Sunday, July 20, 2014

Book Review #7: One up on Wall Street: Author: Peter Lynch

The one overriding message in the delightful book One up on Wall Street (author: Peter Lynch) is this.

An amateur investor (like you and me) are better at identifying winning stocks than a professional !

It comes out clearly in every page in this book that Mr.Lynch wants common people to become extra ordinary investors. The introduction to the book (which starts with the primary rule in investing 'Never listen to a professional') is dotted with anecdotes of how ordinary people were able to identify potential multi-baggers (a stock whose price increase multifold) much before professional investors became aware of the same. Be it author's wife Carolyn who identified Hanes as a  potential multi-bagger after witnessing the market popularity of the company's product (based on this input Mr.Lynch purchased Hanes stock and it turned out to be a six-bagger), or the local fireman who observed that a local company was expanding and went and purchased the stock which went on to become a multi-bagger. Or the imaginary Mrs.Houndstooth who identified 'The Limited' as a potential winner after experiencing the mad rush in their stores (The stock went on to become a 40 bagger)....

The stories abound emphasizing the point that ordinary people can identify potential multi-baggers through simple observation and use of common sense.

In addition, ordinary folks have another advantage. They are experts in some areas. They can easily identify potential opportunities in their areas of expertise. For example, a doctor may be the first to know that a new drug is a potential blockbuster. Insurance salesmen are the first to see that the insurance rates are going up which could mean better times ahead for the insurance industry. A person working in an IT Company could notice that bench strength is coming down which could mean rising demand for the industry. And so on...

The author bemoans the fact that the ordinary folks do not use this advantage when it comes to investing. Common people follow the motto that more obscure the industry, more money they invest in the companies in that industry. The doctor in the example above will invest in the shares of Oil companies without knowing the difference between a block, drill or a rig. The insurance salesperson will invest in Pharma companies without any insight into ANDA, Molecules or Generic Drugs. 

The IT guy? He will invest in everything other than IT.

This book is divided into three parts. Part 1, from Chapter 1 through 5, titled 'Preparing to Invest', aims to help an individual prepare to become a better investor. Part 2, Chapter 6 through 15, titled 'Picking the winners', cover the execution aspects of trading in Stocks. This section deals with how to identify opportunities, what to look for in a company, how to use the information available to your advantage, and a brief explanation of various numbers that one comes up during the analysis. Part 3, Chapters 16 through 20, titled 'Long Term View', deals with how to design a portfolio, how to keeps tabs on the companies, when to buy and when to sell and some general observations on Corporate America.

Before becoming an investor in Stock Market, one has to make some basic decisions about her attitudes towards the market. As the author says, it is personal preparation, as much as knowledge and research, that distinguishes a successful stockpicker from a chronic loser. 

So what are these personal preparations that one has to make before investing in the Stock Market?

First of all, one has to have trust on the market and on the ability of Corporate India to weather the occasional storms and make progress. One has to be clear in the mind that despite occasional hiccups, the Corporate India has persisted in its quest for long term progress and has significantly achieved that. BSE Sensex which was trading at 100 in 1979 is trading today at 25000. A 2500% return in about 35 years. This is despite the crashes in 1988, end of 2000 and in 2008. If one do not have this basic trust, one will end up in investing in the market when it has run up and selling it when it has come down significantly, ending up in significant losses. 

Second decision is regarding the available options. Is one ready to invest in stocks?, if yes, how much amount? and for how long to stay invested?. Stock market is not for the short term investors or the faint-hearted. There will be occasional sharp declines in the share prices. Will one be able to handle the fall and stay invested? 

Third decision is about the risk profile. If one is highly risk averse, Stock Market is not for her. She is better off remaining invested in low-risk investment avenues like money market investments or bank deposits. 

There is a perception that stock market investing is for the nerds. That it is for those savvy, mathematically inclined Whizkids who roam around looking into their Tablets and making 'Buy' and 'Sell' calls on the go. This perception leads ordinary folks to decide that they can't understand how the Stock Market works and hence they end up staying away from the Stock Market.

Chapter 1 aims to debunk this perception through the story of Mr.Lynch himself. Since his family lived through the great recession of 1929, discussing about and investing in stocks was a strict no, no in his house. Mr.Lynch got initiated into the world of stocks while caddying for some of the leading business men in his local golf course. The conversations that he listened to in the golf course, made Mr.Lynch realize that substantial money can be made in Stocks if they are selected after a thorough research and one kept with it as long as the company was growing. 

