Peter Lynch: How To Invest For Beginners | The Ultimate Guide To The Stock Market | Big Money Investing Review

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you shouldn’t be intimidated everyone can do well in the stock market you have the skills you have the intelligence it doesn’t require any education all you have to have is patience do a little research you’ve got it don’t worry about it don’t panic in 1990 peter lynch retired as manager of fidelity magellan the nation’s largest stock mutual fund and one of the most successful in 13 years he drove magellan to a twenty eight hundred percent gain quite simply lynch has been recognized as one of the greatest money managers ever he beat the stock market for so long not by timing the market but by picking the right stocks of course no one can promise you peter’s record but you can learn a lot from him and you don’t need a billion dollar portfolio to follow his rules hi my name is peter lynch for 13 years i managed fidelity magellan fund those were 13 amazing years nine times the market declined by 10 or more and i was very consistent all nine times magellan fund fell 10 or more i learned a lot of lessons i think they’re true now i think they were true 20 years ago i think they’ll be true 20 years from now i think i can help you do a better job of investing you can’t learn years of stock picking experience in one night but you have better stock picking skills than you realize and your advantages that no one on wall street has i’m here to help you find them and use them you may be wondering why stocks are so important for a long-term investment program the short answer over time stocks produce better returns than other investments the past 60 years stocks have returned about 10 percent a year bonds have averaged six percent a year treasury bills or bank cds around three that doesn’t seem like a big difference does it but the power of compounding makes an enormous difference over time suppose you invest fifty dollars a month and earn six percent after thirty years you have over fifty thousand dollars when your investment is taxed the government reduces your return every year if you know you won’t need the money until retirement you should place as much of your investments as possible into tax deferred accounts like iras kios 401k or 403b plans because you don’t pay taxes on the money until it is withdrawn from the accounts the power of compounding achieves the maximum effect providing you the best return possible the more time you have to let your earnings compound the better results you’ll get a 20 year old who invests 200 a month and earns 10 percent on his money all along left 1.1 million dollars the time he was 60. a 35 year old would have to invest 800 a month to have the same 1.1 million dollars at age 60. you’re going to have a tough time getting that 10 return without at least some stocks in your portfolio before you start to invest ask yourself one question when will i need to use this money the stock market is a long-term investment if you need to use the money anytime soon you should not invest in stocks this is money you’re willing to put in the market and leave it there for 5 10 20 30 years that’s the kind of money you can do well with if you’re worried about it don’t invest it the stock market is volatile individual stocks are volatile the average range for stock in a year is 50 between its high and slow stocks go up and down the market goes up and down if you’re investing with a one or two year time horizon you shouldn’t be in individual stocks you shouldn’t be in equity mutual funds if you’ve been lucky enough to save up lots of money to send your children to college and they’re starting school in two years what are you gonna do if the market goes down in the long term 10 15 20 years or more stocks have beaten bonds and banks certificates of deposits but in the short term there’s no telling what will happen in 1987 the s p 500 fell 33 from its august top to its october bottom if you had the stomach to ride through that drop you would have found that the s p performance from 1987 through 1992 still outperform treasury bills and long-term government bonds despite that decline if you want to double your money quickly and safely fold it in half and put it in your wallet any other way you’re simply gambling a good stock can take two three even five years before it really pays off it’s not two or three weeks it’s not two or three months my best stocks have been my fifth sixth seventh year give your investments time to grow many people ask me when is the right time to sell a stock selling stocks is a matter of comparing stories if story a is better than story b then sell b and buy more a if you own eight companies you’re playing eight simultaneous games of poker so only stay in the games that you have the best chance of success but remember that stories rarely change overnight may take years for a good one to be recognized by the market give your good stories the time to grow your advantage in picking stocks is your direct experience with companies as a consumer on your job as a professional or as a neighbor use those advantages as a place to start looking for good stocks you have several things that you possess that will make you a good investor they’re inherent to your life it’s the field you work in it’s the area where you live there may be some local company that’s terrific you’re a consumer you see some products you see some services that are terrific we bought a volvo it was better than the american station wagons it was safer the price was right i did a little bit of research i found that volvo the stock swedish company was selling equal to