1. Invest In What You Know
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 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.
2. Let Your Winners Run
It’s easy to make a mistake and do the opposite, pulling out the flowers and watering the weeds. 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 Coca-Cola, your 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.
3. On Growth Stocks
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, Walmart never looked cheap compared with the overall market. Its price-to-earnings ratio rarely dropped below 20, but Walmart’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 an 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 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.
4. Career risk is more highly regarded than market risk
In fact, between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the normal mutual-fund manager, pension-fund manager, or corporate-portfolio manager would jump at the latter. Success is one thing, but it’s more important not to look bad if you fail. There’s an unwritten rule on Wall Street: “You’ll never lose your job losing your client’s money in IBM.”
5. Stocks are most likely to be accepted as prudent at the moment they’re not.
For two decades after the Crash, stocks were regarded as gambling by a majority of the population, and this impression wasn’t fully revised until the late 1960s when stocks once again were embraced as investments, but in an overvalued market that made most stocks very risky. Historically, stocks are embraced as investments or dismissed as gambles in routine and circular fashion, and usually at the wrong times.
6. Keep your winners, cut your losers
Consistent winners raise their bet as their position strengthens, and they exit the game when the odds are against them, while consistent losers hang on to the bitter end of every expensive pot, hoping for miracles and enjoying the thrill of defeat. In stud poker and on Wall Street, miracles happen just often enough to keep the losers losing.
7. Look for situations, where perceptions are worse than reality
The big winners come from the so-called high-risk categories, but the risks have more to do with the investors than with the categories.
8. Recency effect impacts many investors’ decision making
No matter how we arrive at the latest financial conclusion, we always seem to be preparing ourselves for the last thing that’s happened, as opposed to what’s going to happen next. This “penultimate preparedness” is our way of making up for the fact that we didn’t see the last thing coming along in the first place. The day after the market crashed on October 19, people began to worry that the market was going to crash. It had already crashed and we’d survived it (in spite of our not having predicted it), and now we were petrified there’d be a replay. Those who got out of the market to ensure that they wouldn’t be fooled the next time as they had been the last time were fooled again as the market went up. The great joke is that the next time is never like the last time, and yet we can’t help readying ourselves for it anyway.
9. All stocks are price cyclical
Companies don’t stay in the same category forever. Over my years of watching stocks I’ve seen hundreds of them start out fitting one description and end up fitting another. Fast growers can lead exciting lives, and then they burn out, just as humans can. They can’t maintain double-digit growth forever, and sooner or later they exhaust themselves and settle down into the comfortable single digits of sluggards and stalwarts.
Sooner or later every popular fast-growing industry becomes a slow-growing industry, and numerous analysts and prognosticators are fooled. There’s always a tendency to think that things will never change, but inevitably they do. Alcoa once had the same kind of go-go reputation that Apple Computer has today, because aluminum was a fast-growth industry. In the twenties the railroads were the great growth companies, and when Walter Chrysler left the railroads to run an automobile plant, he had to take a cut in pay. “This isn’t the railroad, Mr. Chrysler,” he was told.
Another sure sign of a slow grower is that it pays a generous and regular dividend. Companies pay generous dividends when they can’t dream up new ways to use the money to expand the business.
10. About Growth stocks
THE FAST GROWERS These are among my favorite investments: small, aggressive new enterprises that grow at 20 to 25 percent a year. If you choose wisely, this is the land of the 10-to 40-baggers, and even the 200-baggers. With a small portfolio, one or two of these can make a career. A fast-growing company doesn’t necessarily have to belong to a fast-growing industry. As a matter of fact, I’d rather it didn’t, as you’ll see in Chapter 8. All it needs is the room to expand within a slow-growing industry. Beer is a slow-growing industry, but Anheuser-Busch has been a fast grower by taking over market share, and enticing drinkers of rival brands to switch to theirs. The hotel business grows at only 2 percent a year, but Marriott was able to grow 20 percent by capturing a larger segment of that market over the last decade. The same thing happened to Taco Bell in the fast-food business, Walmart in the general store business, and The Gap in the retail clothing business. These upstart enterprises learned to succeed in one place, and then to duplicate the winning formula over and over, mall by mall, city by city. The expansion into new markets results in the phenomenal acceleration in earnings that drives the stock price to giddy heights.
