Highlights of 'One Up on Wall Street' by Peter Lynch

Below, you will see notes I wrote down about what I found most interesting. Please note that some parts are directly extracted from the book without modification:

• It's easier than expected to overperform professional investors since they need to follow many rules (they cannot earn more than 5% of a company, invest more than 10% of their portfolio in a single company,etc.) and have too many people to please (firm director with portfolio diversity, customers with well known companies, etc).
• Predicting the economy or the short-term direction of the stock market is futile. Invest in companies, not in the stock market. You should not depend on the market. The market just gives you more good stocks to pick on bad times and less opportunities in raising markets. Use common sense or an edge in the industry to find good companies.
• Spot the opportunities by consuming the goods, services you realized in your normal life that are good and growing or just by knowing how the industry is evolving because you work on it.
• Once you have spot a stock you think, it is interesting, you need to analize it. The less analysts a company has covering it, the bigger the opportunity usually is. You need to be able to give a 2-minutes monologue on why to buy a stock. It's also important to test the product/service and be happy and convince about the future of it before buying the stock.
• Every quarter it's worthwhile to recheck the company.

How to identify Market Sentiment

Peter explains a trick he uses to identify in which part of the cycle the market is: if you are in a party where people know that you have deep interest in the stock market, you can identify the current market sentiment depending on how people interact with you on the topic. Peters says that there are 4 different stages:

1. If they change subjects or wander away, it means that the bull run is still in an early phase and there is a lot of way to go.
2. Whenever they talk for a while with comments like 'the stock market is very risky,' it usually coincides with the market being up around 15%.
3. When the market is up close to +30%, people usually ask you which stocks they should buy.
4. Whenever they tell you which stocks to buy, then sell, since the bull run is very close to its peak and a bear market approaches.

6 types of companies

1. Slow growers: these companies usually are previous fast growers whose industry has reached its maximal potential: cars (everyone has a car already, no big growths yoy), electric utilities, chemicals, etc.
2. Medium growers: 10 to 12% annual growth in earnings. You can earn a lot of money if you buy it in a period of a lot of negativity. He usually close these positions between 30-50% gain. They offer good protection against recession.
3. Fast growers: 20-30% annual growth. Better if they are within a slow growing industry. You should be careful and try to spot accurately when they will stop growing. There are 3 phases to a growth company's life: 1) start-up phase: success not yet established (riskiest phase); 2) rapid expansion phase: safest and where more money is made. The company is growing simply by duplicating it's successful formula; 3) mature phase: other ways must be found to increase earnings.
4. Cyclicals: prices depends on recessions and vigorous times: cars, planes, construction, etc. Timing is everything, you have to be able to detect early signs that business is falling or picking up.
5. Turnarounds: relatively big companies that are in a very bad situation and price can either go into bankruptcy or raise a lot. Companies that depend on government loans to survive that particular moment, companies that have had a disaster (leak of gas e.g), etc.
6. The asset plays: companies that sits on something valuable that you know about and wall Street crowd doesnt. E.g: companies where only the value of the land/real estate they own is higher than it's whole valuation. Companies that own land, patents, natural resources, tax exemptions (operating-loss carryforwards) etc. many times account them at the original prices they paid for them, instead of the current one which would be way higher.

Attributes that can help pick good stocks

• The name sounds dull.
• It does something dull.
• It does something disagreeable.
• It's a spin-off.
• There's heavy insider buying among internal workers.
• The institutions don't own it, and the analyst don't follow it.
• The rumours abound: it's involved with toxic waste and/or the Mafia.
• There's sth depressing about it (like funeral companies).
• It's a no-growth industry.
• It's got a niche (e.g. patent).
• People have to keep buying the product / service.
• It's a user of technology.
• The company is buying back shares.

Tips to avoid bad stocks

• Beware of the next something (related mainly to new disruptive technologies).
• Avoid diworseifications.
• Beware the whisper stock.
• Beware the middleman (1 customer generating 50% of the company' revenue).
• Beware the stock with the exciting name.

When to sell a stock

Peter explains that he doesn't pay attention to external economic conditions, except in the few obvious instances when he is sure that a specific business will be affected in a specific way. But in nine out of ten cases, he sells if company X has a better story than company Y, and especially when the latter story begins to sound unlikely:

• P/E strays top far beyond the normal range of the company and also against other companies of the industry.
• P/E ratio has increased compared to the earnings growth rate.
• The company's growth rate has been slowing down and though it's been maintaining profits by cutting costs, future cost-cutting opportunities are limited.
• Inventories are building up and the company can't get rid of them, which means lower prices and lower profits down the road. Also, when inventories grow faster than sales, it's a red flag.
• Falling commodity prices (if company's business activity is linked to it).
• Competition businesses (the outsider will have to win customers by cutting prices, which forces everyone else to cut prices).
• In fast growers, the main thing to watch for is the end of the second phase of rapid growth. Be sure that the company still has room to grow. ‌Whether the expansion is speeding up or slowing down (compare to previous years). If it is slowing, maybe we have reached the mature phase.
• The company's strongest division sells 50% of its output to one leading customer, and that leading customer is suffering from a slowdown in its own sales.
• Institutional ownership has risen (e.g. from 25% to 60% in 4 years).

Extra tips

• Get out of situations in which the fundamentals are worse and the price has increased and into situations in which the fundamentals are better and the price is down. By successfully rotating in and out of several companies for modest gains, you can get the same results as you would with a single big winner. E.g: a stelwart has done a +40% without any important reason (they are not supposed to grow that much these kind of companies).
• A 20-percent grower selling at 20 p/e is a much better buy than a 10% grower selling at a p/e of 10. It's all based on the arithmetic of compound ed earnings.
• Comparing pretax profit margin it's interesting between companies of the same industry. The company with the highest profit margin is by definition the lowest-cost operator, and therefore has a better chance of surviving if business conditions deteriorate. 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.
• It's usually 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.

On PE ratio, earnings and cash flows

P/e ratio enables you to identify if a stock is over or undervalued. Check the historical p/e ratio of the company and compare which the one from the industry (e.g. mature companies in the industry etc.)

5 ways to increase earnings: 1) reduce costs; 2) raise prices; 3) expand into new markets; 4) increase sales in old markets; 5) close a losing operation.

If p/e ratio smaller than growth rate, then it's a bargain

Free cash flow is what is left over after the normal capital spending is taken out.

On Balance sheet

Cash/cash item + marketable securities - long-term debt --> when cash exceeds debt it's very favourable. The company won't go out of business. Also when cash increases relative to debt YoY, it's an improving balance sheet.

Cash position: cash per share should be extracted from the Share price (since it's a discount).

‌The debt factor: debt to equity ratio. Normal rate is 75% equity and 25% debt. 2 type of long term debt: a) bank debt (due on demand); b) funded debt.

‌Book value: assets - liabilities. The problem is that liabilities are real and assets tend to be overvalued in the balance sheet. E.g: at penn central (went to bankruptcy) tunnels through mountains and useless rail cars counted as assets.

Some companies/industries are more capital intensive. Usually it's a company with a huge depreciation allowance for an old equipment that doesn't need to be replaced in the immediate future. It wouldn't work in the computer business , because the prices drop so fast that old inventory doesn't hold its value long enough for anybody to squeeze anything out of it.

‌Cash position: the net cash per share marks the floor on the stock price.