Mr.Lynch proves the point that one do not have to be a mathematical wizard to become a successful investor by pointing to his background. He majored in Arts including History, Psychology, Political Science, Metaphysics, Epistemology, Logic, Religion and Philosophy of ancient Greeks.

No math, no accounting, no quants...

Shouldn't I know all the latest theoretical concepts when it comes to investing in Stocks, one may ask. What about Efficient Market Hypothesis and Random Walk theory that I have heard about a lot in the TV, I have no clue about them, one may wonder. Mr.Lynch displays a healthy skepticism to these theories. The only expectation for one to become a successful investor is that one identifies good stories and do rigorous analysis based on simple tools that the second part of this book covers, buy the stock, and stick with it till the basic story is in tact. 

It is that simple...

Earlier in this article I mentioned that amateur investors have an edge over professionals when it comes picking winners in the stock market. Chapter 2 elaborates this point. There are multiple factors that hamper the ability of professionals to pick multi-baggers. First one is what is called a 'Street Lag'. By the time a stock appears in the Radar of the professionals, it is already a multi-bagger. However an amateur can identify and invest a potential multi-bagger much earlier in the cycle. 

Sometimes a professional cannot invest in a potential multi-bagger since the company do not fall into any specific industry classifications and the professional is duty bound to invest in certain industries. An ordinary investor do not have this constraint to hamper his investment style. 

Another mistake that a professional makes is what is known as 'Camp-following'. Any stock purchase or sell decision that he makes have to be vetted by multiple stakeholders. This means that there is an incentive for the professional to follow the herd and invest in companies that others invest in. This helps him overcome the vetting process. Due to this thorough vetting process, a professional has a disincentive in investing in off-beat stock which may become potential multi-baggers. An amateur do not have this constraint. 

The other constraints that a professional faces which an amateur do not face are: Constraints of rules and regulations of the Organization that she works for, Having to spent considerable time convincing potential customers on the logic of his investment picks, huge size of the assets to handle etc.

Isn't investing in stocks a gamble? Isn't it risky? Am I not better off investing in Debt Instruments? These are some of the questions addressed in Chapter 3. The author makes multiple points relating to the above questions. First, stocks have significantly outperformed most of the other investment avenues over the long-term. Second, as to the question whether stocks are a gamble, author points out that retail investors enter the market when it is high and exit the market when it is low and this is precisely what makes it a gamble. (Check out this story of Mrs.Preeti Malhotra) Third, amateur investors invest in the stocks without doing the proper due diligence. Author points out that we tend to spend more time evaluating our decision to purchase a piece of clothing than we spend in deciding which stocks to invest in. Fourth, with regard to the point whether Debt Instruments are less risky, author points out multiple instances when runaway inflation made the investment in debt almost worthless. Another related point is that if you focus on curtailing the risk, you will end up getting lower returns on your investment.

Read my related post on this topic

Ok, I understand your point, you say. I plan to get into investing in stocks. Are there some steps that I have to take before I start investing in stocks? As per Chapter 4 of the book, there are three things to consider before investing in stocks. One is to purchase a House before investing in stock market. There are many advantages to buying a house. One is that you get almost 80% loan from the bank and your investment is only 20%. Another is that there are many tax benefits to buying a house. Historically houses have been an appreciating asset. One key point that is made in this chapter is that people tend to buy and hold houses over a long-term unlike stocks which are purchased and sold over a very short term. Another point is that we do a lot of analysis and evaluation before we buy a house and no analysis before buying a stock. 

Second thing to consider before investing in stocks is whether you need money in the short term. Stock investing should not be done to meet short term financial goals. Those should be handled through debt instruments and money market instruments. 

Third aspect to consider is whether you have the personal qualities required to become a successful stock investor. Some of the personal characteristics include patience, self-reliance, common sense, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research and ability to ignore general panic. In addition, you should develop the capability to take decisions without complete or perfect information. Author also emphasizes against going by 'Gut Feelings' and wants the investors to do thorough research and stand by the stock as long as the story is in tact.

Many people wait for the right time to invest in market. Most of them finally invest exactly at the wrong moment. This is the focus of Chapter 5. Author says that when it comes to being prepared for stock market mishaps, we are always preparing for the last disaster that occurred and not anticipating and planning the potential disasters. This is known as 'Penultimate Preparedness'. Author also talks about 'Cocktail Theory'. As per this theory (coined by the author himself), if many people in a Cocktail party are more interested in talking to the Dentist than to the mutual fund manager, the market is due for a rebound. And when many people in the cocktail party (including the dentist) start giving stock tips to the mutual fund manager, the market is due for a correction / fall. 

