Note: While reading a book whenever I come across something interesting, I highlight it on my Kindle. Later I turn those highlights into a blogpost. It is not a complete summary of the book. These are my notes which I intend to go back to later. Let’s start!

  • The nice thing about investing in familiar companies such as L’eggs or Dunkin’ Donuts is that when you try on the stockings or sip the coffee, you’re already doing the kind of fundamental analysis that they pay Wall Street analysts to do. Visiting stores and testing products is one of the critical elements of the analyst’s job.

  • During a lifetime of buying cars or cameras, you develop a sense of what’s good and what’s bad, what sells and what doesn’t. If it’s not cars you know something about, you know something about something else, and the most important part is, you know it before Wall Street knows it. Why wait for the Merrill Lynch restaurant expert to recommend Dunkin’ Donuts when you’ve already seen eight new franchises opening up in your area? The Merrill Lynch restaurant analyst isn’t going to notice Dunkin’ Donuts until the stock has quintupled from $2 to $10, and you noticed it when the stock was at $2.

  • Investing in bonds, money-markets, or CDs are all different forms of investing in debt—for which one is paid interest. There’s nothing wrong with getting paid interest, especially if it is compounded.

  • Only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.

  • However a stock has come to your attention, whether via the office, the shopping mall, something you ate, something you bought, or something you heard from your broker, your mother-in-law, or even from Ivan Boesky’s parole officer, the discovery is not a buy signal. Just because Dunkin’ Donuts is always crowded or Reynolds Metals has more aluminum orders than it can handle doesn’t mean you ought to own the stock. Not yet. What you’ve got so far is simply a lead to a story that has to be developed.

  • The size of a company has a great deal to do with what you can expect to get out of the stock. How big is this company in which you’ve taken an interest? Specific products aside, big companies don’t have big stock moves. In certain markets they perform well, but you’ll get your biggest moves in smaller companies. You don’t buy stock in a giant such as Coca-Cola expecting to quadruple your money in two years. If you buy Coca-Cola at the right price, you might triple your money in six years, but you’re not going to hit the jackpot in two.

  • Once I’ve established the size of the company relative to others in a particular industry, next I place it into one of six general categories: slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds.

  • The growth of an individual company is measured against the growth of the economy at large. Slow-growing companies, as you might have guessed, grow very slowly—more or less in line with the nation’s GNP, which lately has averaged about three percent a year. Fast-growing companies grow very fast, sometimes as much as 20 to 30 percent a year or more. That’s where you find the most explosive stocks.

  • Three of my six categories have to do with growth stocks. I separate the growth stocks into slow growers (sluggards), medium growers (stalwarts), and then the fast growers—the super stocks that deserve the most attention.

  • Slow growers are large and aging companies that are expected to grow slightly faster than the gross national product. Slow growers didn’t start out that way. They started out as fast growers and eventually pooped out, either because they had gone as far as they could, or else they got too tired to make the most of their chances. When an industry at large slows down (as they always seem to do), most of the companies within the industry lose momentum as well.

  • Another sure sign of a slow grower is that it pays a generous and regular dividend.

  • Stalwarts have 10 to 12 percent annual growth in earnings.

  • Stalwarts are stocks that I generally buy for a 30 to 50 percent gain, then sell and repeat the process with similar issues that haven’t yet appreciated.

  • Keep some stalwarts in your portfolio because they offer pretty good protection during recessions and hard times.

  • Bristol-Myers has had only one down quarter in twenty years, and Kellogg hasn’t had a down quarter for thirty. It’s no accident that Kellogg can survive recessions. No matter how bad things get, people still eat cornflakes. They may take fewer trips, postpone the purchase of new cars, buy fewer clothes and expensive knickknacks, and order fewer lobster dinners at restaurants, but they eat just as many cornflakes as ever. Maybe they eat more cornflakes, to make up for the lack of lobsters.

  • 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.

  • 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.

  • 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.

  • Cyclicals are the most misunderstood of all the types of stocks. It is here that the unwary stockpicker is most easily parted from his money, and in stocks that he considers safe. Because the major cyclicals are large and well-known companies, they are naturally lumped together with the trusty stalwarts. Since Ford is a blue chip, one might assume that it will behave the same as Bristol-Myers, another blue chip. But this is far from the truth. Ford’s stock fluctuates wildly as the company alternately loses billions of dollars in recessions and makes billions of dollars in prosperous stretches. If a stalwart such as Bristol-Myers can lose half its value in a sorry market and/or a national economic slump, a cyclical such as Ford can lose 80 percent. That’s just what happened to Ford in the early 1980s. You have to know that owning Ford is different from owning Bristol-Myers. Timing is everything in cyclicals, and you have to be able to detect the early signs that business is falling off or picking up. If you work in some profession that’s connected to steel, aluminum, airlines, automobiles, etc., then you’ve got your edge, and nowhere is it more important than in this kind of investment.

  • Turnaround candidates have been battered, depressed, and often can barely drag themselves into Chapter 11. These aren’t slow growers; these are no growers. These aren’t cyclicals that rebound; these are potential fatalities, such as Chrysler. Actually Chrysler once was a cyclical that went so far down in a down cycle that people thought it would never come back up. A poorly managed cyclical is always a potential candidate for the kind of trouble that befell Chrysler and, to a slightly lesser extent, Ford. In spite of this, the occasional major success makes the turnaround business very exciting, and very rewarding overall.

  • An asset play is any company that’s sitting on something valuable that you know about, but that the Wall Street crowd has overlooked. With so many analysts and corporate raiders snooping around, it doesn’t seem possible that there are any assets that Wall Street hasn’t noticed, but believe me, there are. The asset play is where the local edge can be used to greatest advantage. The asset may be as simple as a pile of cash. Sometimes it’s real estate. I’ve already mentioned Pebble Beach as a great asset play. Here’s why: At the end of 1976 the stock was selling for 14½ per share, which, with 1.7 million shares outstanding, meant that the whole company was valued at only $25 million. Less than three years later (May, 1979), Twentieth Century-Fox bought out Pebble Beach for $72 million, or 42½ per share. What’s more, a day after buying the company, Twentieth Century turned around and sold Pebble Beach’s gravel pit—just one of the company’s many assets—for $30 million. In other words, the gravel pit alone was worth more than what investors in 1976 paid for the whole company. Those investors got all the adjacent land, the 2,700 acres in Del Monte Forest and the Monterey Peninsula, the 300-year-old trees, the hotel, and the two golf courses for nothing.

  • Penn Central might have been the ultimate asset play. The company had everything: tax-loss carryforward, cash, extensive land holdings in Florida, other land elsewhere, coal in West Virginia, and air rights in Manhattan. Anybody who had anything to do with Penn Central could have figured out that this was a stock worth buying. It went up eightfold.

