[Image]

                 Use Your Edge                   

                By Peter Lynch

 

       What's the best way to invest $1        

       million? Tip one: Don't buy

       stocks on tips alone. If your            Amateurs

       only reason for picking a stock          can beat

       is that an expert likes it, then         the Streat

       what you really need is paid             because, well,

       professional help. Mutual funds          they're amateurs.

       are a great idea (I ran one

       once) for folks who want this            Look around

       sort of assistance at a                  you for

       reasonable price.                        good stocks. Down

                                                the road, you

       Still, I'm not convinced that            won't regret it.

       having 4,000 equity funds in

       this country is an entirely              You didn't

       positive development. True, most         need a

       of the cash flooding into these          Ph.D. to figure

       funds comes from retirement and          out that Microsoft

       pension contributions, where             was going to be

       people can't pick their own              powerful.

       stocks. But some of it also has

       to be pouring in from former             If you

       stock pickers who failed to              missed the

       invest wisely on their own               boat on Microsoft,

       account and have given up                there are still

       trying.                                  other technology

                                                stocks you can buy

       ---------------------------------        into.

         One of the oldest sayings on

       Wall Street is "Let your winners         There are

          run, and cut your losers."            ways you

       ---------------------------------        can keep yourself

                                                from gaining on

       When people find a profitable            the good growth

       activity -- collecting stamps or         companies.

       rugs, buying old houses and

       fixing them up -- they tend to           Sometimes

       keep doing it. Had more                  depressed

       individuals succeeded at                 industries can

       individual investing, my guess           produce high

       is they'd still be doing it. We          returns.

       wouldn't see so many converts to

       managed investment care,                 Retail and

       especially not in the greatest           restaurants

       bull market in U.S. history.             haven't been

       Halley's comet may return ten            performing well --

       times before we get another              but they're two of

       market like this.                        Lynch's favorite

                                                areas.

       If I'm right, then large numbers

       of investors must have lost              You can

       money outright or badly trailed          even find

       a market that's up eightfold             bargain stocks in

       since 1982. How did so many do           this market that

       so poorly? Maybe they traded a           have been

       new stock every week. Maybe they         overlooked.

       bought stocks in companies they

       knew little about, companies             Wondering

       with shaky prospects and bad             when you

       balance sheets. Maybe they               should exit the

       didn't follow these companies            market? Use

       closely enough to get out when           Lynch's rule of

       the news got worse. Maybe they           thumb.

       stuck with their losers through

       thin and thinner, without                Stocks do

       checking the story. Maybe they           well for a

       bought stock options. Whatever           reason, and poorly

       the case, they failed at                 for a reason.

       navigating their own course.

                                               

       Amateurs can beat the Streat            

       because, well, they're amateurs.        

                                           

       At the risk of repeating myself,       

       I'm convinced that this type of    

       failure is unnecessary -- that          

       amateurs can not only succeed on        

       their own but beat the Street by        

       (a) taking advantage of the fact        

       that they are amateurs and (b)          

       taking advantage of their              

       personal edge. Almost everyone         

       has an edge. It's just a matter      

       of identifying it.                      

                                               

       While a fund manager is more or         

       less forced into owning a long      

       list of stocks, an individual          

       has the luxury of owning just a         

       few. That means you can afford          

       to be choosy and invest only in         

       outfits that you understand and         

       that have a superior product or         

       franchise with clear                    

       opportunities for expansion. You        

       can wait until the company            

       repeats its successful formula    

       in several places or markets       

       (same-store sales on the rise,         

       earnings on the rise) before you        

       buy the first share.                    

                                               

       If you put together a portfolio         

       of five to ten of these high            

       achievers, there's a decent             

       chance one of them will turn out        

       to be a 10-, a 20-, or even a           

       50-bagger, where you can make           

       10, 20, or 50 times your                

       investment. With your stake             

       divided among a handful of              

       issues, all it takes is a couple        

       of gains of this magnitude in a

       lifetime to produce superior

       returns.