its cash you’re paying almost nothing for the company they had lots of other divisions that were doing terrific buying that car turned out to be a great way to begin researching the stock sometimes people take things for granted my field was the mutual fund industry in the early 1970s the industry grew slowly but then it took off in the 80s money piled in to money market funds to equity funds like an idiot i missed stocks like dreyfus pioneer t rowe price strategic investments franklin resources there’s lots of companies that went up dramatically these are my own field all i had to do was buy these things it was really dumb back in the 1950s a fireman from new england noticed the factory in his town seemed to be hiring expanding all of the time this person didn’t have a great computer he wasn’t a professional investor he was just an observant neighbor he decided to put two thousand dollars per year into tam brands then call tam pax by 1972 the fireman was a millionaire just from using his local edge investing is a personal thing you have to do it by yourself you don’t do it with a committee you have to be able to have the emotional strength to stand the volatility of the market in general and stocks in general the key organ here is not the brain it’s the stomach you have the stomach for this you have the patience for it you should be able to look in the mirror and say to myself what am i going to do if the market goes down if you know something that will drive a company’s earnings higher you know something that will drive the company’s stock higher sooner or later but you can’t just guess at it you have to have some reasons such as costs are coming down our new products going to be a big hit research is developing a company story an idea of why earnings should go up or down it doesn’t mean sitting in the library for hours reading sec filings or fiddling with a calculator research is exciting it’s very little math when i owned chrysler was the biggest position in my fund when i was at a movie theater at a sports event i’d run into somebody driving a minivan i’d ask them what do you think of the minivan would you buy another one what do you like about it people some would say well it’s a little underpowered they only have a four cylinder engine i knew they were already working on a six-cylinder engine so this is research research starts with the things you know your edge if you’re a mechanic look at the tools you use which are the best which are the best value or if you’re a doctor see what new technology saves the insurer money or software systems that reduce costs at hospitals you probably already know a few companies quite thoroughly the amateur investor probably can follow between five and eight companies they could lecture in these five or eight companies they know them very well there’s 10 to 15 000 public companies united states there’s lots more overseas so you don’t have to be experts on lots of companies you just have to know a few very well it’s a lot of fun it only takes a few hours a month it’s not a full-time job i own dunkin donuts for 12 years i think i might talk to him once every year the story didn’t change a lot you don’t have to worry about low-cost imports coming from korea when you own a donut company you don’t have to worry about the economy you don’t have to worry about in some inventing a new computer chip the story doesn’t change that much mcdonald’s earnings have gone up i think more than 80 fold over the last 30 years the stock’s gone up 100 fold what made mcdonald’s earnings continue to grow if they just stuck with a cheap cheeseburger and a cheap hamburger at lunch they probably would have run into earnings problems 10 15 years ago but they expanded their menu they kept their costs low they added breakfast they went overseas every day they add two or three more restaurants people thought there was no room for more mcdonald’s 5 10 15 years ago they were wrong if they had done the research they said well there’s a couple hundred countries out there there’s lots of places to grow actual bad economic news rising interest rates wars elections any of these can push the market down if you’re one of those people that pour over graphs economic statistics or astrology charts trying to figure out what the stock market is going to do next you are wasting your time no one can predict the market you have to understand the market goes down there’s been 95 years this century we’ve had 50 declines of over 10 percent of those 50 declines 15 have been 25 percent more so about once every two years the market falls 10 about once every six years it falls 25 these are big drops you have to understand that that’s the nature of the market in 1990 saddam hussein went into kuwait the banking system was in trouble we had a recession he had all his background noise lots of good companies had nothing to do with wars nothing to do with banking they all went down in 1990 the market fell from 3 000 it fell over 20 this gave you a great opportunity to buy terrific companies at very good prices behind every stock is a company if the company does terrific over a long period of time the stock will do terrific if the company does lousy the stock’s going to do lousy that’s all you’re betting on this is a company that’s had 35 years of double-digit earnings growth every single quarter we’ve had changes in the supreme court we have the stock market go up and down we had changes in presidents we’ve had recessions we’ve had wars all of those things had no effect on automatic data processing so every time the market went down it gave you a chance to buy it you’re saying i believe strongly this company’s going to do well if