resulting in a $70 return on their $20 investment. This stock had great upside potential on cash flow alone.”
Inventories and pension plans
Look for inventory information in the “Management’s Discussion & Analysis” section; the important issue is whether the inventory in and inventory out are close to balancing. Growing inventories can be a sign of future trouble.
On pension plans, Lynch worried about companies’ absolute obligation to pay. These plans may be an issue in turnarounds and he said he always checked their status before investing.
Growth rate
Philip Morris (PM, Financial) and Procter & Gamble got the nod here as companies that enjoyed strong earnings growth, with their ability to reduce costs while holding prices steady or increasing them.
More important, perhaps, was Lynch’s discussion of compound growth rates. He argued investors should choose a stock growing at 20% per year at a price-earnings of 20, rather than a 10% grower with a price-earnings of 10:
“This in a nutshell is the key to the bigbaggers, and why stocks of 20-percent growers produce huge gains in the market, especially over a number of years. It’s no accident that the Wal-Marts and The Limiteds can go up so much in a decade. It’s all based on the arithmetic of compounded earnings.”
Warren Buffett (Trades, Portfolio), anyone?
Conclusion
In chapter 13 of "One Up on Wall Street," Lynch provided a list of topics he researched when looking at stocks. They were:
• Percent of sales
• Price-earnings ratio
• Cash position
• Long-term debt
• Dividends
• Dividend sustainability
• Book value
• Hidden assets
• Cash flow
• Inventories
• Pension plans
• Growth rate
As noted, they were not presented in order of importance, but some value investors will find that the information gleaned from these terms will guide them quite thoroughly through their due diligence.
Peter Lynch screen
The following table shows the first five of 30 results from running the Peter Lynch screen after the close on July 30. Instructions for interpreting the results are available at GuruFocus.com.
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.)