 

       One of the oldest sayings on

       Wall Street is "Let your winners

       run, and cut your losers." It's

       easy to make a mistake and do

       the opposite, pulling out the

       flowers and watering the weeds.

       Warren Buffett quoted me on this

       point in one of his famous

       annual reports (as thrilling to

       me as getting invited to the

       White House). If you're lucky

       enough to have one golden egg in

       your portfolio, it may not

       matter if you have a couple of

       rotten ones in there with it.

       Let's say you have a portfolio

       of six stocks. Two of them are

       average, two of them are below

       average, and one is a real

       loser. But you also have one

       stellar performer. Your

       [Image]Coca-Cola, your

       [Image]Gillette. A stock that

       reminds you why you invested in

       the first place. In other words,

       you don't have to be right all

       the time to do well in stocks.

       If you find one great growth

       company and own it long enough

       to let the profits run, the

       gains should more than offset

       mediocre results from other

       stocks in your portfolio.

 

       Look around you for good stocks.

       Down the road, you won't regret

       it.

 

       A lot of people mistakenly think

       they must search far and wide to

       find a company with this sort of

       potential. In fact, many such

       companies are hard to ignore.

       They show up down the block or

       inside the house. They stare us

       in the face.

 

       This is where it helps to have

       identified your personal

       investor's edge. What is it that

       you know a lot about? Maybe your

       edge comes from your profession

       or a hobby. Maybe it comes just

       from being a parent. An entire

       generation of Americans grew up

       on [Image]Gerber's baby food,

       and Gerber's stock was a

       100-bagger. If you put your

       money where your baby's mouth

       was, you turned $10,000 into $1

       million. Fifty-baggers like

       [Image]Home Depot,

       [Image]Wal-Mart, and Dunkin'

       Donuts were obvious success

       stories to large crowds of

       do-it-yourselfers, shoppers, and

       policemen. Mention any of these

       at a party, though, and you're

       likely to get the predictable

       reaction: "Chances like that

       don't come along anymore."

 

       Ah, but they do. Take

       [Image]Microsoft -- I wish I

       had.

 

       You didn't need a Ph.D. to

       figure out that Microsoft was

       going to be powerful.

 

       I avoided buying technology

       stocks if I didn't understand

       the technology, but I've begun

       to rethink that rule. You didn't

       need a Ph.D. in programming to

       recognize the way computers were

       becoming a bigger and bigger

       part of our lives, or to figure

       out that Microsoft owned the

       rights to MS-DOS, the operating

       system used in a vast majority

       of the world's PCs.

 

       It's hard to believe the

       almighty Microsoft has been a

       public company for only 11

       years. If you bought it during

       the initial public offering, at

       78 cents a share (adjusted for

       splits), you've made 100 times

       your money. But Apple was the

       dominant company at the time, so

       maybe you waited until 1988,

       when Microsoft had had a chance

       to prove itself.

 

       By then, you would have realized

       that [Image]IBM and all its

       clones were using Microsoft's

       operating system, MS-DOS. IBM

       and the clones could fight it

       out for market share, but

       Microsoft would prosper

       regardless of who won. This is

       the old combat theory of

       investing: When there's a war

       going on, don't buy the

       companies that are doing the

       fighting; buy the companies that

       sell the bullets. In this case,

       Microsoft was selling the

       bullets. The stock has risen

       25-fold since 1988.

 

       The next time Microsoft might

       have got your attention was

       1992, when Windows 3.1 made its

       debut. Three million copies were

       sold in six weeks. If you bought

       the stock on the strength of

       that product, you've quadrupled

       your money to date. Then, at the

       end of 1995, Windows 95 was

       released, with more than 7

       million copies sold in three

       months and 40 million copies as

       of this writing. If you bought

       the stock on the Windows 95

       debut, you've doubled your

       money.

 

       If you missed the boat on

       Microsoft, there are still other

       technology stocks you can buy

       into.

