The advantage of being an unsophisticated investor

No one could accuse me of being a sophisticated investor.

  • I don’t have an M.B.A.
  • I never studied accounting.
  • I’ve never worked on Wall Street (and never will).

The reasons for why I don’t qualify as a professional investor are many. Too many to list. Despite my lack of pedigree, I’m successful at finding worthwhile investments. How’s this possible? I use what Peter Lynch calls my “amateur’s edge.”

Here’s a story of my amateur’s edge leading me to a great company.

J and J Snack Foods (JJSF)

After reading “One Up on Wall Street” in the early 2000’s, I took Lynch’s advice. I went to the public library and began reading the Value Line. It’s a monster. You can’t borrow it like a regular library book. There’s only one. Cement blocks weigh less. If you haven’t combed through its pages, I encourage you to try. It’s how I found J and J Snack Foods.

Back then I was a greenhorn. I was bewildered by the amount of information contained within the Value Line. Having never read financial statements, I was quickly overwhelmed. To stay buoyant in the cascade of information, I marked all the important pages of One Up on Wall Street. Anywhere Lynch outlined the makings of a decent investment, I bookmarked. As I read the Value Line, I kept coming back to those bookmarks to see if what I was looking at qualified as a Lynch-worthy investment. More times than I can count, they were not.

After many hours and free weekends searching through the Value Line I compiled a list of companies. There were a lot of different kinds but because of my lack of sophistication one stood out… J and J Snack Foods.

I eat junk food but should I invest in it?

It’s likely you’ve never heard of J and J Snack Foods but you’ve probably consumed at least one of their products. They make junk food. The kind of junk food you buy at a corner store or gas station. Slurpees, pretzels and burrito’s are counted as J and J Snack Foods products.

As a connoisseur of junk food, it was the company from my Value Line list I understood best. It wasn’t complicated like a high-tech computer networking company. As a result, I decided to invest.

I owned J and J Snack Foods for several years. I made some money on it. That was great. What was better? The confidence gained from proving Lynch’s theory worked. There’s no way I would have invested in J and J Snack Foods if I had taken the advice of an investment adviser at the bank. The only regret I have was not taking Lynch’s advice on holding stocks for the long haul. I could have had a 14-bagger. Lesson learned.

A free app that makes stock valuation easy

In Peter Lynch’s book, he discusses the idea of valuation. He has a few different ways of doing it.

The Peter Lynch Method

One way is to look at the P/E ratio over time and compare it to a hypothetical average of 15. If the stock dips below the average, it’s a signal that it’s undervalued.

Another method is to look at the PEG ratio. The PEG ratio is the Price/Earnings divided by the Growth rate. For the “Fast Growers” this is an easy way to assess value. If the PEG ratio is higher than one, the stock is over valued. If the PEG ratio is below one, the stock is under valued.

These are a couple of the many ways Lynch assesses value. I’ve used them myself with great success.

The Aswath Damodaran Method

Of course, other ways of valuation exist. I like to seek out experts in valuation. NYU’s professor of Finance, Aswath Damodaran, is one such expert in business valuation.

For almost four decades Damodaran has valued businesses. As a result, his reputation for accurate valuation has earned him respect. Everyone from investment firms, to the media, consult him on asset valuation.

Lucky for us he’s written a book on valuation. The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit gives individual investors an opportunity to learn his valuation techniques.

A free valuation app

Also, Damodaran has a free app called uValue.

The link above takes you to the uValue website. There you can learn about how it works before downloading it. You’ll need to download it through the app store on your iPhone or Android device.

To be a successful investor, it’s important to understand valuation. I hope this helps you on your investment journey.

Be sure to subscribe to the Peter Lynch Investor newsletter to get more great tips on investing.

One big investment decision I regret

One big investment decision I regret is not starting sooner.

If you’ve ever looked at a chart of the Dow Jones Industrial Average over a 30-year period, you’ll notice it always goes up. The further you go back in time, the larger the increase.

Of course, there are blips on the chart where the direction is down and not up (like the last 3 months of 2018). Those downward trends eventually reverse.

30 years vs. 10 years

30 years ago, if you had invested $1000 in the Dow Jones Industrial Average, you would have made $10,000. You wouldn’t have to do anything. Time takes care of your investment.

10 years ago, if you had invested $1000 in the Dow Jones Industrial Average, you would have made $1650. See the difference 20 years can make?

If you’re the type of investor who doesn’t have time to research stocks, then consider investing in index funds. Index funds make it easy to benefit from one of the most important ingredients to successful stock market investing… time.

Should you sell your shares in Apple?