  • Getting the story on a company is a lot easier if you understand the basic business. That’s why I’d rather invest in panty hose than in communications satellites, or in motel chains than in fiber optics. The simpler it is, the better I like it. When somebody says, “Any idiot could run this joint,” that’s a plus as far as I’m concerned, because sooner or later any idiot probably is going to be running it.

  • If it’s a choice between owning stock in a fine company with excellent management in a highly competitive and complex industry, or a humdrum company with mediocre management in a simpleminded industry with no competition, I’d take the latter.

  • Owning a rock pit is safer than owning a jewelry business. If you’re in the jewelry business, you’re competing with other jewelers from across town, across the state, and even abroad, since vacationers can buy jewelry anywhere and bring it home. But if you’ve got the only gravel pit in Brooklyn, you’ve got a virtual monopoly, plus the added protection of the unpopularity of rock pits. The insiders call this the “aggregate” business, but even the exalted name doesn’t alter the fact that rocks, sand, and gravel are as close to inherently worthless as you can get. That’s the paradox: mixed together, the stuff probably sells for $3 a ton. For the price of a glass of orange juice, you can purchase a half ton of aggregate, which, if you’ve got a truck, you can take home and dump on your lawn. What makes a rock pit valuable is that nobody else can compete with it. The nearest rival owner from two towns over isn’t going to haul his rocks into your territory because the trucking bills would eat up all his profit. No matter how good the rocks are in Chicago, no Chicago rock-pit owner can ever invade your territory in Brooklyn or Detroit. Due to the weight of rocks, aggregates are an exclusive franchise. You don’t have to pay a dozen lawyers to protect it.

  • I always look for niches. The perfect company would have to have one. Warren Buffett started out by acquiring a textile mill in New Bedford, Massachusetts, which he quickly realized was not a niche business. He did poorly in textiles but went on to make billions for his shareholders by investing in niches. He was one of the first to see the value in newspapers and TV stations that dominated major markets, beginning with the Washington Post.

  • Drug companies and chemical companies have niches—products that no one else is allowed to make. It took years for SmithKline to get the patent for Tagamet. Once a patent is approved, all the rival companies with their billions in research dollars can’t invade the territory. They have to invent a different drug, prove it is different, and then go through three years of clinical trials before the government will let them sell it. They have to prove that it doesn’t kill rats, and most drugs, it seems, do kill rats.

  • Philip Morris, a company that sells cigarettes—a negative-growth industry in the U.S. Over the past fifteen years Xerox dropped from $160 to $60, while Philip Morris rose from $14 to $90. Year after year Philip Morris increases its earnings by expanding its market share abroad, by raising prices, and by cutting costs. Because of its brand names—Marlboro, Virginia Slims, Benson & Hedges, Merit, etc.—Philip Morris has found its niche. Negative-growth industries do not attract flocks of competitors.

  • A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies—such as Shoney’s, The Limited, or Marriott—when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well.

  • K mart has a p/e ratio of 10. This was derived by taking the current price of the stock ($35 a share) and dividing it by the company’s earnings for the prior 12 months or fiscal year (in this case, $3.50 a share). The $35 divided by the $3.50 results in the p/e of 10.

  • 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. Let’s say you buy 100 shares of K mart for $3,500. Current earnings are $3.50 per share, so your 100 shares will earn $350 in one year, and the original investment of $3,500 will be earned back in ten years.

  • The fact that some stocks have p/e’s of 40 and others have p/e’s of 3 tells you that investors are willing to take substantial gambles on the improved future earnings of some companies, while they’re quite skeptical about the future of others.

  • p/e levels tend to be lowest for the slow growers and highest for the fast growers, with the cyclicals vacillating in between. An average p/e for a utility (7 to 9 these days) will be lower than the average p/e for a stalwart (10 to 14 these days), and that in turn will be lower than the average p/e of a fast grower (14–20). Some bargain hunters believe in buying any and all stocks with low p/e’s, but that strategy makes no sense to me. We shouldn’t compare apples to oranges. What’s a bargain p/e for a Dow Chemical isn’t necessarily the same as a bargain p/e for a Wal-Mart.

  • A company with a high p/e must have incredible earnings growth to justify the high price that’s been put on the stock. In 1972, McDonald’s was the same great company it had always been, but the stock was bid up to $75 a share, which gave it a p/e of 50. There was no way that McDonald’s could live up to those expectations, and the stock price fell from $75 to $25, sending the p/e back to a more realistic 13. There wasn’t anything wrong with McDonald’s. It was simply overpriced at $75 in 1972.

  • Look at what happened to Ross Perot’s company, Electronic Data Systems (EDS), a hot stock in the late 1960s. I couldn’t believe it when I saw a brokerage report on the company. This company had a p/e of 500! It would take five centuries to make back your investment in EDS if the earnings stayed constant. Not only that, but the analyst who wrote the report was suggesting that the p/e was conservative, because EDS ought to have a p/e of 1,000.

  • When Avon Products sold for $140 a share, it had an extremely high p/e ratio of 64—though nowhere near as extreme as EDS’s. The important thing here is that Avon was a huge company. It’s a miracle for even a small company to expand enough to justify a p/e of 64, but for a company the size of Avon, which already had over a billion in sales, it would have had to sell megabillions worth of cosmetics and lotions. In fact, somebody calculated that for Avon to justify a 64 p/e it would have to earn more than the steel industry, the oil industry, and the State of California combined. That was the best-case scenario. But how many lotions and bottles of cologne can you sell? As it was, Avon’s earnings didn’t grow at all. They declined, and the stock price promptly plummeted to $18⅝ in 1974.

  • Company p/e ratios do not exist in a vacuum. The stock market as a whole has its own collective p/e ratio, which is a good indicator of whether the market at large is overvalued or undervalued. During the five years of the latest bull market, from 1982 to 1987, you could see the market’s overall p/e ratio creep gradually higher, from about 8 to 16. This meant that investors in 1987 were willing to pay twice what they paid in 1982 for the same corporate earnings—which should have been a warning that most stocks were overvalued. Interest rates have a large effect on the prevailing p/e ratios, since investors pay more for stocks when interest rates are low and bonds are less attractive. But interest rates aside, the incredible optimism that develops in bull markets can drive p/e ratios to ridiculous levels, as it did in the cases of EDS, Avon, and Polaroid. In that period, the fast growers commanded p/e ratios that belonged somewhere in Wonderland, the slow growers were commanding p/e ratios normally reserved for fast growers, and the p/e of the market itself hit a peak of 20 in 1971.

  • Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. The two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot. Once you’re able to tell the story of a stock to your family, your friends, or the dog (and I don’t mean “a guy on the bus says Caesars World is a takeover”), and so that even a child could understand it, then you have a proper grasp of the situation.