you start to see symptoms that’s not going to happen the stock’s going to very rapidly respond to that if the company runs out of steam the stock’s going to run out of steam look at fannie mae from july through october 1990 the standard poor’s 500 fell 21 fannie mae fell from about 42 a share to about 26 even though earnings were still increasing this was a terrific time to buy fannie mae the company was doing well management was still great the story was solid and they had a very good business but you got to buy the stock at a 38 discount if you start by looking at the entire universe’s stocks more than 3 000 stocks on the new york stock exchange alone and over 13 000 public companies in total you’ll blow a gasket so i break stocks into categories partly to make the job of researching more manageable putting stocks into categories is the first step in developing the story at least you’ll know what kind of story it’s supposed to be the category tells you what questions you should be asking about a company you simply can’t expect all stocks to behave the same basing a strategy on general maxims like sell when you double your money or sell when the price falls 10 is absolute folly no formula will apply to all stocks different stocks behave differently so they require different approaches different expectations and different kinds of stories suppose you’ve made a 50 gain on two companies one is a fast grower with a long way to go the other is a big lumbering slow growth company that has already saturated 95 of its market and that market itself is growing slowly the 50 return is fantastic for the slow grower the chances are it’s time to sell it the same 50 return could be just the tip of the iceberg for the fast grower there are basically five categories one would be fast growers two would be slow growers three would be cyclicals four would be asset plays and the fifth one would be turn arounds in the meantime remember categories are guidelines they are not hard rules some companies may not fit neatly into a category others may seem to be in two categories at once almost all companies change categories at some time throughout their lifetimes fast growers if successful will always eventually slow their growth they’ll run out of places to go cyclicals experiencing long down cycles may become turnarounds once recovered they probably will be cyclicals again use the categories as guides to help you build your story but don’t let them limit the questions you ask or the research you do one thing we can say about companies in general it’s easier to go from 100 million in sales to 200 million dollars in sales than it is to go from 10 billion in sales to 20 billion dollars in sales so smaller companies tend to have more upside potential than larger companies but don’t dismiss all big companies out of hand some big companies defy their size and find exciting new ways to grow their earnings as well good opportunities exist in companies that are cyclical regardless of their size when most people think about investing in stock market they dream about investing in a fast grower a company that is growing at over 25 percent a year at 25 a year a company’s profits will double in three they quadruple in six up eightfold in nine years that’s how you get a huge stock in a decade there’s not a lot of these but they’re very powerful and the best part is you don’t have to catch them just as they’re taking off the beauty of growth companies is you have plenty of time if they’re gonna grow for five ten twenty 30 years you don’t have to be there the first year of the second year you could about walmart 10 years after they went public made 30 times your money what makes a company grow earnings so quickly either it is a rapidly growing industry or it’s a rapidly growing company in a slow growth industry rapid revenue growth and rapid earnings growth are the hallmarks of a fast grower you just can’t buy any stock with hot earnings and hot sales you have to check the balance sheet make sure the company can keep growing one way you can look at growth companies is think of baseball a normal baseball game has nine innings you should look at a growth company and say i don’t want to buy it when they’re in the first inning i want to buy it when they’re in the second or third inning they’ve got the formula right they get lots of room to go so you want to say yourself this is a company that’s very early in its cycle like a mcdonald’s when they’re only in a few stores or limited when they’re only in 100 stores and they had lots of malls to go to microsoft was a company you could have bought three years after it went public and made over 20 times your money sales and earnings were growing at several times the rate of the companies in the s p 500 in an industry that was exploding by leaps and bounds and it had a lot of potential both overseas and domestically this was only the beginning of a 15 to 20 year growth cycle you had plenty of time to get involved this amazing company called superior industries i think the stock went up over 100 fold they were very good at making aluminum wheels a lot of car companies went to aluminum wheels the industry for autos wasn’t growing aluminum wheels are growing dramatically and they were the best at it the fast growers get all the attention in the media but there’s nothing wrong with slow growing stock provided you get it at a very decent price some would say to you i’m gonna sell you a business for a hundred thousand dollars and they’re earning fifty thousand dollars a year you say what’s the bad news let’s say the bad news the earnings are never going to grow they earn fifty thousand dollars a year forever so this