My mother asked me this question a couple of days ago. Shares in Apple dropped 10%. Tim Cook admitted iPhone sales in China were poor.

Before this day, Apple shares had already dropped 35% from its high of $233.

Apple… No Longer a Great Investment?

For investors, Apple has for a long time been a great company. People covet their products. Sales are great. Earnings are even better. Year after year after year.

It’s this predictability of growth that puts a smile on the face of investors. It’s been years since Apple has encountered any challenge to its business. There’s been concern about iPhone sales before but the last real time was 2011, when Steve Jobs died.

Then, like now, fear overwhelmed reason.

Fear Grips the Apple Investor

If you’re like my Mom, fear sets in when watching your investment go from a 4-bagger to a 3-bagger in a few months.

Psychologists call it loss aversion. The feeling you get when you see your money disappearing. It’s a challenge but this is when you need to breathe deeply and recall why you invested in the first place.

Investment Thesis

A good investor has a thesis that supports their decision to invest. For Peter Lynch, it started by putting his investments into categories. “Fast Grower” or “Value Play” made it easy to recall why he invested in companies.

My Mom, like many others, didn’t have an investment thesis. She bought the shares because of my suggestion. As a result, fear overwhelms reason and the urge to panic sell begins.

Patience is your Ally

To be a good investor, it’s important to cultivate patience. There are many reasons to cultivate patience but one is to avoid overreacting.

I read Guy Spier’s book on investing and he has a great rule that forces patience. Let’s say a company has bad news and it challenges his investment thesis. He waits at least one financial quarter before selling.

Lots of people sold their Apple shares immediately after Tim cook’s warning. Perhaps they’re right and this is the beginning of the end for Apple. No one knows for sure.

One thing I do know is that this is not the first time fear has circled Apple. I remained calm in the past and kept my shares. Can you guess my reward?

Best and Worst stocks of 2018

This is a fortuitous time to be looking back at 2018’s best and worst stocks. As I write this the Dow Jones has dropped over 4000 points since it’s high in October. You’re wondering, “How could this possibly be a good time to talk about stocks?”

It’s because one of the most valuable lessons of being an investor is being taught right now. That lesson is:

Don’t let emotions govern your investment decisions.

Pessimism about the future for companies to generate earnings has set in. What are the reasons? Interest rates are going up. Trade tensions between nations throughout the world have increased. A yield curve inversion has occurred (a forecast of recession)… the list is long.

As a result, fear has kicked in.

Fear now governs the decisions of investors. As a result, a stock market sell off. When this happens I think of Warren Buffet’s response, “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.”

I know I’ll be getting greedy soon. Probably with many of the companies I have listed on my Best and Worst of 2018.

Best of 2018

Adobe (ADBE)

Up 28% on the year. Adobe has been great at improving its earnings quarter-after-quarter. The subscription-based graphics software is a fundamental component of the modern businesses. Without much in the way of competition and the expansion of the internet, Adobe will be a core holding for some time.

Twitter (TWTR)

Up 25% on the year. In late 2017, Twitter began to make some changes in management and in its platform. I began to get interested as a result. Limits in the amount of characters were increased, clearing out of dead accounts and the most important (but not often cited) factor was the ability to deliver thought-provoking, culturally-relevant content.

Stamps.com (STMP)

Up 60%. I sold my shares in Stamps.com after President Trump continued to make statements reforming the US Postal Service. Since Stamps.com business model depended on its ability to give customers a discount on USPS service, the risk of continuing to hold the highly profitable company became too great.

Worst of 2018

Amazon (AMZN)

Down 27%. After years of watching this company transform itself into a retail giant, I gave in and decided to buy. My timing was impeccable because I purchased shortly before it reached its 52-week high.

Activision (ATVI)

Down 45%. I’ve been a long-time buyer of Activision. I began buying over 5 years ago when it’s share price was hovering around $15 and Wall Street was claiming its best days were behind it. It’s again feeling the weight of Wall Street’s negative sentiment. Its PE ratio is still higher than when I first started buying but if you like to invest for the long-term this is a good time to buy.

Weibo (WB)

Down 53%. Like most Chinese stocks this year, Weibo’s stock price has succumbed to the US-China trade war as well as Wall Street’s negative view of the Chinese economy. If you’re a younger investor with time on your side (like me), it’s easier to stomach the ups-n-downs of investing in China. I’m looking at China long-term so I’m holding and buying shares of many Chinese companies, like Weibo.

What to do when the stock market falls

Recently the stock market has been hit hard. It’s been up and down by hundreds of points a day. That can be a little scary.