  • Here are some of the topics that might be addressed in the monologue:
    • If it’s a slow-growing company you’re thinking about, then presumably you’re in it for the dividend, (Why else own this kind of stock?) Therefore, the important elements of the script would be: “This company has increased earnings every year for the last ten, it offers an attractive yield; it’s never reduced or suspended a dividend, and in fact it’s raised the dividend during good times and bad, including the last three recessions. It’s a telephone utility, and the new cellular operations may add a substantial kicker to the growth rate.”
    • If it’s a cyclical company you’re thinking about, then your script revolves around business conditions, inventories, and prices. “There has been a three-year business slump in the auto industry, but this year things have turned around. I know that because car sales are up across the board for the first time in recent memory. I notice that GM’s new models are selling well, and in the last eighteen months the company has closed five inefficient plants, cut twenty percent off labor costs, and earnings are about to turn sharply higher.”
    • If it’s an asset play, then what are the assets, how much are they worth? “The stock sells for $8, but the videocassette division alone is worth $4 a share and the real estate is worth $7. That’s a bargain in itself, and I’m getting the rest of the company for a minus $3. Insiders are buying, and the company has steady earnings, and there’s no debt to speak of.”
    • If it’s a turnaround, then has the company gone about improving its fortunes, and is the plan working so far? “General Mills has made great progress in curing its diworseification. It’s gone from eleven basic businesses to two. By selling off Eddie Bauer, Talbot’s, Kenner, and Parker Brothers and getting top dollar for these excellent companies, General Mills has returned to doing what it does best: restaurants and packaged foods. The company has been buying back millions of its shares. The seafood subsidiary, Gortons, has grown from 7 percent of the seafood market to 25 percent. They are coming out with low-cal yogurt, no-cholesterol Bisquick, and microwave brownies. Earnings are up sharply.”
    • If it’s a stalwart, then the key issues are the p/e ratio, whether the stock already has had a dramatic run-up in price in recent months, and what, if anything, is happening to accelerate the growth rate. You might say to yourself: “Coca-Cola is selling at the low end of its p/e range. The stock hasn’t gone anywhere for two years. The company has improved itself in several ways. It sold half its interest in Columbia Pictures to the public. Diet drinks have sped up the growth rate dramatically. Last year the Japanese drank 36 percent more Cokes than they did the year before, and the Spanish upped their consumption by 26 percent. That’s phenomenal progress. Foreign sales are excellent in general. Through a separate stock offering, Coca-Cola Enterprises, the company has bought out many of its independent regional distributors. Now the company has better control over distribution and domestic sales. Because of these factors, Coca-Cola may do better than people think.”
    • If it is a fast grower, then where and how can it continue to grow fast? “La Quinta is a motel chain that started out in Texas. It was very profitable there. The company successfully duplicated its successful formula in Arkansas and Louisiana. Last year it added 20 percent more motel units than the year before. Earnings have increased every quarter. The company plans rapid future expansion. The debt is not excessive. Motels are a low-growth industry, and very competitive, but La Quinta has found something of a niche. It has a long way to go before it has saturated the market.”
    • Those are some basic themes for the story, and you can fill in as much detail as you want. The more you know the better. I often devote several hours to developing a script, though that’s not always necessary. Let me give you two examples, one a situation that I checked out properly, and the other where there was something I forgot to ask. The first was La Quinta, which has been a fifteenbagger, and the second was Bildner’s, a fifteenbagger in reverse.

  • At one point I’d decided the motel industry was due for a cyclical turnaround. I’d already invested in United Inns, the largest franchiser of Holiday Inns, and I was keeping my ears open for other opportunities. During a telephone interview with a vice president at United Inns, I asked which company was Holiday Inn’s most successful competitor. Asking about the competition is one of my favorite techniques for finding promising new stocks. Muckamucks speak negatively about the competition ninety-five percent of the time, and it doesn’t mean much. But when an executive of one company admits he’s impressed by another company, you can bet that company is doing something right. Nothing could be more bullish than begrudging admiration from a rival. “La Quinta Motor Inns,” the vice president of United Inns enthused. “They’re doing a great job. They’re killing us in Houston and in Dallas.” He sounded very impressed, and so was I. That’s the first I’d ever heard of La Quinta, but as soon as I got off the phone with this exciting new tip, I got back on the phone with Walter Biegler at La Quinta headquarters in San Antonio to find out what the story was. Mr. Biegler told me that in two days he’d be coming to Boston for a business conference at Harvard, at which time he’d be glad to tell me the story in person. Between the United Inns man’s dropping the hint and five minutes later the La Quinta man’s mentioning that he just happened to be traveling to Boston, the whole thing sounded like a set-up job to sucker me into buying millions of shares. But as soon as I heard Biegler’s presentation, I knew it wasn’t a set-up job, and the best way to have gotten suckered would have been not to have bought this wonderful stock.The concept was simple. La Quinta offered rooms of Holiday Inn quality, but at a lower price. The room was the same size as a Holiday Inn room, the bed was just as firm (there are bed consultants to the motel industry who figure these things out), the bathrooms were just as nice, the pool was just as nice, yet the rates were 30 percent less. How was that possible? I wanted to know. Biegler went on to explain. La Quinta had eliminated the wedding area, the conference rooms, the large reception area, the kitchen area, and the restaurant—all excess space that contributed nothing to the profits but added substantially to the costs. La Quinta’s idea was to install a Denny’s or some similar 24-hour place next door to every one of its motels. La Quinta didn’t even have to own the Denny’s. Somebody else could worry about the food. Holiday Inn isn’t famous for its cuisine, so it’s not as if La Quinta was giving up a major selling point. Right here, La Quinta avoided a big capital investment and sidestepped some big trouble. It turns out that most hotels and motels lose money on their restaurants, and the restaurants cause 95 percent of the complaints.I always try to learn something new from every investment conversation I have. From Mr. Biegler I learned that hotel and motel customers routinely pay one one-thousandth of the value of a room for each night’s lodging. If the Plaza Hotel in New York is worth $400,000 a room, you’re probably going to pay $400 a night to stay there, and if the No-Tell Motel is built for $20,000 a room, then you’ll be paying $20 a night. Because it cost 30 percent less to build a La Quinta than it did to build a Holiday Inn, I could see how La Quinta could rent out rooms at a 30-percent discount and still make the same profit as a Holiday Inn. Where was the niche? I wanted to know. There were hundreds of motel rooms at every fork in the road already. Mr. Biegler said they had a specific target: the small businessman who didn’t care for the budget motel, and if he had the choice, he’d rather pay less for the equivalent luxury of a Holiday Inn. La Quinta was there to provide the equivalent luxury, and at locations that were often more convenient to traveling businessmen. Holiday Inn, which wanted to be all things to all travelers, frequently built its units just off the access ramps of major turnpikes. La Quinta built its units near the business districts, government offices, hospitals, and industrial complexes where its customers were most likely to do business. And because these were business travelers and not vacationers, a higher percentage of them booked their rooms in advance, giving La Quinta the advantage of a steadier and more predictable clientele. Nobody else had captured this part of the market, the middle ground between the Hilton hotels above and the budget inn below. Also, there was no way that some newer competitor could sneak up on La Quinta without Wall Street’s knowing about it. That’s one reason I prefer hotel and restaurant stocks to technology stocks—the minute you invest in an exciting new technology, a more exciting and newer technology is brought out of somebody else’s lab. But the prototypes of would-be hotel and restaurant chains have to show up someplace—you simply can’t build 100 of them overnight, and if they are in a different part of the country, they wouldn’t affect you anyway. What about the costs? When small and new companies undertake expensive projects like hotel construction, the burden of debt can weigh them down for years. Biegler reassured me on this point as well. He said that La Quinta had kept costs low by building 120-room inns instead of 250-room inns, by supervising the construction in-house, and by following a cookie-cutter blueprint. Furthermore, a 120-room operation could be managed by a live-in retired couple, which saved on overhead. And most impressive, La Quinta had struck a deal with major insurance companies who were providing all the financing at favorable terms, in exchange for a small share in the profits. As partners in La Quinta’s success or failure, insurance companies weren’t likely to make loan demands that would drive the company into bankruptcy if a shortfall ever occurred. In fact, this access to insurance-company money is what enabled La Quinta to grow rapidly in a capital-intensive business without incurring the dreaded bank debt. Soon enough, I was satisfied that Biegler and his employers had thought of everything. La Quinta was a great story, and not one of those would-be, could-be, might-be, soon-to-be tales. If they aren’t already doing it, then don’t invest in it. La Quinta had already been operating for four or five years at the time Biegler visited my office. The original La Quinta had been duplicated several times and in several different locations. The company was growing at an astounding 50 percent a year, and the stock was selling at ten times earnings, which made it an incredible bargain. I knew how many new units La Quinta was proposing to build, so I could keep track of progress in the future. To top it all off, I was delighted to discover that only three brokerage firms covered La Quinta in 1978, and that less than 20 percent of the stock was held by the big institutions. The only thing wrong with La Quinta that I could see was it wasn’t boring enough.I followed up on this conversation by spending three nights in three different La Quintas while I was on the road talking to other companies. I bounced on the beds, stuck my toe into the shallow end of the swimming pools (I never learned to swim), tugged at the curtains, squeezed the towels, and satisfied myself that La Quinta was the equal of Holiday Inn. The La Quinta story checked out in every detail, and even then I almost talked myself out of buying any shares. That the stock had doubled in the previous year wasn’t bothersome—the p/e ratio relative to the growth rate still made it a bargain. What bothered me was that one of the important insiders had sold his shares at half the price I was staring at in the newspaper. (I found out later that this insider, a member of the founding family of La Quinta, was simply diversifying his portfolio.)