The key advise to potential investors is never to try to time the market. Identify potential multi-baggers with great stories, buy them and keep them all the way till the story remains intact. 

Chapter 6 through 15 takes the reader through the next section 'Picking the Winners'. Chapter 6 presents two different types of advantages that an average investor will have. First one is the Professional Edge, which involves having a deep understanding of the industry and the other is the Consumer Edge, knowledge of small retail companies that are doing good business in the market. One main advantage of having a professional edge is that it will help you decide when to buy or sell a stock in your familiar industry. The chapter ends with a story of how the author totally missed the entire boom in the Financial Services Industry which he is a part of !

Talk about missed opportunities...

Once you identify a stock, the next step is to do the analysis. That is the focus of Chapter 7. The first step in the analysis is to identify the type of the company that one is planning to invest in. Depending on the pace of growth or the timing of business cycle, companies can be grouped into 6 categories. They are:
  • Slow Growers: Big companies that grow at a very minimal rate. The only reason to keep them is for the regular dividends that they pay out.
  • Stalwarts: Big companies that grow faster than a Slow Grower but not as rapidly as a Fast Grower. They are less volatile and can act as a defensive play in times of market downturn. 
  • Fast Growers: These are small companies that grow at a high rate. You make money in stock market if you are able to identify a Fast Grower early in the growth cycle. Once the growth peaks, a Fast Grower either turns to a Stalwart or fizzle out.
  • Turnarounds: These are companies that have gone through a series of negative events and which are bouncing back from their lows. Once they turn around, they make up lost ground very quickly. In addition the ups and downs of these companies are totally unrelated to the market conditions. There are different types of turnarounds. Mr.Lynch gives them quaint names like.
  1. Bail-us-out-or-else 
  2. Who-would-have-thought ('Who would have thought that this company can go down so rapidly and who would have thought it will bounce off so dramatically')
  3. Little-problem-we-didn't-anticipate (As in a natural disaster)
  4. Perfectly-good-company-inside-a-bankrupt-company
  5. Restructuring-to-maximize-shareholder-value
  • Cyclicals: The fortunes of these companies go through regular ups and downs. Some of these cyclicals may be big companies and could easily be confused with Stalwarts. However what differentiate cyclicals is regularity in their upturns and downturns. In Indian conditions, companies like TISCO, Auto makers, Banks, Infra companies like L&T and most of the Industrials like Crompton Greaves, Voltas etc fall into this category. It is very important to know when to get in to these stocks and when to get out of them. 
  • Asset Plays: These are companies holding significant assets in their books of which the market is not aware of. Some of the assets could include Real Estate held at book value, Carry forward losses which provide tax benefits to the company, Investments in the shares of other companies, huge customer base etc.
Identifying the category to which a stock falls is the first step in developing your story. Next step is to fill in the details to help you see how your story is going to pan out. To further develop the story you have to understand the basic business of the company. In Chapter 8, Mr.Lynch has identified a set of 13 Criteria to help identify potential multi-baggers. Some of these criteria include: 
  • It sounds dull or ridiculous: If you identify such company early, you could get a few rupees benefit simply because the name is dull. 
  • It does something dull or boring: Money is made in doing dull or boring stuff repeatedly. For example, Payroll Processing.
  • It does something disagreeable
  • It is a spinoff: These are companies that are spun off from large companies as independent entities. Normally spinoffs have strong balance sheets and are well prepared for success. In Indian context 'Marico Kaya' is a recent example of a spinoff. 
  • Institutions do not own it and the analysts do not follow it
  • There are a lot of rumors about the company
  • There is something depressing about it
  • It is in a no-growth industry: This is a bit counter intuitive. The logic is that in a no-growth industry there will be hardly any competitors and a good company has the market all to itself.
  • It has got a niche: The niche could be market, patents, brand names etc. In business parlance a niche is also called a 'Barrier to Entry'.
  • People have to keep buying the product: If you are in the business of selling inhalers for Asthma, the patient will keep buying your product. Same is the case with Insulin drugs, Printer Cartridges, Food items etc. 
  • It is a user of technology: As an ERP Consultant, I can relate to this point. Over and over I have observed that market pays a premium for the companies that implement ERP. 
  • Insiders are buying: A high level of promoter stake is a signal of the strength of the company. A side advantage is that when insiders have high level of stake, rewarding investors become high priority for the company
  • The company is buying back shares: This increases P/E and hence the market price of the share. This is the best way to reward a shareholder other than paying dividends. 
Having identified the category of the company from Chapter 7 and grouped the company into one of the above criteria, there is one more lesson that one has to learn. This relates to the type of companies that one should avoid. 