is a price earnings multiple of two you pay a hundred thousand dollars fifty thousand dollars earnings but they’re never gonna grow you say i don’t care i’m gonna get a fifty thousand dollar return every year in two years i get all my money back and i’m gonna make fifty thousand dollars a year on my hundred thousand investment forever so sometimes even if a company has a very low growth rate in earnings if the stock is selling at the right price it may still be a very good deal a slow to moderate grower will have earnings growth of three to fifteen percent a year one company that i was very lucky with was service corp international it’s a funeral home company that bought up local family funeral homes a very steady business service corp could grow earnings at 15 a year when i owned it with very little problems a slow goer that turns into a no grower is a very bad news situation so when you start researching to the stock look for these signs steady earnings growth rising dividends companies that raise their dividends each year have to have the earnings to do so a rising dividend is normally a good sign for a stock room to keep growing you want slow growers to go on forever that’s one reason i like service corp international so much this was a great stock for me in the 1980s at that point it had a long way to go cyclical companies rise and fall with the economy typically they make expensive big-ticket items that people buy when the economy is good things like houses cars and furniture the economy is bad and people are worried about losing their jobs they don’t buy big ticket items they’re too broke or too scared that they will go broke don’t try to time a cyclical stock if you don’t have intimate knowledge of the business if you don’t have an investor’s edge everyone on wall street tries to time cyclical stocks too because the stock market looks forward you could be left with a sinking stock even though the company’s earnings are terrific you make your best money in a cyclical when earnings go from rotten to mediocre or from mediocre to pretty good the danger point is when earnings go from great to spectacular somewhere between these two points wall street will figure out there’s only one way to go and that’s for profits to go down some point in the future just don’t buy in the hope wait for things to get better prices to get better capacity to shrink inventories to go down scrap prices to get better something ought to be happening so you just want to wait for something really to happen and then when it happens it’s going to be big let’s take a look at chrysler in 1990 the company was selling for ten dollars a share the economy was lousy people were talking about chrysler going out of business but guess what the economy came back everyone’s old car was falling apart as people made more money they started buying new cars because chrysler had great products the minivan the jeep and its first new full-size truck in 20 years the stock was big in addition very importantly the balance sheet was decent in 1990. this was not a company about to go bankrupt if it’s a cyclical you’re hoping for a dramatic turnaround on earnings it’s going to happen over two or three years earnings going to go from a loss to a huge profit stock’s going to go up and you’re going to get out make sure you’re picking a strong company that can survive when the cycle goes down that means good cash flow and low debt if its cash flow is spotty or its debt is high when the downturn comes the company faces the danger of going bankrupt turnarounds these are stocks that are battered down or they’re hated companies or they’ve been forgotten about they’re depressed in price but you have determined some one thing or a few things that have the potential for reversing this company’s fortunes independent of the industry getting better with the economy getting better you always have to do a balance sheet check on any company this includes turnarounds do they have enough cash to make it through the next 12 months next 24 months do they have a lot of debt that’s due right now these are important questions to answer make sure you understand and believe in the plan to restore corporate profits it’s all internal they’re doing something either new product new management cutting costs getting rid of something something inside the company that allows them to improve themselves lots of turnarounds never happen but a few winners can make up for lots of losers what’s important is to wait for the actual evidence of the turnaround occurring not just the symptoms the turnaround you had plenty of time so just don’t buy on the hope wait for the reality turnarounds are so big it’s worth waiting to get some real evidence ss kresge was a company going nowhere in real trouble they invented the kmart formula they rolled it out across the country the stock went up over 50 fold kmart became a massive stock sometimes two and two equals eight how could this be because a company has a hidden asset that isn’t reflected in the stock price when wall street wakes up to the hidden assets the stock could be terrific want a great example let’s look at disney walt disney is an example of an asset play after they opened up disney world and after they’d opened up epcot the company’s growth rate sort of slowed down they weren’t growing very fast and then they discovered there was a lot of assets inside the company there was the name walt disney they started the disney channel they started selling things that they sold at disney world into disneyland they started selling them everywhere they used their licenses for mickey mouse and all their characters made a fortune on that these were on the books