  • The mistake I didn’t make with La Quinta I made with J. Bildner and Sons. My having invested in Bildner’s is a perfect example of what happens when you get so caught up in the euphoria of an enterprise that you ask all the questions except a most important one, and that turns out to be the fatal flaw.Bildner’s is a specialty food store located right across the street from my office on Devonshire in Boston. There was also a Bildner’s out in the town where I live—although it’s gone now. Among other things, Bildner’s sells gourmet sandwiches and prepared hot foods, a sort of happy compromise between a convenience store and a three-star restaurant. I’m well-acquainted with their sandwiches, since I’ve been eating them for lunch for several years. That was my edge on Bildner’s: I had firsthand information that they had the best bread and the best sandwiches in Boston.The story was that Bildner’s was planning to expand into other cities and was going public to raise the money. It sounded good to me. The company had carved out a perfect niche—the millions of white-collar types who had no tolerance for microwave sandwiches in plastic wrappers, and yet who also refused to cook. Bildner’s takeout already was the salvation of working couples who were too tired to set up the Cuisinart and yet who wanted to serve something that looked as if it could have been prepared in a Cuisinart for dinner. Before they went home to the suburbs, they could stop at Bildner’s and buy the kind of designer meal they would have cooked themselves, if they were still cooking: something with French beans, béarnaise sauce, and/or almonds.I’d fully researched the operation by wandering into the store across the street. One of the original Bildner’s, it was clean, efficient, and full of satisfied customers, a regular yuppie 7-Eleven. I also discovered it was a fabulous money-maker. When I heard that Bildner’s was planning to sell stock and use the proceeds to open more stores, I was understandably excited. From the prospectus of the stock offering, I learned that the company was not going to burden itself with excessive bank debt. This was a plus. It was going to lease space for its new stores, as opposed to buying the real estate. This, too, was a plus. Without further investigation I bought Bildner’s at the initial offering price of $13 in September, 1986. Soon after this sale of stock, Bildner’s opened two new outlets in a couple of Boston department stores, and these flopped. Then it opened three new outlets in the center of Manhattan, and these got killed by the delis. It expanded into more distant cities, including Atlanta. By quickly spending more than the proceeds from the public offering, Bildner’s had overextended itself financially. One or two mistakes at a time might not have been so damaging, but instead of moving cautiously, Bildner’s suffered multiple and simultaneous failures. The company no doubt learned from these mistakes, and Jim Bildner was a bright, hardworking, and dedicated man, but after the money ran out, there was no second chance. It’s too bad, because I thought Bildner’s could have been the next Taco Bell. (Did I really say the “next Taco Bell”? That probably doomed it from the start.) The stock eventually bottomed out at $⅛, and the management retreated to its original stores, including the one across the street. Bildner’s optimistic new goal was to avoid bankruptcy, but recently it’s bought The Chapter. I gradually unloaded my shares at losses ranging from 50 percent to 95 percent. I continue to eat sandwiches from Bildner’s, and every time I take a bite of one it reminds me of what I did wrong. I didn’t wait to see if this good idea from the neighborhood would actually succeed someplace else. Successful cloning is what turns a local taco joint into a Taco Bell or a local clothing store into The Limited, but there’s no point buying the stock until the company has proven that the cloning works.If the prototype’s in Texas, you’re smart to hold off buying until the company shows it can make money in Illinois or in Maine. That’s what I forgot to ask Bildner’s: Does the idea work elsewhere? I should have worried about a shortage of skilled store managers, its limited financial resources, and its ability to survive those initial mistakes. It’s never too late not to invest in an unproven enterprise. If I’d waited to buy Bildner’s until later, I wouldn’t have bought it at all. I should also have sold sooner. It was clear from the two department-store flops and the New York flops that Bildner’s had a problem, and it was time to fold the hand right then, before the cards got worse. I must have been asleep at the table.