When you first start out in investing it’s overwhelming to watch the value of your stocks fall when the stock market moves downwards. You want to sell your stocks before they lose even more money. Do not do this. 

Stock markets go up and they go down. Having the temperament to hold your emotions in check while this happens will make you a successful investor. 

Right now the market is up and down because of rising interest rates, trade war fears and election jitters in the US. These circumstances do have an impact on companies trying to make money. However, if they’re a good company with strong fundamentals then they should be able to withstand outside pressures. 

If you look at the DJIA over a 20 year period it goes upwards, not downwards. There are blips, like the one we are experiencing now, where the market goes down but it’s always temporary. If you have the temperament to ride it out, you will be rewarded.

Stay strong.

The Best and Worst Stocks in my Peter Lynch portfolio from 2017

This year, like every year, was a year in which I made some good decisions… and some bad ones. No investor ever goes without taking some hits to their pride. I’m no exception. I’ll start with three of my worst decisions.

The Worst of 2017

Neulion (TSE: NLN)

I lost 50% of my investment in this company in 6 months. That’s when I decided to cut my losses. I’m glad I did because the stock has continued its decline.

The reason I bought this company was because I felt it was in a position to ride the trend in delivering video content over the internet. Specifically, it helps organizations deliver live sports via the internet. The Mayweather-McGregor fight is an example of Neulion’s services.

I still believe that there is a gap in how sports leagues around the world are leveraging the internet to deliver content to fans. A prime example is ESPN. With headlines like, Please Put ESPN Out of its Misery, it’s hard to defend its leadership.

Netflix wrote the blueprint in delivering video content to paying subscribers via the internet. Amazon is following suit. The question now is how, and when, will sports leagues like the NFL, NBA, NHL, MLB start the transition.

This is one of the investment themes I’m following for 2018. My portfolio has added a few new names in anticipation of live sports moving to the internet as its primary source for delivery.

Freshii (TSE:FRII)

This is a case where I bought the stock too soon. A newcomer to the fast-casual restaurant landscape, Freshii has a healthy food menu. It’s a trend I’m following and personally value. I’ve eaten here in the past and continue to do so. That’s what got me interested in the first place.

The problem was I fell in love with this company before it had proven itself. It had rapid expansion plans which have not worked out as expected. It’s Q3 2017 results damned the company and its stock was punished accordingly. At one point I was down over 70% in my initial investment.

Since then Freshii’s stock has recovered somewhat but its management’s reputation has been damaged. Wisely, it’s decided to moderate its growth expectations by scaling back the aggressive number of new store openings.

Regardless of the reduced optimism around the stock, I still hold my shares. It’s early days for Freshii and I’m a believer in the overall trend towards healthy eating. My portfolio contains several companies that are positioning themselves to serve health conscious consumers.

Chipotle Mexican Grill (NYSE: CMG)

I’m a big believer in the Turnaround stock thesis. Peter Lynch was right about these stocks being a good place to find bargains. My portfolio owes much of its success to the Turnaround stock. That’s why I invested in Chipotle Mexican Grill.

As many of you know already know, Chipotle had some issues with food poisoning at its restaurants back in 2015. Like its customers lunches, the hugely popular restaurant saw its stock flushed down the toilet.  

When bad things happen to a good company, I keep an eye on the stock and prepare for an eventual return to form. This is why at the beginning of 2017, I purchased shares in Chipotle. The worst looked like it was behind them.

I wasn’t alone in that assessment and at one point I was up 30%. However, guidance from the company in Q2 moderated expectations. Customers weren’t coming back as quickly as hoped. The stock retreated to $400 at which point I sold for a small loss.

I’m still a believer in the Turnaround stock but for the time being, Chipotle challenges that investment thesis.

The Best of 2017

Activision (NASDAQ: ATVI)

This has been one of my best performing stocks for the last 2 years. In 2017, Activision is up over 80%. In the two years combined, it’s a 160% increase.

I started looking at this stock in 2013 when it had been written off by Wall Street. They were certain mobile gaming would see the end of platform gaming. In 2013, you could’ve bought Activision when it was trading for roughly $15/share and a P/E of 7.

Now, Activision is trading at $65/share and has a P/E in the 40’s. Expectations are high for this stock but not out of reach. It’s titles are extremely popular. Overwatch continues to grow legions of fans with each release. As well, legacy franchises like Call of Duty continue to provide revenue from loyal customers.

In general, I’m a fan of the video game space and will continue to add gaming companies to my portfolio.

Alibaba (NYSE: BABA)

The first time I came to acquire Alibaba stock was through a classic Peter Lynch Value Play. In 2013, I started buying shares of the most-hated stock in Silicon Valley… Yahoo!

