There’s a lot of research in finding and buying a stock, as Peter Lynch has explained in previous chapters of "One Up on Wall Street." In chapter 14, he counselled us to stay alert for new developments among the stocks we already own.
Three phases in a company’s life
To illustrate the importance of these reviews, he naturally told us a few stories. First, though, he had to go through the basics, starting with the three phases of a company’s life:
- The start-up phase, in which the company gets off the ground and proves its conceptual plan can handle reality. This is the riskiest phase because success remains uncertain.
- The rapid expansion phase sees it build on its initial success and expand into new markets. It has not yet saturated any markets and has lots of runway to build revenue, earnings and share price. It was in this phase that Lynch expected to make the greatest returns.
- The mature phase emerges as the company runs out of new opportunities and new markets. With saturated markets, management must find new ways to make money, and Lynch provides with examples. There are also the possibilities of bad expansion and diworsification.
McDonald's
One mature company that refused to accept saturation and continued to grow after reaching the mature phase was McDonald's (MCD, Financial). According to Lynch, investors began worrying in the late 1970s that the fast-food chain was running out of expansion room. Management had other ideas, however, and was able to act on them because earnings remained strong:
- Drive-through windows: These were a novelty at the time and have maintained their popularity since. Lynch said they accounted for a third of McDonald’s business a decade later.
- Breakfast: Until that time, its restaurants sat empty in the mornings, earning nothing but still incurring costs. Lynch found sales increased by 20% with little extra cost.
- Salads and chicken: Both added to earnings and reduced the company’s sole dependence on beef and beef prices.
- Foreign countries: Lynch observed it would be many, many years before there would be a McDonald's on every street corner in every country.
Cable TV
Lynch told a similar tale about the cable industry, which began with a burst of rural installations. While it might have stopped growing then, cable went on to new and sometimes better layers of profitable operations:
- Pay services such as HBO, Cinemax and Disney (DIS, Financial), from which the cable providers received a percentage.
- Urban installations, as city and suburban consumers wanted to see cable-only programs.
- Royalties from programs such as Home Shopping Network, which made a payment to the cable operator for each item or unit sold.
- Last, but certainly not least, has been the introduction of paid advertising. Contemporary readers will note, of course, the huge ratings for cable news shows and subsequently large advertising receipts.
Not all companies have an opportunity to grow through the mature phase as McDonald's and the cable industry have done, but some will. That’s why it’s essential to keep an eye on where the cash flow from mature companies is being applied.
Texas Air
Sometimes, though, you can take a ride too far, as Lynch described his wild ride with Texas Air (later to become a unit of United Continental Holdings Inc. (UAL, Financial) along with Continental Air, referenced below).
He took a “small position” in the middle of 1983, just before its key asset, Continental Air, fell into bankruptcy. With that, Texas Air stock dropped from $12 to $4.75, while Continental’s stock fell to $3 (Texas Air was the major owner of Continental).
To remedy the situation, Texas Air cut costs and Continental managed to get back enough of its customers to climb out of bankruptcy. Lynch bought shares in both airlines and both had tripled by 1986.
Then, in 1986, Texas Air bought a large position in Eastern Airlines, which the market considered a good idea. Texas Air tripled again in one year and was then up 10-fold from its low in 1983. With this good news still fresh in his mind, Lynch went into buy-and-hold mode. He says he became complacent because the potential earnings power of Texas Air and Eastern Air was so “terrific.”
Lynch had taken his eyes off what he calls the “near-term realities.” Texas Air bought out the remaining Continental shares, including those held by Lynch, and he reported making a “tidy profit.” Texas was also buying up Frontier Air and People’s Express. In February 1987, he bought another tranche of shares at $48.25.
He held on to his Texas Air shares, however, not realizing the company's balance sheet had deteriorated because of the acquisitions, saying “total debt from all the various airlines was probably greater than that of several underdeveloped countries.”
He was lulled, he said, by the great story of buying failed airlines, cutting costs and enjoying above-average returns. He was also ignoring near-daily stories about lost bags, scheduling failures, angry customers and unhappy employees. And then there were the problems of the new acquisitions failing to mesh with each other, which led to further problems. (Eastern was liquidated in 1991).
Earnings began to deteriorate in early 1987, Eastern failed to deliver on plans to cut $400 million from operating costs, and a big labor contract was due for renewal in the immediate future. From more than $48 in February, the stock plunged to $9 by the end of the year; Lynch was able to sell some of the stock for $17 to $18 per share on the way down and held on to some shares.
As he put it, he failed to bail out in the summer of 1987, when all these problems were becoming obvious:
“Like Don Quixote, I was so enamored of the promise that I forgot to notice I was riding a nag.”
Conclusion
The job of an investor doesn’t end the day a stock is bought. Instead, investors who want to score multibaggers like Peter Lynch should prepare to maintain their due diligence.
Using information from annual reports and other sources, keep looking for new initiatives that are important enough and big enough to push earnings higher or lower. Similarly, be continually concerned about developments that could pull down the earnings or stock price. Understanding where a company fits in the three life stages will help put this information in context.
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.)