  • Reading Balance Sheets: I flip past all that and turn directly to the Consolidated Balance Sheet. In the top column marked Current Assets, I notice that the company has $5.672 billion in cash and cash items, plus $4.424 billion in marketable securities. Adding these two items together, I get the company’s current overall-cash position, which I round off to $10.1 billion. Comparing the 1987 cash to the 1986 cash in the right-hand column, I see that Ford is socking away more and more cash. This is a sure sign of prosperity. Then I go to the other half of the balance sheet, down to the entry that says “long-term debt.” Here I see that the 1987 long-term debt is $1.75 billion, considerably reduced from last year’s long-term debt. Debt reduction is another sign of prosperity. When cash increases relative to debt, it’s an improving balance sheet. When it’s the other way around, it’s a deteriorating balance sheet. Subtracting the long-term debt from the cash, I arrive at $8.35 billion, Ford’s “net cash” position. The cash and cash assets alone exceed the debt by $8.35 billion. When cash exceeds debt it’s very favorable. No matter what happens, Ford isn’t about to go out of business. I discover that there are 511 million shares outstanding. I can also see that the number has been reduced in each of the past two years. This means that Ford has been buying back its own shares, another positive step. Dividing the $8.35 billion in cash and cash assets by the 511 million shares outstanding, I conclude that there’s $16.30 in net cash to go along with every share of Ford.

  • When I’m interested in a company because of a particular product—such as L’eggs, Pampers, Bufferin, or Lexan plastic—the first thing I want to know is what that product means to the company in question. What percent of sales does it represent? L’eggs sent Hanes stock soaring because Hanes was a relatively small company. Pampers was more profitable than L’eggs, but it didn’t mean as much to the huge Procter and Gamble. Let’s say you’ve gotten excited about Lexan plastic, and you find out that General Electric makes Lexan. Next, you discover from your broker (or from the annual report if you can follow it) that the plastics division is part of the materials division, and that entire division contributes only 6.8 percent to GE’s total revenues. So what if Lexan is the next Pampers—it’s not going to mean much to the shareholders of GE. You look at this and ask yourself who else makes Lexan, or you forget about Lexan.

  • The p/e ratio of any company that’s fairly priced will equal its growth rate. I’m talking about growth rate of earnings here. How do you find that out? Ask your broker what’s the growth rate, as compared to the p/e ratio. If the p/e of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year (also known as a “12-percent grower”) and a p/e ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown.

  • A slightly more complicated formula enables us to compare growth rates to earnings, while also taking the dividends into account. Find the long-term growth rate (say, Company X’s is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the p/e ratio (Company X’s is 10). 12 plus 3 divided by 10 is 1.5.Less than a 1 is poor, and 1.5 is okay, but what you’re really looking for is a 2 or better.

  • We just went over Ford’s $8.35 billion in cash net of long-term debt. When a company is sitting on billions in cash, it’s definitely something you want to know about. Here’s why: Ford’s stock had moved from $4 a share in 1982 to $38 a share in early 1988 (adjusted for splits). Along the way I’d bought my 5 million shares. At $38 a share I’d already made a huge profit in Ford, and the Wall Street chorus had been sounding off for almost two years about Ford’s being overvalued. Numerous advisors said that this cyclical auto company had had its last hurrah and the next move was down. I almost cashed in the stock on several occasions.But by glancing at the annual report I’d noticed that Ford had accumulated the $16.30 a share in cash beyond debt. For every share of Ford I owned, there was this $16.30 bonus sitting there on paper like some delightful hidden rebate. The $16.30 bonus changed everything. It meant that I was buying the auto company not for $38 a share, the stock price at the time, but for $21.70 a share ($38 minus the $16.30 in cash). Analysts were expecting Ford to earn $7 a share from its auto operations, which at the $38 price gave it a p/e of 5.4, but at the $21.70 price it had a p/e of 3.1. A p/e of 3.1 is a tantalizing number, cycles or no cycles. Maybe I wouldn’t have been impressed if Ford were a lousy company or if people were turned off by its latest cars. But Ford is a great company, and people loved the latest Ford cars and trucks.The cash factor helped convince me to hold on to Ford, and it rose more than 40 percent after I made the decision not to sell. I also knew that Ford’s financial services group—Ford Credit, First Nationwide, U. S. Leasing, and others—earned $1.66 per share on their own in 1987. For Ford Credit, which alone contributed $1.33 per share, it was “its 13th consecutive year of earnings growth.” Assigning a hypothetical p/e ratio of 10 to the earnings of Ford’s financial businesses (finance companies commonly have p/e ratios of 10) I estimated the value of these subsidiaries to be 10 times the $1.66, or $16.60 per share. So with Ford selling for $38, you were getting the $16.30 in net cash and another $16.60 in the value of the finance companies, so the automobile business was costing you a grand total of $5.10 per share. And this same automobile business was expected to earn $7 a share. Was Ford a risky pick? At $5.10 per share it was an absolute steal, in spite of the fact that the stock was up almost tenfold already since 1982. Boeing is another cash-rich stock. In early 1987 it sold in the low $40s, but with $27 in cash, you were buying the company for $15. I tuned in to Boeing with a small position in early 1988, then built it up to a major one—partly because of the cash and partly because Boeing had a record backlog of commercial orders yet to be filled.Cash doesn’t always make a difference, of course. More often than not, there isn’t enough of it to worry about. Schlumberger has a lot of cash, but not an impressive amount per share. Bristol-Myers has $1.6 billion in cash and only $200 million in long-term debt, which produces an impressive ratio, but with 280 million shares outstanding, $1.4 billion net cash (after subtracting debt) works out to $5 per share. The $5 doesn’t count for much with the stock selling for over $40. If the stock dropped to $15, it would be a big deal. Nevertheless, it’s always advisable to check the cash position (and the value of related businesses) as part of your research. You never know when you’ll stumble across a Ford.

  • How much does the company owe, and how much does it own? Debt versus equity. It’s just the kind of thing a loan officer would want to know about you in deciding if you are a good credit risk. A normal corporate balance sheet has two sides. On the left side are the assets (inventories, receivables, plant and equipment, etc.). The right side shows how the assets are financed. One quick way to determine the financial strength of a company is to compare the equity to the debt on the right side of the balance sheet. This debt-to-equity ratio is easy to determine. Looking at Ford’s balance sheet from the 1987 annual report, you see that the total stockholder’s equity is $18.492 billion. A few lines above that, you see that the long-term debt is $1.7 billion. (There’s also short-term debt, but in these thumbnail evaluations I ignore that, as I’ve said. If there’s enough cash—see line 2—to cover short-term debt, then you don’t have to worry about short-term debt.)