for nothing the company was loaded with assets in addition they had all that land inside of disney world and everybody had hotels outside of disney world they decided to use their land inside to develop more parks and then even have other companies come in these companies paid their money to build inside of epcot or inside of areas of disney world so what are hidden assets many companies particularly old line companies companies been around 20 40 50 100 years or more have real estate holdings whose true market value is not reflected on the balance sheet in the annual report in many cases the hidden asset is the company’s name and its reputation disney is one example of a company with a great name so is coca-cola that name can be a huge asset when the company rolls out a new product this name is carried at little or no value on the balance sheet whereas it is incredibly valuable companies like intel and att not only make great products but they have numerous patents for these great products as long as they have those patents no one can make the exact same product that’s a tremendous aid in any business back in 1987 when the stock market had a major correction dreyfus fell to below its price of cash per share stock fell from over 50 to under 20 at that point was selling for less than its cash anytime you buy a stock at less than its cash after subtracting all debt and it has good business you’re getting something for nothing the price of a stock will follow the direction of earnings in almost every case you can generally state if companies earnings go up sharply the stock’s going to go up if earnings go from very poor to mediocre the stock’s probably going to rise if they go from mediocre to good it’s probably going to have another rise if it goes from good to excellent it’s probably going to have another rise or if a company’s earnings grow dramatically over a long period of time the stock’s probably going to go up dramatically even if you have a waterford crystal ball you probably can’t predict a company’s earnings but wall street is a whole army of people who make such predictions obviously you want to invest in companies whose earnings are expected to rise but again these are just estimates if you really understand a company you should know how it plans to make earnings rise if you know it has good growth prospects then you’ll be better able to evaluate the company as an investment you can’t predict the future but you can learn from the past a company with a long history of earnings increases and dividend increases is obviously a stable performer that has a reasonable chance of continuing to perform well in the industry many times that’s a good company to investigate further johnson johnson has raised its earnings something like 19 in the last 20 years it’s raised its dividend over 30 years in a row but just because a company has had a great wreck in the past does not mean earnings will grow terrifically well in the future you have to have reasons for it strong growth and research and development cost cutting new products great brand name and a terrific balance sheet were the items that made me optimistic about johnson johnson and what’s the outlook that’s going to keep continuing to grow they run out of steam stocks going to run out of steam price earnings ratio is something that some people make very complex it’s actually very simple if a company is selling a hundred dollars a share and earning ten dollars is a price earnings multiple of ten the p e ratio can be thought of as the number of years it will take the company to earn back the amount of your initial investment assuming of course that the company’s earnings stay constant why look at pe and tell you if you’re paying too much for stock the higher the pe the more expensive the stock relative the company’s future earning power the lower pe the cheaper the stock i use a rule of thumb to level out these differences a fairly priced stock is a p e it’s about equal to the expected annual growth rate over the next three to five years if the p e is substantially higher than the growth rate the stock is normally expensive if the p e is substantially lower stock is probably cheap a stock pe in part depends on the industry it’s in when you look in a growth company compare the company’s growth rate and its own pe to that of the industry all of things being equal if you find a company with a much lower pe and a higher growth rate you’re off to a good start you can also compare a company’s pe to its own historical pe if a company normally sells for 25 times earnings now it’s selling at 15 or less you have to ask yourself why the company could be maturing competition may be entering the field and its growth prospects may be uncertain but maybe it’s simply been beaten down by some other factors and it’s possibly a bargain it’s worth researching back in the 1970s electronic data systems or eds had a p e of 500 times earnings if you had invested in a company the pe this high when columbus discovered america the company’s already stayed constant you’d just be breaking even today in 1974 eds performed very well but stock fell from 40 to 3 simply because the stock was so grossly overpriced relative to current earnings dividends are cash payments that companies make to shareholders usually every quarter nearly half the return from the s p 500 the past 50 years has come from dividends dividends come from profits if a company earns five dollars a share they have the choice of paying out some of it to the shareholders in a form of a cash dividend a stock’s yield is the annual dividend payout divided by its current price the yield is the return you get on your investment