One Up On Wall Street: How to Use What You Already Know to Make Money in the Market

Lynch discusses the importance of diligent research for individual investors. He emphasizes that while professional investors like himself have the advantage of direct access to companies, amateurs can access almost all necessary information through public sources. Lynch notes, “Although there are various drawbacks to being a fund manager, there’s the advantage that companies will talk to us—several times a week if we’d like” (183).

Lynch advises investors to utilize full-service brokers for information, not just transaction services. He also encourages contacting companies directly, visiting headquarters, and conducting “grassroots research” by experiencing products or services firsthand. This provides a tangible sense of a company’s operations and market presence.

While professional investors have certain advantages, individual investors can effectively gather crucial investment information through diligent research, asking the right questions, and engaging directly with companies and their products.

Lynch lays out various financial metrics that are crucial for evaluating stocks. He emphasizes the importance of understanding these numbers for making informed investment decisions.

Percent of Sales: Understanding the contribution of a particular product to a company’s overall sales is vital. For instance, L’eggs significantly impacted Hanes’s stock because Hanes was a relatively small company.

Price/Earnings Ratio (P/E Ratio): A fair P/E ratio for a company should be equal to its growth rate. Lynch advises, “If the p/e of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc.” (199). A P/E ratio less than the growth rate could indicate a bargain.

Cash Position: Companies with significant cash reserves offer a safety net and potential for appreciation. Lynch illustrates this with Ford; a strong cash position influenced his decision to hold onto the stock.

Debt Factor: Debt, particularly bank debt, can be a critical factor in a company’s survival during crises. Comparing debt to equity helps in assessing financial health.

Dividends: Dividend-paying stocks are often preferred for additional income. Lynch advises looking for companies with a history of consistent dividend payments.

Book Value: While book value can indicate the net value of a company’s assets, it doesn’t always reflect the true worth of the company. (Note: Book value refers to the net asset value of a company, calculated by subtracting its total liabilities from its total assets.)

Hidden Assets: These can include undervalued assets like land, patents, or brand names that are not accurately reflected in the book value.

Cash Flow: Free cash flow, money left after capital spending, is a significant indicator of a company’s financial health.

Inventories: A company’s inventory levels can indicate operational efficiency. Increasing inventories relative to sales might signal trouble.

Pension Plans: Pension obligations can impact a company’s financial future, especially in turnarounds.

Growth Rate: A company’s growth should be evaluated based on its earnings growth rather than just sales or expansion.

The Bottom Line: The final profit after taxes, or the net income, is a crucial indicator of a company’s profitability.

Lynch concludes that understanding these numbers is essential for investors to make well-informed decisions and identify potential investment opportunities.

Lynch emphasizes the importance of periodically reassessing the investment story of a company. He points out that companies typically go through three phases: the start-up phase, the rapid expansion phase, and the mature or saturation phase. The first phase is the riskiest for investors, while the second phase is the safest and most profitable. The third phase is problematic as the company reaches its expansion limits.

Lynch stresses that investors must continually monitor these phases to understand where a company stands in its lifecycle. For instance, he notes, “If you look at Automatic Data Processing, the company that processes paychecks, you see that they haven’t even begun to saturate the market, so Automatic Data Processing is still in phase two” (223).

He uses examples of companies like Sensormatic, Sears, and The Limited to illustrate how companies can plateau after rapid growth, necessitating a reassessment of their investment story. Lynch also points out how companies like McDonald’s have continued to innovate and grow even after reaching apparent market saturation.

Further, Lynch discusses how an investor’s perception can be clouded by a rising stock price, leading to missed signals of fundamental problems. He shares his own experience with Texas Air, where he was captivated by the stock’s ascent despite underlying operational issues. This serves as a cautionary tale about the importance of staying attuned to a company’s fundamentals, regardless of its stock price movements.

Lynch summarizes key considerations for evaluating different categories of stocks. He emphasizes that thorough research is crucial but that it doesn’t require excessive time or expertise. Here’s a summary of his main points:

General Stock Evaluation: Focus on the price-to-earnings (P/E) ratio, institutional ownership, insider buying, earnings growth consistency, financial strength, and cash position.

Slow Growers: Since these are primarily for dividends, ensure consistent dividend payments and reasonable payout ratios.

Stalwarts: Evaluate P/E ratios, potential diworseifications, long-term growth rates, and past performance during economic downturns.

Cyclicals: Monitor inventories and the supply-demand balance, watch for new market entrants, and understand industry cycles.

Fast Growers: Check the significance of the product, earnings growth rate, expansion sustainability, and P/E ratio in relation to growth.

Turnarounds: Assess the company’s ability to survive financial stress, its debt structure, and its operational improvement plans.

Asset Plays: Determine the real value of assets, debt levels, new debt acquisition, and any potential for takeover interest.

Lynch’s checklist serves as a guide for investors, emphasizing the importance of understanding a company’s business, financial health, and market position across different stock categories. He advocates for a balanced approach that combines financial metrics with a qualitative understanding of the company and its industry.