 

       Many parents with children in

       college or high school (I'm one

       of them) have had to step around

       the wiring crews as they

       installed the newfangled

       campuswide computer networks.

       Much of this work is being done

       by Cisco Systems, a company that

       recently wired two campuses my

       daughters have attended. Cisco

       is another opportunity a lot of

       people had a chance to notice.

       Its earnings have been growing

       at a rapid rate, and the stock

       is a 100-bagger already. No

       matter who ends up winning the

       battle of the Internet, Cisco is

       selling its bullets to various

       combatants.

 

       Computer buyers who can't tell a

       microchip from a potato chip

       still could have spotted the

       intel inside label on every

       machine being carried out of the

       computer stores. Not

       surprisingly, [Image]Intel has

       been a 25-bagger to date: The

       company makes the dominant

       product in the industry.

 

       Early on, it was obvious Intel

       had a huge lead on its

       competitors. The Pentium scare

       of 1994 gave you a chance to

       pick up a bargain. If you bought

       at the low in 1994, you've more

       than quintupled your investment,

       and if you bought at the high,

       you've more than quadrupled it.

 

       Physicians, nurses, candy

       stripers, patients with heart

       problems -- a huge potential

       audience could have noticed the

       brisk business done by

       medical-device manufacturers

       Medtronics, a 20-bagger, and

       Saint Jude Medical, a 30-bagger.

 

       There are ways you can keep

       yourself from gaining on the

       good growth companies.

 

       There are two ways investors can

       fake themselves out of the big

       returns that come from great

       growth companies.

 

       The first is waiting to buy the

       stock when it looks cheap.

       Throughout its 27-year rise from

       a split-adjusted 1.6 cents to

       $23, Wal-Mart never looked cheap

       compared with the overall

       market. Its price-to-earnings

       ratio rarely dropped below 20,

       but Wal-Mart's earnings were

       growing at 25 to 30 percent a

       year. A key point to remember is

       that a p/e of 20 is not too much

       to pay for a company that's

       growing at 25 percent. Any

       business that can manage to keep

       up a 20 to 25 percent growth

       rate for 20 years will reward

       shareholders with a massive

       return even if the stock market

       overall is lower after 20 years.

 

       The second mistake is

       underestimating how long a great

       growth company can keep up the

       pace. In the 1970s I got

       interested in [Image]McDonald's.

       A chorus of colleagues said

       golden arches were everywhere

       and McDonald's had seen its best

       days. I checked for myself and

       found that even in California,

       where McDonald's originated,

       there were fewer McDonald's

       outlets than there were branches

       of the Bank of America.

       McDonald's has been a 50-bagger

       since.

 

       These "nowhere to grow" stories

       come up quite often and should

       be viewed skeptically. Don't

       believe them until you check for

       yourself. Look carefully at

       where the company does business

       and at how much growing room is

       left. I can't predict the future

       of Cisco Systems, but it doesn't

       suffer from a lack of potential

       customers: Only 10 to 20 percent

       of the schools have been wired

       into networks, and don't forget

       about office buildings,

       hospitals, and government

       agencies nationwide.

       [Image]Petsmart is hardly at the

       end of its rope -- its 320

       stores are in only 34 states.

 

       Whether or not a company has

       growing room may have nothing to

       do with its age. A good example

       is [Image]Consolidated Products,

       the parent of the Steak & Shake

       chain that's been flipping

       burgers since 1934. Steak &

       Shake has 210 outlets in only 12

       states; 78 of the outlets are in

       St. Louis and Indianapolis.

       Obviously, the company has a lot

       of expansion ahead of it. With

       160 continuous quarters of

       increased earnings over 40

       years, Consolidated has been a

       steady grower and a terrific

       investment, even in a lousy

       market for fast food in general.

 

       Sometimes depressed industries

       can produce high returns.