every year one drawback the irs considers dividends as income so you have to pay taxes on dividends not all companies pay a dividend fast growers for example almost never pay a dividend they reinvest all of their earnings back into the company slow growers tend to pay up profits and dividends it’s their way of rewarding shareholders over time those dividends can add up some people have bought stocks for five dollars a share and twenty years later they’re getting ten dollars a share of dividends per year dividends do make a difference dividends are a great way to measure company success particularly a slow growing company when a company raises dividend every year it raises the bar for its financial performance the years that follow few companies want to cut their dividends investors clobber the stock figuring a dividend cut is a sign of worse things to come so by raising a dividend 12 to 15 this year the company is saying it expects earnings to be at least as good next year as they are now and probably rising by at least the 12 to 15 percent you can get a list of companies that raise their dividends many years in a row for moody’s there are some great names in this list however you can find warning signs and dividends as well a high yield isn’t always a good thing if a stock is 30 and it’s paying a three dollar dividend you might say wow that’s terrific a ten percent yield but if the earnings are only three dollars and 10 cents a share then the company is essentially paying out all of its earnings in dividends that’s only 10 cents to expand or to invest in more efficient equipment if this continues for a number of quarters or years the company will have very little room for any errors or setbacks eventually the company will probably cut back or totally suspend its dividend the stock price is going to tumble with it be careful with high-yield stocks particularly when they’re paying out a very high percentage of their earnings any company’s operations can hit an air pocket from time to time you’ve got to make sure your company can survive tough times the balance sheet tells you about the company’s financial structure how much debt it has how much cash it has and how much equity its shareholders have there’s nothing scary about a balance sheet no story is complete without a check of the balance sheet the basic concept of a balance sheet is that everything a company owns its assets are listed on one side on the other side you find everything a company owes it’s liabilities the difference between what it owns and what it owes is its equity also called its net worth does the company have a lot of cash on hand that’s great accompanied a lot of cash can buy more stock make an acquisition or pay off all its debt all moves that shareholders love to see a company should have at least enough cash to pay off its short-term debt if it doesn’t you could have to keep borrowing more and more if you subtract cash from short-term debt and long-term debt and the total is only one quarter of net worth the company has a decent balance sheet however if short-term debt and long-term debt combined minus cash equals or exceeds net worth the company has a weak balance sheet it’s simple to recognize a strong balance sheet no debt and lots of cash suppose a company has 20 million dollars in cash after subtracting all debt if the company has four million shares outstanding it has five dollars of cash per share of stock if you buy the company at ten dollars a share you’re paying only five dollars for the company and you’re getting five dollars a share in cash that’s a really amazing price in effect that means your real price is five if this company has a very solid predictable business this extra cash is quite valuable but if a company has lots of cash and they’re losing money you still have to value it how quickly will they run through all that cash that’s all you really have to know it’s not much but you should know it if you don’t check your company’s survivability you’re not only skimping on your research you’re gambling that’s not why you invest in the stock market check the debt most companies have some debt but how much is too much add up the company’s long-term debt and total equity that’s a good approximation of the company’s total capitalization the money the company has available to grow its business in the future now compare the long-term debt to total capitalization if total debt equals half of the company’s capitalization or more aware that’s quite a bit of debt to service that much debt everything has to work right things don’t always work just right if debt equals 20 of capitalization or less that’s better that’s fairly low debt as usual there’s no rule without some exception debt in some industries like banking insurance and financial services routinely runs much higher than 20 to 50 percent know the industry and what is normal for it when you evaluate a balance sheet in many industries such as retailing and restaurants companies have leases they have commitments on buildings to rent for a long period of time often this form of debt will only appear in the footnotes this is a very substantial form of debt look into the footnotes see if you see capitalized lease obligations have this back this is an important exercise five or ten years ago investment professionals had a big edge they got more research and information than small investors and they got it sooner but those days are long gone basic financial information is readily available from a dozen or more different sources investment pros aren’t digesting all the good information and throwing just the scraps to the public anymore everyone has a seat at the table right now here