  • A normal corporate balance sheet has 75 percent equity and 25 percent debt. Ford’s equity-to-debt ratio is a whopping $18 billion to $1.7 billion, or 91 percent equity and less than 10 percent debt. That’s a very strong balance sheet. An even stronger balance sheet might have 1 percent debt and 99 percent equity. A weak balance sheet, on the other hand, might have 80 percent debt and 20 percent equity. Among turnarounds and troubled companies, I pay special attention to the debt factor. More than anything else, it’s debt that determines which companies will survive and which will go bankrupt in a crisis. Young companies with heavy debts are always at risk.

  • The kind of debt, as much as the actual amount, that separates the winners from the losers in a crisis. There’s bank debt and there’s funded debt
    • Bank debt (the worst kind, and the kind that GCA had) is due on demand. It doesn’t have to come from a bank. It can also take the form of commercial paper, which is loaned from one company to another for short periods of time. The important thing is that it’s due very soon, and sometimes even “due on call.” That means that the lender can ask for his money back at the first sign of trouble. If the borrower can’t pay back the money, it’s off to Chapter 11. Creditors strip the company, and there’s nothing left for the shareholders after they get through with it.
    • Funded debt (the best kind, from the shareholder’s point of view) can never be called in no matter how bleak the situation, as long as the borrower continues to pay the interest. The principal may not be due for 15, 20, or 30 years. Funded debt usually takes the form of regular corporate bonds with long maturities. Corporate bonds may be upgraded or downgraded by the rating agencies depending on the financial health of the company, but whatever happens, the bondholders cannot demand immediate repayment of principal the way a bank can. Sometimes even the interest payments can be deferred. Funded debt gives companies time to wiggle out of trouble. (In one of the footnotes of a typical annual report, the company gives a breakdown of its long-term debt, the interest that is being paid, and the dates that the debt is due.)

  • I pay particular attention to the debt structure, as well as to the amount of the debt, when I’m evaluating a turnaround like Chrysler. Everyone knew that Chrysler had debt problems. In the famous bailout arrangement, the key element was that the government guaranteed a $1.4-billion loan in return for some stock options. Later the government sold these stock options and actually made a big profit on the deal, but at the time you couldn’t have predicted that. What you could have realized, though, was that Chrysler’s loan arrangement gave the company room to maneuver. I also saw that Chrysler had $1 billion in cash, and that it had recently sold off its tank division to General Dynamics for another $336 million. True, Chrysler was losing a small amount of money at the time, but the cash and the structure of the loan from the government told you that the bankers weren’t going to shut the place down for at least a year or two. So if you believed the auto industry was coming back, as I did, and you knew that Chrysler had made major improvements and had become a low-cost producer in the industry, then you could have had some confidence in Chrysler’s survival. It wasn’t as risky as it looked from the newspapers.

