The last article I wrote discussed the key attributes that Peter Lynch looks for in the “perfect stock” (here); this article will look at the other end of the spectrum – a few of the things Mr. Lynch says investors should avoid or keep an eye out for. As I did in the last article, I’ll add some of my own commentary where I think have something worthwhile to say.
The hottest stock in the hottest industry
“If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the carpool or on the commuter train – and succumbing to the social pressure, often buys.”
In “One Up on Wall Street,” Mr. Lynch discusses the hottest industry he can remember: carpets. “Every housewife in America wanted wall-to-wall carpeting,” with new production technology driving a significant reduction in costs and prices to consumers; as a result, demand shot through the roof. But as is often the case in high-growth industries, the success of the earlier entrants was short-lived; before too long, a slew of competitors joined the party in hopes of riches.
“If you have a can’t-fail idea but no way of protecting it with a patent or niche, as soon as you succeed, you’ll be warding off the imitators. In business, imitation is the sincerest form of battery.”
Without any sustainable competitive advantage, the benefits ultimately find their way to the end consumers. Here’s another example to consider: the airline industry. Despite significant growth over time (air travel has grown ~5% a year over the past three decades), the airline industry has had an atrocious return on the cumulative investment of its participants: the industry lost ~$60 billion in the decade to 2012 (here), and has been unprofitable every other year (on average) over the past three decades. Few companies in the industry have been able to stay away from Chapter 11, let alone make a solid return on their invested capital; as Richard Branson famously quipped, “If you want to be a millionaire, start with a billion dollars and launch a new airline”.
At the same time, prices have fallen precipitously for end users: according to The Atlantic, the per-mile cost of a flight has declined by half over the past 35 years (here). Consumers have clearly been the primary beneficiary of ruthless competition in the airline industry.
Warren Buffett (Trades, Portfolio) discussed this dreadful experience in his 2008 shareholder letter: “If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”
The next something
“Another stock I’d avoid is a stock in a company that’s been touted as the next IBM (IBM, Financial), the next McDonald’s (MCD, Financial), the next Intel (INTC, Financial), or the next Disney (DIS, Financial), etc. In my experience, the next of something almost never is – on Broadway, the best seller list, the NBA, or Wall Street.”
Avoid diworseification
Instead of buying back shares or raising dividends, profitable companies often prefer to blow the money on foolish acquisitions… merchandise that is (1) overpriced, and (2) completely beyond his or her realm of understanding. This ensures that losses will be maximized.
Mr. Lynch hints at something Warren Buffett (Trades, Portfolio) has discussed previously in his annual letters: it’s more exciting to engage in M&A than to manage the business and mail dividend checks to investors (and isn’t as fun as chasing a potential target – particularly if fellow CEOs are doing so as well). In addition, executive compensation tends to be tied to the size and complexity of the organization, incentivizing the creation of a larger pie versus maximizing the size of the individual slices (in my experience, executive compensation usually dwarfs equity ownership, partly because ownership requirements tend to be measured as a multiple of base salary – despite the fact that vast majority of executive / CEO compensation isn’t paid in the form of a salary).
“There’s a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them.”
The same goes for repurchases: companies are quick to boost buybacks when they’re flush with cash; this generally happens when the business is doing well and Mr. Market is optimistic it will continue indefinitely. Sure enough, when the company / market as a whole starts to stumble and prices start to come back to earth (or even reflect an overly pessimistic view of what lies ahead), managers suddenly lose interest in buying back shares. On average, there’s plenty of room for improvement in the share repurchase activity of large companies in the United States.
The whisper stock
Whisper stocks are the long shots that are just on the cusp of making boatloads of money, usually by solving a huge problem (for example, that elusive weight loss pill). As Mr. Lynch notes, the analysis of “whisper stocks” can be pretty limited: “the stock picker is relieved of the burden of checking earnings and so forth because usually there are no earnings”.
Mr. Lynch offers some advice for investors that get swept up in believing it’s a “now or never” moment (which is almost always not the case) for the whisper stock:
“I try to remind myself that if the prospects are so phenomenal, then this will be a fine investment next year and the year after that. Why not put off buying the stock until later, when the company has established a record? Wait for the earnings… When in doubt, tune in later.”
In my early days as an investor, I invested in a few solar panel producers; while it was undoubtedly a hot industry at the time (no pun intended), the companies that caught my attention were developing under the radar, proprietary technologies that were going to revolutionize the industry – and ultimately the world. I don’t remember what I was thinking at the time, but I’m sure I was convinced that my time to act was drawing to a close: before too long, everybody would realize just how much long term potential these companies had. It was a classic “now or never” moment.
A few years later, those companies have all gone belly up; to this day, I still can’t tell you what “String Ribbon” solar cells are (one of the proprietary technologies that grabbed my attention at the time). One thing I can tell you with certainty is that they haven’t revolutionized the world.
Conclusion
All three of the stock-specific topics from above share a general theme: investors can get in a lot of trouble when they start focusing exclusively on upside potential. The starting point should be margin of safety; as Joel Greenblatt (Trades, Portfolio) likes to say, “If you don’t lose money, most of the remaining alternatives are good ones.”
That’s an important lesson to learn as a novice (and remember indefinitely); I only wish I had followed Mr. Greenblatt’s and Mr. Lynch’s advice more closely when I first started investing!
