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

Lynch explores the importance of thorough research before investing in a stock. He emphasizes that discovering a potentially good stock is merely the first step, and discovery should not be an immediate signal to buy. He likens initial discovery to receiving an anonymous tip that requires further investigation: “Just because Dunkin’ Donuts is always crowded or Reynolds Metals has more aluminum orders than it can handle doesn’t mean you ought to own the stock. Not yet. What you’ve got so far is simply a lead to a story that has to be developed” (106).

Lynch warns against investing based on whims or the reputation of the person providing the tip. He argues that investing without proper research is akin to playing poker without looking at your cards. Lynch criticizes the tendency of some investors to spend more time and effort on mundane purchases than on their significant investments. He uses the Houndstooth family as an example, highlighting their meticulous approach to shopping for groceries in contrast to their haphazard investments in stocks.

Lynch outlines different categories of stocks and the importance of understanding a company’s size and growth potential. He categorizes stocks into six groups: slow growers, stalwarts, fast growers, cyclicals, turnarounds, and asset plays. Each category has unique characteristics and potential for growth, impacting how an investor should approach them.

Slow Growers: Lynch suggests that these are not ideal for significant gains. Slow growers are typically large and mature companies growing slightly faster than the nation’s gross national product, which measures the total market value of all goods and services produced by the residents of a country, including income from abroad.

Stalwarts: These are also large companies, like Coca-Cola and Procter & Gamble, known for moderate but reliable growth.

Fast Growers: These are small, aggressive new enterprises growing at 20-25% per year.

Cyclicals: Cyclicals are companies with sales and profits that rise and fall in regular, often predictable patterns, like Ford or American Airlines.

Turnarounds: These companies are in dire straits but have potential for recovery, such as Chrysler in the past.

Asset Plays: These companies are sitting on undervalued assets that the market has overlooked.

Understanding these categories helps investors set realistic expectations for stock performance. For instance, one shouldn’t expect a large, mature company to deliver rapid growth like a small, fast-growing enterprise.

The chapter emphasizes the dynamic nature of companies, noting that they can shift categories over time due to various factors, including industry changes, management decisions, and market conditions.

Lynch discusses the attributes of an ideal investment, emphasizing that simplicity and dullness in a business can be advantageous. He notes, “Getting the story on a company is a lot easier if you understand the basic business. That’s why I’d rather invest in panty hose than in communications satellites, or in motel chains than in fiber optics. The simpler it is, the better I like it” (130). Lynch prefers straightforward businesses, even remarking that companies that are so simple “any idiot could run” them are attractive to him (130).

Lynch lists several characteristics of a “perfect” company, though he acknowledges that such a company is more of a construct for understanding what to look for in a good investment. Key attributes include:

Dullness: Companies with boring or even ridiculous names, like “Pep Boys—Manny, Moe, and Jack,” tend to be overlooked, which can make them undervalued.

Simple Operations: These are businesses that do something unexciting, like Crown, Cork, and Seal, which makes cans and bottle caps.

Disagreeable Nature: Companies involved in disagreeable businesses, such as Safety-Kleen, which cleans greasy auto parts, tend to be ignored by investors.

Spinoffs: These often perform well as independent entities, like Toys “R” Us from Interstate Department Stores.

Low Institutional Ownership and Analyst Coverage: Stocks not widely followed are more likely to be undervalued.

Rumors and Controversy: Companies involved in industries like waste management can be misunderstood and undervalued.

Depressing Nature: Businesses in sectors that people prefer to ignore, such as funeral services (e.g., Service Corporation International), can offer good investment opportunities.

No-Growth Industry: Investing in industries with little or no growth can be more lucrative than high-growth sectors due to less competition and more stability.

Niche Markets: Companies with a unique market position or product, like a local rock pit, offer advantages due to limited competition.

Recurring Purchases: Industries where customers repeatedly buy products, such as drugs or cigarettes, provide steady revenue.

Users of Technology: These are companies that benefit from technological advancements without being in the tech industry themselves.

Insider Buying: Insider purchases indicate confidence in the company’s future.

Share Buybacks: Companies buying back their own stock often see increased share value.

Lynch’s ideal company, “Cajun Cleansers,” is a hypothetical firm that embodies these characteristics and suggests that investing in simple, stable, and often overlooked businesses can be more profitable than chasing after the latest hot industry. This chapter reinforces the value of fundamental analysis and understanding the underlying business in making investment decisions.

Lynch advises against investing in the trendiest stocks of the most popular industries. He explains, “If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train—and succumbing to the social pressure, often buys” (149). Lynch warns that such stocks often rise rapidly based on hype and not on solid financial foundations, leading to equally rapid declines.

Lynch cites Home Shopping Network as an example of a stock that soared and then plummeted, underscoring the risk of investing in “hot stocks.” He notes, “Look at the chart for Home Shopping Network, a recent hot stock in the hot teleshop industry, which in 16 months went from $3 to $47 back to $3½ (adjusted for splits)” (149).

Lynch cautions against the allure of high-growth industries and “the next big thing,” where competition often erodes profitability. Lynch also advises against investing in companies undergoing “diworseification,” a play on diversification that he uses for firms that make unwise acquisitions outside their areas of expertise. He suggests avoiding stocks based on rumors or with overly exciting names, as these often lack substance. Instead, Lynch emphasizes the importance of investing in companies with solid fundamentals, rather than being swayed by trends or hype.

Lynch emphasizes the paramount importance of a company’s earnings in determining its stock value. He states, “What you’re asking here is what makes a company valuable, and why it will be more valuable tomorrow than it is today. There are many theories, but to me, it always comes down to earnings and assets. Especially earnings” (161). This underscores Lynch’s view that the fundamental value of a stock is deeply rooted in the company’s ability to generate profits.

Lynch explains that much like evaluating any business venture, assessing a stock’s worth involves a close examination of its earnings and assets. A share of stock is, after all, part ownership of a business, and its value is largely determined by the company’s financial health and profitability.

To illustrate his point, Lynch uses the example of Sensormatic, which saw its stock rise significantly as the company expanded. He advises investors to consider how a company plans to increase its earnings, which can be achieved through various means such as cost reduction, price increases, market expansion, selling more products, or revamping unprofitable segments.

Lynch also probes the price/earnings (P/E) ratio, where share price is compared to the business’s revenue. Lynch explains that the P/E ratio is a key indicator of stock value relative to a company’s earnings. He advises caution against stocks with excessively high P/E ratios, as they often set unrealistic expectations for growth. Historical P/E ratios can provide context for whether a stock is overpriced or underpriced.

Lynch concludes with a note on predicting future earnings, a challenging task even for professional analysts. Lynch suggests that while precise prediction is difficult, understanding a company’s strategy for growth can provide insights into its potential future performance.