Part of the answer to that is that one should avoid those companies that do not fall into any of the criteria defined in Chapter 8. Chapter 9 further elaborates on this and lists down a few types of stocks that Mr.Lynch would avoid. These include:
  • The 'Next' something
  • Excessive diversificationMr.Lynch calls them 'Diworsefications'. Some companies cannot stand prosperity and go into an acquisition mode into unrelated industries. The only way an investor should play this game is to buy the shares of the company being acquired. However there are exceptions to the rule. Asian Paints has grown through acquisitions in the last decade, but the point to be noted is that all these were in the related industry (Paints).
  • Whisper stocks: These are much touted stocks with no earnings history. You can make money in these only during IPO
  • Middlemen: These are companies with one or two significant customers. They are always at the mercy of their customers.
  • Stocks with Exciting Names: If the names include words like 'Advanced', 'Leading', 'Micro' etc, it is better to avoid the stocks. There is an amusing anecdote about an Indian Textile company named 'Soft Wear Industries', which was into manufacturing undergarments. Its IPO came during the IT boom and the shares were lapped up mistaking the name for 'Software'.
Ok. Let us say that you have identified the company. You have categorized it into 'Fast Growth' as discussed in Chapter 7. The name of the company is boring (Lets say 'Motherson Sumi' for example) as per the points discussed in Chapter 8 and it doesn't fall into any of the groups to be avoided as discussed in Chapter 9.

Now what?

Chapter 10 initiate the detailed analysis of the company. The questions to ask are, what makes the company valuable and will it continue to be valuable in the future. The analysis focuses on Earnings and Assets. One should evaluate the rate at which the earnings have grown in the past and expected growth rate of earnings. The company which has strong earnings growth will grow in value whatever may be the market conditions. The chapter also focuses on the importance of P/E ratio and cautions the investors to avoid the companies with excessively high P/Es. The chapter also contains a brief discussion on Market P/E. 

The chapter explains that there are five basic ways in which a company can increase earnings. It can cut costs, raise prices, expand into new markets, sell more of its products in the current market, or revitalize, close or otherwise dispose off a losing operation. As you analyze the company you may want to evaluate how the company propose to increase its earnings. 

Now that you have identified your company and classified it into a specific category, you might want to see if your story logically fits together. In Chapter 11, Mr.Lynch suggests what is known as a 'Two minute drill'. Take two minutes of your time and make a case as to why you are interested in the company and what you think are its future prospects. The drill should make a sound case for investing in the specific stock. The author recommends us to follow this process even for the stocks that we currently own. 

Chapter 12 talks about various sources from which one can get information to analyze the company. There are research reports available dime a dozen. One could directly call the company and talk to the investor relations team. One could also seek information from one's broker. Company financial statements are another great source for information regarding the company and industry in general. 

Chapter 13 covers some of the most important numbers to consider while analyzing. The numbers should not be looked at in isolation but as a part of an overall story. 'Percent of Sales' tells you how much percentage a specific product is contributing to the overall revenue of the company. We have already discussed the 'P/E Ratio'. Another important number is the 'Cash Position', more importantly do the company have the cash to cover the short term debt. The cash position also tells you the floor to which the stock price could fall. When it comes to Cash Position, it is also important to know what the company is proposing to do with the cash that it has got. Another number is the 'Debt / Equity Ratio', which shows the Long Term Debt as a proportion to the Equity of the company. Higher this ratio, higher is the risk to the investor. There are two debts, one is called the Bank Debt (more risky since it is callable) and Funded Debt (Less risky since it is not callable). Yet another number is the 'Dividend Payout', both in terms of the amount and the consistency of payments. Other numbers to look for include the Cash Flow (Positive, Operating), Inventories (depleting), Growth Rate and the Bottom Line. 

While you may have done all the due diligence before purchasing the stock, as Mr.Lynch mentions in Chapter 14, it is very important to recheck the story to ensure that the story line has not changed. The company's prospects should progress as you had anticipated

Chapter 15 closes Part 2 by running a quick summary of all the points covered from Chapter 6 through 14.