 

       The best companies often thrive

       even as their competitors

       struggle to survive. Until

       recently, the airline sector has

       been a terrible place to put

       money, but if you had invested

       $1,000 in [Image]Southwest

       Airlines in 1973, you would have

       had $460,000 after 20 years. Big

       Steel has disappointed investors

       for years, but [Image]Nucor has

       generated terrific returns.

       [Image]Circuit City has done

       well as other electronics

       retailers have suffered. While

       the Baby Bells have toddled, a

       new competitor, [Image]WorldCom,

       has been a 20-bagger in seven

       years.

 

       Depressed industries, such as

       broadcasting and cable

       television, telecommunications,

       retail, and restaurants, are

       likely places to start a

       research list of potential

       bargains. If business improves

       from lousy to mediocre,

       investors are often rewarded,

       and they're rewarded again when

       mediocre turns to good and good

       turns to excellent. Oil drillers

       are in the middle of such a

       recovery, with some stocks

       delivering tenfold returns in

       the past 18 months. Yet it took

       a decade of lousy before they

       even got to mediocre. Readers of

       my column in Worth learned of

       the potential in this

       long-suffering sector in

       February 1995.

 

       Retail and restaurants haven't

       been performing well -- but

       they're two of Lynch's favorite

       areas.

 

       Retail and restaurants are two

       of the worst-performing

       industries in recent memory, and

       both are among my favorite

       research areas. I've taken a

       beating in a number of retail

       stocks (some of which I still

       like and have continued to buy),

       but the general decline hasn't

       stopped Staples, [Image]Borders,

       Petsmart, [Image]Finish Line,

       and [Image]Pier 1 Imports from

       rewarding shareholders. Two of

       my daughters and my wife,

       Carolyn, have continued to shop

       at Pier 1, reminding me of its

       popularity. The stock has

       doubled in the past 18 months.

 

       A glut in casual-dining outlets

       didn't hurt [Image]Outback

       Steakhouse, and a surplus of

       pizza parlors didn't bother

       [Image]Papa John's, whose stock

       was a double last year.

       [Image]CKE Restaurants -- whose

       operations include the Carl's

       Jr. restaurants -- has been a

       profitable turnaround play in

       California.

 

       You can even find bargain stocks

       in this market that have been

       overlooked.

 

       So far, we've been talking about

       growth companies on the move,

       but even in this so-called

       extravagant market, there are

       plenty of bargains among the

       laggards. Of the nearly 4,000

       IPOs in the past five years,

       several hundred have missed the

       rally on Wall Street. From the

       class of 1995, 37 percent, or

       202 companies, are selling below

       their IPO price. From the class

       of 1996, 33 percent, or 285, now

       trade below their offering

       price. So much for the average

       investor's never having a chance

       to profit from an offering. In

       more than half the cases, you

       can wait a few months and buy

       these stocks cheaper than the

       institutions that were cut in on

       the original deals.

 

       As the Dow has hit new records

       week after week, many small

       companies have been ignored. In

       1995 and 1996, the Standard &

       Poor's 500 Stock Index was up 69

       percent, but the Russell 2000

       index of smaller issues was up

       only 44 percent. And while the

       Nasdaq market rose 25 percent in

       1996, a lot of this gain can be

       attributed to just three stocks:

       Intel, Microsoft, and Oracle.

       Half the stocks on the Nasdaq

       were up less than 6.9 percent

       during 1996.

 

       That's not to say owning these

       laggards will protect you if the

       bottom drops out of the market.

       If that happens, the stocks that

       didn't go up will go down just

       as hard and fast as the stocks

       that did. I learned that lesson

       in the 197173 bear market.

       Before the selling was over,

       companies that looked cheap by

       any measure got much cheaper.

       McDonald's dropped from $15 a

       share to $4. I thought Kaiser

       Industries was a steal at $13,

       but it also fell to $4. At that

       point, this asset-rich

       conglomerate, with holdings in

       aluminum, steel, real estate,

       cement, fiberglass, and

       broadcasting, was trading at a

       market value equal to the price

       of four airplanes.