are some places to get started if a balance sheet provides a snapshot of a company’s financial position an income statement tells you how the company got there income statements tell you how much money the company made or lost from its operations over some period of time the basic formula is simple you are asking how things went over the period usually a quarter or a year over that time you add up all the money the company brought in from selling products or services then subtract all of the money the company spent to create those products or deliver those services what is left is the net income net income is also referred to as earnings or profits i hope by now you’ve been convinced that your story should always include an explanation of how the company plans to improve its earnings or to sustain its growth rate over time there are only two ways for company to increase earnings they can increase sales or reduce costs most companies work to do both of these things the income statement can help you figure out if the company is succeeding if earnings equal revenues minus costs then a valid way to raise earnings is to reduce costs reducing costs not only pushes up the earnings number it makes a company more competitive if two companies both produce competitive products of similar quality then the one who can build it more cheaply has the advantage they can choose to charge less for the product and sell more than their competitor or can sell it for the same price and make much more money than their competitor one way to measure cost reduction is to check out the costs listed on the income statement each quarter but it’s difficult to do so because what you really care about is how costs are changing relative to revenues one way to measure this cost of revenues is the profit margin this number is not shown on the income statement itself to calculate the number for yourself just divide the earnings before taxes by the net revenues the higher the profit margin the more money the company makes for each product it sells once we have the profit margin as a tool we can evaluate how successful the company is being in reducing costs unless the company has raised prices significantly if the profit margin goes up then costs are going down relative to revenues you can compare the profit margin of the company to the profit margin of a competitor or to the average profit margin of the industry when a company that’s highly profitable already must depend on cost cutting to boost its profits even further you have to be skeptical if its profit margins are unusually high compared to the rest of the industry there’s a limit to how much additional profit you can squeeze out of the business by economizing ask yourself is there a long road of margin cutting ahead are they already extremely efficient your goal is to feel as confident as possible with your story how does a company plan to increase earnings sales growth is the single most important factor in growing earnings long term so you must ask yourself how the company is going to make sales rise the company can expand its customer base selling its existing products to new customers brings in new revenue when evaluating this strategy consider how far the company is from saturate in the market or its products if a company is already selling to 98 of its potential customers there aren’t a lot left to reach the company can introduce new products into its existing customer base this is the most difficult but potentially the most rewarding strategy if the product catches on it can breathe new life into the company advantages like brand names and a good reputation come in very useful here a company can also raise prices to increase revenues that way even if unit sales stay constant revenues will still grow of course the danger of raising prices is that the higher prices will drive customers to competitors or encourage new competitors to enter the market the details of a company’s plan will vary by industry and by individual company just make sure you understand that plan and include it in your story once you’ve built the story for your company you have a powerful tool for judging the stock but like any powerful instrument you must use it wisely and carefully or you’ll get burned use your story to pick the right time to buy a stock i promise you that the right time to buy a stock does not occur often when i’m following a stock buying opportunities present themselves once or twice a year if i’m lucky i look for times when the potential upside is high and the potential downside is reduced understanding that balance is a key to successful stock investing you have to understand stock picking is a risk reward trade-off you have to know how much you’re going to lose if you’re wrong and how much you’re going to make if you’re right the skill is to minimize your risk and maximize your reward you can be wrong in this business i’ve been wrong quite a bit but you can be wrong and still make money as long as your good stocks more than offset your mistakes i figure if i can be right six times out of ten that’s a good batting average when i pick stocks i think of risk as a measure of my confidence in the story i’ve built when i feel that my story is optimistic solid and well researched then i’ve got a low risk investment if i’m not too sure about how the story will turn out then the risk is considerably higher don’t try to categorize risk by other measures like small companies are riskier than large in the late 1970s or the early 1980s walmart was a lower risk investment than ibm because the walmart story was nearly bulletproof if a startup company sounds exciting keep an eye on it perhaps a year or two