Back then, a few people recognized you could buy into the extraordinary growth of Alibaba by purchasing shares of the “worthless” Yahoo. Jerry Yang, the former CEO of Yahoo, bought a stake in Alibaba in its infancy. Long after Yang was gone, that stake had grown large but wasn’t clearly reflected in Yahoo’s balance sheet or stock.

That trade netted me well over a 100% gain. I sold my shares in Yahoo and Alibaba in 2014. However, I bought back into Alibaba this year a couple of times. So far it’s up 96% in 2017.

Compared to its rival Amazon, it’s a bargain. Amazon has a P/E of 300. Alibaba is at 48. I like both companies but Alibaba is cheaper.

China Yuchai Ltd (NYSE: CYD)

This small-cap company makes diesel engines for Asian markets. It’s not an exciting business and barely gets any coverage. I bought it because it’s a Value play.

This company has roughly $11/share in cash sitting on its balance sheet. It’s trading at $24/share so with the cash you’re buying shares at $13. That’s a pretty decent discount.

Outside of the cash position, this company is cyclical in nature. As economies in Asia make gains, China Yuchai benefits by selling its industrial engines. So far this year, I’m up 29% with China Yuchai Ltd.

Onwards to 2018

Overall 2017 has been a good year. The value of the stock market has increased making it harder to find bargains.

If you’re interested in leveraging the research I do to find stocks for your portfolio, sign up my DIY Peter Lynch portfolio.

It lists stocks according to Lynch’s six categories. It’s easy to use and gives simple Buy, Sell and Hold recommendations so you know when to buy and when to sell.

An Unlikely Growth Stock Sitting Right Under your Nose

One of the things I love about using Peter Lynch’s method for picking stocks is it gives amateur’s like me a chance to use my everyday experience to spot investments.

That’s exactly the story with Microsoft (NASDAQ:MSFT).

You’d never guess it to look at it but Microsoft is growing. It’s transition into cloud computing and IAAS / SAAS is generating revenue results. In Q1, year-over-year revenue from Azure was up 90%.

The cloud contributes substantially to Microsoft’s free cash flow, $32 billion last year, which is a theme I’m using for stock picks in my portfolio. Another area of growth for Microsoft comes from gaming.

The XBOX isn’t usually thought of as a driver for Microsoft’s revenue. What’s changing is the trend towards distributing content via the internet. You saw the transformation of the movie and TV industry turn Netflix into a company with a market cap of $86 billion and Blockbuster’s into zero.

Gaming hardware manufacturers like Microsoft are syphoning off customers from GameStop (NYSE:GME). The subscription-based model for gaming is becoming more popular with gamers and Microsoft is positioned to take advantage. Year-over-year, XBOX SAAS revenues are up 20%. Sorry GameStop, your days are numbered.

All this growth has turned this Stalwart into a Fast Grower. It still carries a 1.8% dividend and it’s PEG ratio sits at a tantalizing 0.864. This year alone the stock is up 35%.

Not bad for a dinosaur like Microsoft.

Microsoft

A Peter Lynch spin-off stock you’ll want to consider for your portfolio

As Peter Lynch mentions in his book One Up on Wall Street, spinoff’s can be a great investment for several reasons.

Often the spin-off is well capitalized by its parent company and has a strong balance sheet.

It’s value isn’t being recognized under the parent company. The parent spins it off so it can grow unencumbered.

The spin-off flies “under the radar” of Wall Street and doesn’t attract a lot of attention allowing investors to buy a good company at a discount.

A spin-off that I’m liking right now is Conduent (NYSE: CNDT). Conduent is a spin-off from Xerox (NYSE:XRX).

As of January 2017, Conduent operates in the “business processing outsourcing” industry. That’s business jargon for handling things like payments for government organizations. In places like New York, New Jersey, Georgia and California, it handles ETC (Electronic Toll Collection) on state highways.

Business processing qualifies as boring. Another checkmark on Peter Lynch’s investment criteria.

Despite being in a boring space, Conduent makes the most of new technology. You can see how they have improved highway traffic by allowing single-person drivers to use multi-person carpool lanes at a premium.

I’ve come to this company because I have been doing work for one of Conduent’s competitors. I’m using my amateur’s edge. I have first-hand knowledge and can see the profits that are being made.

New technology and data analytics is changing the industry. Augmenting existing infrastructure to improve efficiencies in business processing will drive demand for Conduent’s services.

I wouldn’t classify Conduent as a fast-grower considering the business processing industry is growing at 5%/year. However, if it continues to leverage technology, earnings could outperform that benchmark.