11. THE CYCLICALS
A cyclical is a company whose sales and profits rise and fall in regular if not completely predictable fashion. In a growth industry, business just keeps expanding, but in a cyclical industry it expands and contracts, then expands and contracts again. The autos and the airlines, the tire companies, steel companies, and chemical companies are all cyclicals. Even defense companies behave like cyclicals, since their profits’ rise and fall depends on the policies of various administrations.
Coming out of a recession and into a vigorous economy, the cyclicals flourish, and their stock prices tend to rise much faster than the prices of the stalwarts. This is understandable, since people buy new cars and take more airplane trips in a vigorous economy, and there’s greater demand for steel, chemicals, etc. But going the other direction, the cyclicals suffer, and so do the pocketbooks of the shareholders. You can lose more than fifty percent of your investment very quickly if you buy cyclicals in the wrong part of the cycle, and it may be years before you’ll see another upswing.
12. Boring is good
A company that does boring things is almost as good as a company that has a boring name, and both together is terrific. Both together is guaranteed to keep the oxymorons away until finally the good news compels them to buy in, thus sending the stock price even higher. If a company with terrific earnings and a strong balance sheet also does dull things, it gives you a lot of time to purchase the stock at a discount. Then when it becomes trendy and overpriced, you can sell your shares to the trend-followers.
13. Who are the winners in a cyclical recovery
Depressed enterprises on the edge of disaster can become very big winners on the rebound. It happens again and again in the auto, chemical, paper, airline, steel, electronics, and nonferrous metals industries. The same potential exists in such currently depressed industries as nursing homes, natural gas producers, and many retailers. What you want, then, is a relatively high profit-margin in a long-term stock that you plan to hold through good times and bad, and a relatively low profit-margin in a successful turnaround.
14. Embrace market corrections
It is not entirely clear what causes deep market corrections (a clear prove that markets are irrational), but without them many of the best performing long-term investors would have never achieved their spectacular returns.
15. Hunting for bargains
There are two particular periods when great bargains are likely to be found. The first is during the peculiar annual ritual of end-of-the-year tax selling. It’s no accident that the most severe drops have occurred between October and December. It’s the holiday period, after all, and brokers need spending money like the rest of us, so there’s extra incentive for them to call and ask what you might want to sell to get the tax loss. For some reason investors are delighted to get the tax loss, as if it’s a wonderful opportunity or a gift of some kind— I can’t think of another situation in which failure makes people so happy. Institutional investors also like to jettison the losers at the end of the year so their portfolios are cleaned up for the upcoming evaluations. All this compound selling drives stock prices down, and especially in the lower-priced issues, because once the $ 6-per-share threshold is reached, stocks do not count as collateral for people who buy on credit in margin accounts. Margin players sell their cheap stocks, and so do the institutions, who cannot own them without violating one stricture or another. This selling begets more selling and drives perfectly good issues to crazy levels. If you have a list of companies that you’d like to own if only the stock price were reduced, the end of the year is a likely time to find the deals you’ve been waiting for. The second is during the collapses, drops, burps, hiccups, and freefalls that occur in the stock market every few years. If you can summon the courage and presence of mind to buy during these scary episodes when your stomach says “sell,” you’ll find opportunities that you wouldn’t have thought you’d ever see again. Professionals are often too busy or too constrained to act quickly in market breaks, but look at the solid companies with excellent earnings growth that you could have picked up in the latest ones.
16. About selling
If you know why you bought a stock in the first place, you’ll automatically have a better idea of when to say good-bye to it.
17. WHEN TO SELL A CYCLICAL
The best time to sell is toward the end of the cycle, but who knows when that is? Who even knows what cycles they’re talking about? Sometimes the knowledgeable vanguard begins to sell cyclicals a year before there’s a single sign of a company’s decline. The stock price starts to fall for apparently no earthly reason. To play this game successfully you have to understand the strange rules. That’s what makes cyclicals so tricky. In the defense business, which behaves like a cyclical, the price of General Dynamics once fell 50 percent on higher earnings. Farsighted cycle-watchers were selling in advance to avoid the rush.