Chapter 16 covers the designing of your portfolio. It answers the following questions. One, how many stocks should be in my portfolio? What is the advantage of having a larger number of stocks in my portfolio? What is the proportion of various categories (portfolio diversification) that I should carry in my portfolio? and How frequently should I rotate my portfolio?

As per Mr.Lynch the ideal number of stocks to be had in a portfolio is between 3 and 10. It is another matter that Mr.Lynch's portfolio contains about 1400 stocks !. There are two advantages to having more stocks in your portfolio. First, higher the number of stocks in the portfolio, higher your chances are of having a couple of multi-baggers. Second, more number of stocks give you more flexibility for portfolio rotation. 

As to the question what proportion of stocks of various categories should I have in my portfolio, it is an individual choice. Ideally one should have a part of the portfolio in Stalwarts and (probably Slow Growers, esp. for their dividend) and the rest should be divided over the other categories. If you follow the main theme of this book, you will have a major portion in Fast Growers followed by Turnarounds and Cyclicals and a few Asset Plays.

Regarding frequency of rotation, it depends on market condition. Generally you rotate Stalwarts more than others (once a Stalwart attains about 50% profit, get out of it and move to another). You move in and out of Cyclicals based on the economic environment. You move out of a fast grower as soon as the story begins to change for the worse. When it comes to Asset Plays, you wait for the market raider to appear.

Are there some opportune moments when I can buy or sell a stock? This very important question is discussed in Chapter 17. As to the question of when one should buy a stock, there are two particular periods when great bargains are likely to be found in the market. One is during the annual, year-end tax filing. This is when many funds do a portfolio cleanup and this provides a buy opportunity. Another is during market downturns when prices of all the companies are dragged down to ridiculous levels.

The chapter also addresses the question of 'when to sell' in a bit of a detail. In summary, you must sell a stock when either your story has fully played out or when the actuals have turned worse from what the story had anticipated. Other times to sell are when the company moves into unrelated diversifications.

Remember, never sell based on Quant based targets. For example, never decide that 'I will sell when I get 30% profit or 10% loss'. (I did). The chances are that you will always meet your 10% loss targets. Check this out.

Chapter 18 discusses 12 of the silliest things that people say about stock prices. These include:
  1. It has gone this much down, it can't go much lower. I can relate to that. I had seen a stock trading at 500, I purchased it at 200 thinking is a bargain, again at 100 thinking it has hit bottom, again at 50 thinking it can't go further down. The stock stopped at 15 !.
  2. You can always tell when a stock has hit bottom. No you can't.
  3. It has gone so high, how can it go higher?
  4. It is only 8 rupees a share. What can I lose?. You can lose your investment
  5. Eventually they all come back: No they don't. I purchased a share in 1996 for 20, again for 13, for 6 and for 4. The company declared bankruptcy and became a BIFR case. 
  6. It is always darkest before the dawn
  7. When it rebounds to 100, I will sell.
  8. Conservative stocks do not fluctuate much
  9. It is taking too long for anything to ever happen: Currently I am experiencing this with HLL. I have been holding it from 2005 when it was trading at 140. Today, 10 years hence it is at around 600. Nothing seem to be happening in this stock. I am getting impatient. 
  10. If only I had bought the stock / not sold it quickly, I would be a millionaire by now.
  11. I missed that one, I will catch the next one: Looking back, I can see the opportunities that I missed in the bull run of 2003 - 2008. I am determined not to repeat those mistakes in the current bull run. 
  12. Stock is gone up, so I must be right (and vice versa) 
Chapter 19 talks about risks of investing in Futures and Options and other derivative products. Mr.Lynch does not believe in playing this segment. Chapter 20 is a recap of various events that have happened over the years in the Wall Street and how, despite all the negative news, the market have been going up. The central theme of Chapter 20 is about hope. How things eventually pan out for the best when it comes to the economy. The chapter ends with a summary of the points learned in this section. 

This ends the review of the book. It has been a difficult book to review since each page of the book contains some gems or other. Also, one has to really strive hard to ferret out the main points of a chapter from all the noise about individual stocks and their performance. 

But the effort is worth it. I will say that this book is an essential primer for anyone who plans to invest in stock market. If not for the concepts, you should read it for the inherent positiveness and the confidence that this book gives to an amateur investor to venture into the market.

1 comment:

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