later it will be over the hump the story will be solid and there’s a good time to consider investing if you believe strongly in your company’s story then you shouldn’t waste your time waiting for the ultimate buying opportunity investors who bought mcdonald’s in the 1970s or home depot in the 1980s were happy almost any time they bought the stock even with these great companies during stock market corrections the stock dipped and the story was solid but if you held on for a reasonable amount of time you were a very happy camper watch out for ridiculously high prices when a company is selling at several times its growth rate and earnings remember that’s what we talked about in the price earnings presentation but in general if a story is good you probably want to own it later if a buying opportunity comes along the stock falls well below its growth rate and the story hasn’t changed you can buy even more therefore you can take advantage of market declines use the tools i’ve presented in this consultation to help make a judgment on your stock if the story is sound check the price use the p e ratio most importantly rely on your edge first to build your story then to find the right times to add or reduce your position focus on the company what is it making where’s its money coming from what is the competition doing ignore all the background noise just keep checking that fundamental story see if it’s valid see if it’s getting better see if it’s getting worse know what category your stock is in and how those stocks behave your stock isn’t behaving as you expect and try and find out why the answer changes the story then think again keep your story up to date don’t check on it three times a day but don’t just ignore it either and checking the price to stock does not count it’s checking the fundamental story don’t expect to make a ton of money overnight the stock market does provide the highest return for long-term investments but that’s not a month or two months a year if you need the money next winter you don’t have the tolerance to keep it tied up for the long term and stocks may not be for you don’t forget to use your edge these are all kinds of things that you know about because of where you live what you do you have lots of edges use them and finally remember that stock picking isn’t gambling and it isn’t for everyone you have to be prepared to do some work you have to be prepared for market declines if you enjoy doing research enjoy learning about companies you have the stomach for the ups and downs of the stock market then investing can be a lot of fun these principles investing work well for me i hope they can help you you can’t just go out and buy a stock and hope it goes up you have to have a reason why you think a stock will go up you should be able to tell those reasons to someone else in just a few minutes people who love stocks don’t talk about sports they don’t talk about their dog they talk about stories a story is what’s happening inside a company and signs that point to what’s likely to happen in the future they’ll be able to put it down in two paragraphs it could be something like earnings are turning around a new product somebody’s gone out of business that was competing with them they’ve just discovered oil they’ve got new management their balance sheets getting better they’re getting rid of a losing division there’s lots of different elements but that’s what a story is and that’s what you rely on a good story is one that you could tell a fifth grader and he or she would understand the more complicated the story more likely it is to fall apart you just need one good simple story to buy a stock and then follow that story read through the story that i wrote for toys r us back in 1978 you didn’t need a degree from business school to realize this company had a great formula and had lots of room to grow the thousands of people who shop there knew the store was great i did the rest of the research i needed to fill in the story and bought the stock building stores like this one is how i decide what companies to own and which ones to stay away from remember that stories unfold over time companies are never stagnant so you have to stay tuned and sometimes make adjustments just like playing seven card stud poker or perhaps 27 cards stud poker at the beginning of the game you only know some of the cards you must place your bet accordingly but as each new card is revealed the game changes you’re forced to alter your betting strategy perhaps even drop out of the game altogether in the meantime if you’d like to invest in stocks your best option may be an equity mutual fund if you want to put some of your money in the stock market you don’t have the time you’re not willing to the effort you don’t have the stomach to do the research equity mutual funds are a great answer investing in mutual funds is also a way of making sure your investments are diversified mutual funds by law must invest in at least 20 stocks at a time though most funds invest in far more than that as a mutual fund investor you are protected from the danger of one or two stocks dropping sharply in price at most they would only represent five or ten percent of the fund this would cushion the decline remember the mutual funds are like any other investment they carry real risks of losing your money and even though they can be purchased through many banks they are not insured by the government since they are made up of individual stocks equity mutual funds are also volatile you must do some research to evaluate and choose a mutual fund that will meet your temperament and your investment objectives

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