One obvious sell signal is that inventories are building up and the company can’t get rid of them, which means lower prices and lower profits down the road. I always pay attention to rising inventories. When the parking lot is full of ingots, it’s certainly time to sell the cyclical. In fact, you may be a little late.
18. WHEN TO SELL A FAST GROWER
Here, the trick is not to lose the potential ten-bagger. On the other hand, if the company falls apart and the earnings shrink, then so will the p/ e multiple that investors have bid up on the stock. This is a very expensive double whammy for the loyal shareholders. The main thing to watch for is the end of the second phase of rapid growth, as explained earlier. If The Gap has stopped building new stores, and the old stores are beginning to look shabby, and your children complain that The Gap doesn’t carry acid-washed denim apparel, which is the current rage, then it’s probably time to think about selling. If forty Wall Street analysts are giving the stock their highest recommendation, 60 percent of the shares are held by institutions, and three national magazines have fawned over the CEO, then it’s definitely time to think about selling.
There’s simply no rule that tells you how low a stock can go in principle. I learned this lesson for myself in 1971, when I was an eager but somewhat inexperienced analyst at Fidelity. Kaiser Industries had already dropped from $ 25 to $ 13. On my recommendation Fidelity bought five million shares— one of the biggest blocks ever traded in the history of the American Stock Exchange— when the stock hit $ 11. I confidently asserted that there was no way the stock could go below $ 10. When it reached $ 8, I called my mother and told her to go out and buy it, since it was absolutely inconceivable that Kaiser would drop below $ 7.50. Fortunately my mother didn’t listen to me. I watched with horror as Kaiser faded from $ 7 to $ 6 to $ 4 in 1973— where it finally proved that it couldn’t go much lower.
19. The biggest winners are usually a pleasant surprise
The point is, there’s no arbitrary limit to how high a stock can go, and if the story is still good, the earnings continue to improve, and the fundamentals haven’t changed, “can’t go much higher” is a terrible reason to snub a stock. Shame on all those experts who advise clients to sell automatically after they double their money. You’ll never get a ten-bagger doing that.
Frankly, I’ve never been able to predict which stocks will go up tenfold, or which will go up fivefold. I try to stick with them as long as the story’s intact, hoping to be pleasantly surprised. The success of a company isn’t the surprise, but what the shares bring often is.
20. Picking bottoms – If they don’t scare you out, they will wear you out
Bottom fishing is a popular investor pastime, but it’s usually the fisherman who gets hooked. Trying to catch the bottom on a falling stock is like trying to catch a falling knife. It’s normally a good idea to wait until the knife hits the ground and sticks, then vibrates for a while and settles down before you try to grab it. Grabbing a rapidly falling stock results in painful surprises, because inevitably you grab it in the wrong place. If you get interested in buying a turnaround, it ought to be for a more sensible reason than the stock’s gone down so far it looks like up to you. Maybe you realize that business is picking up, and you check the balance sheet and you see that the company has $ 11 per share in cash and the stock is selling for $ 14. But even so, you aren’t going to be able to pick the bottom on the price. What usually happens is that a stock sort of vibrates itself out before it starts up again. Generally this process takes two or three years, but sometimes even longer.
How many times have you heard people say this? Maybe you’ve said it yourself. You come across some stock that sells for $ 3 a share, and already you’re thinking, “It’s a lot safer than buying a $ 50 stock.” I put in twenty years in the business before it finally dawned on me that whether a stock costs $ 50 a share or $ 1 a share, if it goes to zero you still lose everything. If it goes to 50 cents a share, the results are slightly different. The investor who bought in at $ 50 a share loses 99 percent of his investment, and the investor who bought in at $ 3 loses 83 percent, but what’s the consolation in that?
The point is that a lousy cheap stock is just as risky as a lousy expensive stock if it goes down. If you’d invested $ 1,000 in a $ 43 stock or a $ 3 stock and each fell to zero, you’d have lost exactly the same amount. No matter where you buy in, the ultimate downside of picking the wrong stock is always the identical 100 percent.
Sometimes it’s always darkest before the dawn, but then again, other times it’s always darkest before pitch black.