  • STOCKS IN GENERAL
    • The p/e ratio. Is it high or low for this particular company and for similar companies in the same industry.
    • The percentage of institutional ownership. The lower the better.
    • Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs.
    • The record of earnings growth to date and whether the earnings are sporadic or consistent. (The only category where earnings may not be important is in the asset play.)
    • Whether the company has a strong balance sheet or a weak balance sheet (debt-to-equity ratio) and how it’s rated for financial strength.
    • The cash position. With $16 in net cash, I know Ford is unlikely to drop below $16 a share. That’s the floor on the stock.
  • SLOW GROWERS
    • Since you buy these for the dividends (why else would you own them?) you want to check to see if dividends have always been paid, and whether they are routinely raised.
    • When possible, find out what percentage of the earnings are being paid out as dividends. If it’s a low percentage, then the company has a cushion in hard times. It can earn less money and still retain the dividend. If it’s a high percentage, then the dividend is riskier.
  • STALWARTS
    • These are big companies that aren’t likely to go out of business. The key issue is price, and the p/e ratio will tell you whether you are paying too much.
    • Check for possible diworseifications that may reduce earnings in the future.
    • Check the company’s long-term growth rate, and whether it has kept up the same momentum in recent years.
    • If you plan to hold the stock forever, see how the company has fared during previous recessions and market drops. (McDonald’s did well in the 1977 break, and in the 1984 break it went sideways. In the big Sneeze of 1987, it got blown away with the rest. Overall it’s been a good defensive stock. Bristol-Myers got clobbered in the 1973–74 break, primarily because it was so overpriced. It did well in 1982, 1984, and 1987. Kellogg has survived all the recent debacles, except for ’73–’74, in relatively healthy fashion.)
  • CYCLICALS
    • Keep a close watch on inventories, and the supply-demand relationship. Watch for new entrants into the market, which is usually a dangerous development.
    • Anticipate a shrinking p/e multiple over time as business recovers and investors look ahead to the end of the cycle, when peak earnings are achieved.
    • If you know your cyclical, you have an advantage in figuring out the cycles. (For instance, everyone knows there are cycles in the auto industry. Eventually there are going to be three or four up years to follow three or four down years. There always are. Cars get older and they have to be replaced. People can put off replacing cars for a year or two longer than expected, but sooner or later they are back in the dealerships.
    • The worse the slump in the auto industry, the better the recovery. Sometimes I root for an extra year of bad sales, because I know it will bring a longer and more sustainable upside.
    • Lately we’ve had five years of good car sales, so I know we are in the middle, and perhaps somewhere close to the end, of a prosperous cycle. But it’s much easier to predict an upturn in a cyclical industry than it is to predict a downturn.)
  • FAST GROWERS
    • Investigate whether the product that’s supposed to enrich the company is a major part of the company’s business. It was with L’eggs, but not with Lexan.
    • What the growth rate in earnings has been in recent years. (My favorites are the ones in the 20 to 25 percent range. I’m wary of companies that seem to be growing faster than 25 percent. Those 50 percenters usually are found in hot industries, and you know what that means.)
    • That the company has duplicated its successes in more than one city or town, to prove that expansion will work.
    • That the company still has room to grow. When I first visited Pic ’N’ Save, they were established in southern California and were just beginning to talk about expanding into northern California. There were forty-nine other states to go. Sears, on the other hand, is everywhere.
    • Whether the stock is selling at a p/e ratio at or near the growth rate.
    • Whether the expansion is speeding up (three new motels last year and five new motels this year) or slowing down (five last year and three this year). For stocks of companies such as Sensormatic Electronics, whose sales are primarily “one-shot” deals—as opposed to razor blades, which customers have to keep on buying—a slowdown in growth can be devastating. Sensormatic’s growth rate was spectacular in the late seventies and early eighties, but to increase earnings they had to sell more new systems each year than they had sold the year before. The revenue from the basic electronic surveillance system (the one-time purchase) far overshadowed whatever they got from selling those little white tags to their established customers. So, in 1983, when the rate of growth slowed, earnings didn’t just slow, they dived. And so did the stock, from $42 to $6 in twelve months.
    • That few institutions own the stock and only a handful of analysts have ever heard of it. With fast growers on the rise this is a big plus.
  • TURNAROUNDS
    • Most important, can the company survive a raid by its creditors? How much cash does the company have? How much debt? (Apple Computer had $200 million in cash and no debt at the time of its crisis, so once again you knew it wasn’t going out of business.) What is the debt structure, and how long can it operate in the red while working out its problems without going bankrupt? (International Harvester—now Navistar—was a potential turnaround that has disappointed investors, because the company printed and sold millions of new shares to raise capital. This dilution resulted in the company’s having turned around, but not the stock.)
    • If it’s bankrupt already, then what’s left for the shareholders?
    • How is the company supposed to be turning around? Has it rid itself of unprofitable divisions? This can make a big difference in earnings. For example, in 1980 Lockheed earned $8.04 per share from its defense business, but it lost $6.54 per share in its commercial aviation division because of its L-1011 TriStar passenger jet. The L-1011 was a great airplane, but it suffered from competition with McDonnell Douglas’s DC10 in a relatively small market. And in the long-distance market, it was getting killed by the 747. These losses were persistent, and in December, 1981, the company announced that it would phase out the L-1011. This resulted in a large write-off in 1981 ($26 per share), but it was a one-time loss. In 1982, when Lockheed earned $10.78 per share from defense, there were no more losses to deal with. Earnings had gone from $1.50 to $10.78 per share in two years! You could have bought Lockheed for $15 at the time of the L-1011 announcement. Within four years it hit $60, for a fourbagger.
    • Texas Instruments was another classic turnaround. In October, 1983, the company announced it would leave the home-computer business (another hot industry with too many competitors). It had lost over $500 million from home computers in that year alone. Again, the decision made for big write-offs, but it meant that the company could concentrate on its strong semiconductor and defense-electronics businesses. The day after the announcement, TI stock spurted from $101 to $124. And four months later it was $176.
    • Time also has sold off divisions and dramatically cut costs. It is one of my favorite recent turnarounds. Actually it’s an asset play as well. The cable-TV part of the business is potentially worth $60 a share, so if the stock sells for $100, you’re buying the rest of the company for $40.
    • Is business coming back? (This is what’s happening at Eastman Kodak, which has benefited from the new boom in film sales.)
    • Are costs being cut? If so, what will the effect be? (Chrysler cut costs drastically by closing plants. It also began to farm out the making of a lot of the parts it used to make itself, saving hundreds of millions in the process. It went from being one of the highest-cost producers of automobiles to one of the lowest.
    • The turnaround in Apple Computer was harder to predict. However, if you’d been close to the company, you might have noticed the surge in sales, the cost-cutting, and the appeal of the new products, which all came at once.)
  • ASSET PLAYS
    • What’s the value of the assets? Are there any hidden assets?
    • How much debt is there to detract from these assets? (Creditors are first in line.)
    • Is the company taking on new debt, making the assets less valuable?
    • Is there a raider in the wings to help shareholders reap the benefits of the assets?
  • Understand the nature of the companies you own and the specific reasons for holding the stock. (“It is really going up!” doesn’t count.)
  • By putting your stocks into categories you’ll have a better idea of what to expect from them.
  • Big companies have small moves, small companies have big moves.
  • Consider the size of a company if you expect it to profit from a specific product.
  • Look for small companies that are already profitable and have proven that their concept can be replicated.
  • Be suspicious of companies with growth rates of 50 to 100 percent a year.
  • Avoid hot stocks in hot industries.
  • Distrust diversifications, which usually turn out to be diworseifications.
  • Long shots almost never pay off.
  • It’s better to miss the first move in a stock and wait to see if a company’s plans are working out.
  • People get incredibly valuable fundamental information from their jobs that may not reach the professionals for months or even years.
  • Separate all stock tips from the tipper, even if the tipper is very smart, very rich, and his or her last tip went up.
  • Some stock tips, especially from an expert in the field, may turn out to be quite valuable. However, people in the paper industry normally give out tips on drug stocks, and people in the health care field never run out of tips on the coming takeovers in the paper industry.
  • Invest in simple companies that appear dull, mundane, out of favor, and haven’t caught the fancy of Wall Street.
  • Moderately fast growers (20 to 25 percent) in nongrowth industries are ideal investments.
  • Look for companies with niches.
  • When purchasing depressed stocks in troubled companies, seek out the ones with the superior financial positions and avoid the ones with loads of bank debt.
  • Companies that have no debt can’t go bankrupt.
  • Managerial ability may be important, but it’s quite difficult to assess. Base your purchases on the company’s prospects, not on the president’s resume or speaking ability.
  • A lot of money can be made when a troubled company turns around.
  • Carefully consider the price-earnings ratio. If the stock is grossly overpriced, even if everything else goes right, you won’t make any money.
  • Find a story line to follow as a way of monitoring a company’s progress.
  • Look for companies that consistently buy back their own shares.
  • Study the dividend record of a company over the years and also how its earnings have fared in past recessions.
  • Look for companies with little or no institutional ownership.
  • All else being equal, favor companies in which management has a significant personal investment over companies run by people that benefit only from their salaries.
  • Insider buying is a positive sign, especially when several individuals are buying at once.
  • Devote at least an hour a week to investment research. Adding up your dividends and figuring out your gains and losses doesn’t count.
  • Be patient. Watched stock never boils.
  • Buying stocks based on stated book value alone is dangerous and illusory. It’s real value that counts.
  • When in doubt, tune in later.

  • Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.

  • I never put more than 30–40 percent of my fund’s assets into growth stocks. The rest I spread out among the other categories described in this book. Normally I keep about 10–20 percent or so in the stalwarts, another 10–20 percent or so in the cyclicals, and the rest in the turnarounds. Although I own 1,400 stocks in all, half of my fund’s assets are invested in 100 stocks, and two-thirds in 200 stocks. One percent of the money is spread out among 500 secondary opportunities I’m monitoring periodically, with the possibility of tuning in later. I’m constantly looking for values in all areas, and if I find more opportunities in turnarounds than in fast-growth companies, then I’ll end up owning a higher percentage of turnarounds. If something happens to one of the secondaries to bolster my confidence, then I’ll promote it to a primary selection.