 

       Wondering when you should exit

       the market? Use Lynch's rule of

       thumb.

 

       Should we all exit the market to

       avoid the correction? Some

       people did that when the Dow hit

       3000, 4000, 5000, and 6000. A

       confirmed stock picker sticks

       with stocks until he or she

       can't find a single issue worth

       buying. The only time I took a

       big position in bonds was in

       1982, when inflation was running

       at double digits and long-term

       U.S. Treasurys were yielding 13

       to 14 percent. I didn't buy

       bonds for defensive purposes. I

       bought them because 13 to 14

       percent was a better return than

       the 10 to 11 percent stocks have

       returned historically. I have

       since followed this rule: When

       yields on long-term government

       bonds exceed the dividend yield

       on the S&P 500 by 6 percent or

       more, sell stocks and buy bonds.

       As I write this, the yield on

       the S&P is about 2 percent and

       long-term government bonds pay

       6.8 percent, so we're only 1.2

       percent away from the danger

       zone. Stay tuned.

 

       So, what advice would I give to

       someone with $1 million to

       invest? The same I'd give to any

       investor: Find your edge and put

       it to work by adhering to the

       following rules:

 

       With every stock you own, keep

       track of its story in a logbook.

       Note any new developments and

       pay close attention to earnings.

       Is this a growth play, a

       cyclical play, or a value play?

       Stocks do well for a reason and

       do poorly for a reason. Make

       sure you know the reasons.

 

       Stocks do well for a reason, and

       poorly for a reason.

 

       *Pay attention to facts, not

       forecasts.

 

       *Ask yourself: What will I make

       if I'm right, and what could I

       lose if I'm wrong? Look for a

       risk-reward ratio of three to

       one or better.

 

       *Before you invest, check the

       balance sheet to see if the

       company is financially sound.

 

       *Don't buy options, and don't

       invest on margin. With options,

       time works against you, and if

       you're on margin, a drop in the

       market can wipe you out.

 

       *When several insiders are

       buying the company's stock at

       the same time, it's a positive.

 

       *Average investors should be

       able to monitor five to ten

       companies at a time, but nobody

       is forcing you to own any of

       them. If you like seven, buy

       seven. If you like three, buy

       three. If you like zero, buy

       zero.

 

       *Be patient. The stocks that

       have been most rewarding to me

       have made their greatest gains

       in the third or fourth year I

       owned them. A few took ten

       years.

 

       *Enter early -- but not too

       early. I often think of

       investing in growth companies in

       terms of baseball. Try to join

       the game in the third inning,

       because a company has proved

       itself by then. If you buy

       before the lineup is announced,

       you're taking an unnecessary

       risk. There's plenty of time (10

       to 15 years in some cases)

       between the third and the

       seventh innings, which is where

       the 10- to 50-baggers are made.

       If you buy in the late innings,

       you may be too late.

 

       *Don't buy "cheap" stocks just

       because they're cheap. Buy them

       because the fundamentals are

       improving.

 

       *Buy small companies after

       they've had a chance to prove

       they can make a profit.

 

       *Long shots usually backfire or

       become "no shots."

 

       *If you buy a stock for the

       dividend, make sure the company

       can comfortably afford to pay

       the dividend out of its

       earnings, even in an economic

       slump.

 

       *Investigate ten companies and

       you're likely to find one with

       bright prospects that aren't

       reflected in the price.

       Investigate 50 and you're likely

       to find 5.

 

       Peter Lynch owns shares in the

       following companies mentioned

       above: Outback Steakhouse, Pier

       1 Imports, Consolidated

       Products, Staples, and WorldCom.

 

       Read "How to Invest a Million"

       in its entirety in the March

       1997 issue of Worth (on

       newsstands today), or in the

       Worth archives on this site.

 

     Home | Departments | Search | Message         Top of page

                    Boards

 

       1996 Capital Publishing Limited

                 Partnership