  • A better strategy, it seems to me, is to rotate in and out of stocks depending on what has happened to the price as it relates to the story. For instance, if a stalwart has gone up 40 percent—which is all I expected to get out of it—and nothing wonderful has happened with the company to make me think there are pleasant surprises ahead, I sell the stock and replace it with another stalwart I find attractive that hasn’t gone up. In the same situation, if you didn’t want to sell all of it, you could sell some of it.

  • By successfully rotating in and out of several stalwarts for modest gains, you can get the same result as you would with a single big winner: six 30-percent moves compounded equals a fourbagger plus, and six 25-percent moves compounded is nearly a fourbagger.

  • The fast growers I keep as long as the earnings are growing and the expansion is continuing, and no impediments have come up. Every few months I check the story just as if I were hearing it for the first time. If between two fast growers I find that the price of one has increased 50 percent and the story begins to sound dubious, I’ll rotate out of that one and add to my position in the second fast grower whose price has declined or stayed the same, and where the story is sounding better. Ditto for cyclicals and turnarounds. 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.

  • A price drop in a good stock is only a tragedy if you sell at that price and never buy more. To me, a price drop is an opportunity to load up on bargains from among your worst performers and your laggards that show promise. If you can’t convince yourself “When I’m down 25 percent, I’m a buyer” and banish forever the fatal thought “When I’m down 25 percent, I’m a seller,” then you’ll never make a decent profit in stocks.

  • For reasons that should by now be obvious, I’ve always detested “stop orders,” those automatic bailouts at a predetermined price, usually 10 percent below the price at which a stock is purchased. True, when you put in a “stop order” you’ve limited your losses to 10 percent, but with the volatility in today’s market, a stock almost always hits the stop. It’s uncanny how stop orders seem to guarantee that the stock will drop 10 percent, the shares are sold, and instead of protecting against a loss, the investor has turned losing into a foregone conclusion. You would have lost Taco Bell ten times over with stop orders!

  • WHEN TO SELL A SLOW GROWER
    • I can’t really help you with this one, because I don’t own many slow growers in the first place. The ones I do buy, I sell when there’s been a 30–50 percent appreciation or when the fundamentals have deteriorated, even if the stock has declined in price.
    • Here are some other signs:
      • The company has lost market share for two consecutive years and is hiring another advertising agency.
      • No new products are being developed, spending on research and development is curtailed, and the company appears to be resting on its laurels.
      • Two recent acquisitions of unrelated businesses look like diworseifications, and the company announces it is looking for further acquisitions “at the leading edge of technology.”
      • The company has paid so much for its acquisitions that the balance sheet has deteriorated from no debt and millions in cash to no cash and millions in debt. There are no surplus funds to buy back stock, even if the price falls sharply.
      • Even at a lower stock price the dividend yield will not be high enough to attract much interest from investors.
  • WHEN TO SELL A STALWART
    • These are the stocks that I frequently replace with others in the category. There’s no point expecting a quick tenbagger in a stalwart, and if the stock price gets above the earnings line, or if the p/e strays too far beyond the normal range, you might think about selling it and waiting to buy it back later at a lower price—or buying something else, as I do.
    • Other sell signs:
      • New products introduced in the last two years have had mixed results, and others still in the testing stage are a year away from the marketplace.
      • The stock has a p/e of 15, while similar-quality companies in the industry have p/e’s of 11–12.
      • No officers or directors have bought shares in the last year.
      • A major division that contributes 25 percent of earnings is vulnerable to an economic slump that’s taking place (in housing starts, oil drilling, etc.)
      • 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.
  • 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.
    • Other than at the end of the cycle, the best time to sell a cyclical is when something has actually started to go wrong. Costs have started to rise. Existing plants are operating at full capacity, and the company begins to spend money to add to capacity. Whatever inspired you to buy XYZ between the last bust and latest boom ought to clue you in that the latest boom is over.
    • 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.
    • Falling commodity prices is another harbinger. Usually prices of oil, steel, etc., will turn down several months before the troubles show up in the earnings. Another useful sign is when the future price of a commodity is lower than the current, or spot, price. If you had enough of an edge to know when to buy the cyclical in the first place, then you’ll notice the price changes.
    • Competition businesses are also a bad sign for cyclicals. The outsider will have to win customers by cutting prices, which forces everyone else to cut prices and leads to lower earnings for all the producers. As long as there’s strong demand for nickel and nobody to challenge Inco, Inco will do fine, but as soon as demand slackens or rival nickel producers begin to sell nickel, Inco’s got problems.
    • Other signs:
      • Two key union contracts expire in the next twelve months, and labor leaders are asking for a full restoration of the wages and benefits they gave up in the last contract.
      • Final demand for the product is slowing down.
      • The company has doubled its capital spending budget to build a fancy new plant, as opposed to modernizing the old plants at low cost.
      • The company has tried to cut costs but still can’t compete with foreign producers.
  • WHEN TO SELL A FAST GROWER
    • Here, the trick is not to lose the potential tenbagger. 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.
    • Unlike the cyclical where the p/e ratio gets smaller near the end, in a growth company the p/e usually gets bigger, and it may reach absurd and illogical dimensions. Remember Polaroid and Avon Products. P/e’s of 50 for companies of their size? Any astute fourth-grader could have figured it was time to sell those. Was Avon going to sell a billion bottles of perfume? How could it, when every other housewife in America was an Avon representative?
    • You could have sold Holiday Inn when it hit 40 times earnings and been confident that the party was over there, and you were right. When you saw a Holiday Inn franchise every twenty miles along every major U.S. highway, and then you traveled to Gibraltar and saw a Holiday Inn at the base of the rock, it had to be time to worry. Where else could they expand? Mars?
    • Other signs:
      • Same store sales are down 3 percent in the last quarter.
      • New store results are disappointing.
      • Two top executives and several key employees leave to join a rival firm.
      • The company recently returned from a “dog and pony” show, telling an extremely positive story to institutional investors in twelve cities in two weeks.
      • The stock is selling at a p/e of 30, while the most optimistic projections of earnings growth are 15–20 percent for the next two years.
  • The best time to sell a turnaround is after it’s turned around. All the troubles are over and everybody knows it. The company has become the old self it was before it fell apart: growth company or cyclical or whatever. The shareholders aren’t embarrassed to own it again. If the turnaround has been successful, you have to reclassify the stock. Chrysler was a turnaround play at $2 a share, at $5, and even at $10 (adjusted for splits), but not at $48 in mid-1987. By then the debt was paid and the rot was cleaned out, and Chrysler was back to being a solid, cyclical auto company. The stock may go higher, but it’s unlikely to see a tenfold rise. It has to be judged the same way that General Motors, Ford, or other prosperous companies are judged. If you like the autos, keep Chrysler. It’s doing well in all divisions, and the acquisition of American Motors gives it some extra long-term potential, along with some extra short-term problems. But if you specialize in turnarounds, sell Chrysler and look for something else.