Use Your Edge by Peter Lynch

What’s the best way to invest $1 million? Tip one: Don’t buy stocks on tips alone. If your only reason for picking a stock is that an expert likes it, then what you really need is paid professional help. Mutual funds are a great idea (I ran one once) for folks who want this sort of assistance at a  reasonable price.

Still, I’m not convinced that having 4,000 equity funds in this country is an entirely positive development. True, most  of the cash flooding into these funds comes from retirement and pension contributions, where people can’t pick their own stocks. But some of it also has to be pouring in from former stock pickers who failed to invest wisely on their own account and have given up trying.

One of the oldest sayings on Wall Street is “Let your winners run, and cut your losers.”

When people find a profitable activity — collecting stamps or rugs, buying old houses and fixing them up — they tend to keep doing it. Had more individuals succeeded at individual investing, my guess is they’d still be doing it. We wouldn’t see so many converts to managed investment care, especially not in the greatest bull market in U.S. history. Halley’s comet may return ten times before we get another market like this.

If I’m right, then large numbers  of investors must have lost  money outright or badly trailed a market that’s up eightfold  since 1982. How did so many do so poorly? Maybe they traded a new stock every week. Maybe they bought stocks in companies they knew little about, companies with shaky prospects and bad balance sheets. Maybe they didn’t follow these companies closely enough to get out when the news got worse. Maybe they stuck with their losers through thin and thinner, without checking the story. Maybe they bought stock options. Whatever the case, they failed at navigating their own course.

Amateurs can beat the Street because, well, they’re amateurs.

At the risk of repeating myself, I’m convinced that this type of failure is unnecessary – that amateurs can not only succeed on their own but beat the Street by (a) taking advantage of the fact that they are amateurs and (b) taking advantage of their personal edge. Almost everyone has an edge. It’s just a matter of identifying it.

While a fund manager is more or less forced into owning a long list of stocks, an individual has the luxury of owning just a few. That means you can afford to be choosy and invest only in outfits that you understand and that have a superior product or franchise with clear opportunities for expansion. You can wait until the company repeats its successful formula in several places or markets (same-store sales on the rise, earnings on the rise) before you buy the first share.

If you put together a portfolio of five to ten of these high achievers, there’s a decent chance one of them will turn out to be a 10-, a 20-, or even a 50-bagger, where you can make 10, 20, or 50 times your investment. With your stake divided among a handful of issues, all it takes is a couple of gains of this magnitude in a lifetime to produce superior returns.

One of the oldest sayings on Wall Street is “Let your winners run, and cut your losers.” It’s easy to make a mistake and do the opposite, pulling out the flowers and watering the weeds. Warren Buffett quoted me on this point in one of his famous annual reports (as thrilling to me as getting invited to the White House). If you’re lucky enough to have one golden egg in your portfolio, it may not matter if you have a couple of rotten ones in there with it. Let’s say you have a portfolio of six stocks. Two of them are average, two of them are below average, and one is a real loser. But you also have one stellar performer. Your Coca-Cola, your Gillette. A stock that reminds you why you invested in the first place. In other words, you don’t have to be right all the time to do well in stocks. If you find one great growth company and own it long enough to let the profits run, the gains should more than offset mediocre results from other stocks in your portfolio.

Look around you for good stocks. Down the road, you won’t regret it.

A lot of people mistakenly think they must search far and wide to find a company with this sort of potential. In fact, many such companies are hard to ignore. They show up down the block or inside the house. They stare us in the face.

This is where it helps to have identified your personal investor’s edge. What is it that you know a lot about? Maybe your edge comes from your profession or a hobby. Maybe it comes just from being a parent. An entire generation of Americans grew up on Gerber’s baby food, and Gerber’s stock was a 100-bagger. If you put your money where your baby’s mouth was, you turned $10,000 into $1 million. Fifty-baggers like Home Depot, Wal-Mart, and Dunkin’Donuts were obvious success stories to large crowds of do-it-yourselfers, shoppers, and policemen. Mention any of these at a party, though, and you’re likely to get the predictable reaction: “Chances like that don’t come along anymore.”

Ah, but they do. Take Microsoft – I wish I had.

You didn’t need a Ph.D. to figure out that Microsoft was going to be powerful.

I avoided buying technology stocks if I didn’t understand the technology, but I’ve begun to rethink that rule. You didn’t need a Ph.D. in programming to recognize the way computers were becoming a bigger and bigger part of our lives, or to figure out that Microsoft owned the rights to MS-DOS, the operating system used in a vast majority of the world’s PCs.

It’s hard to believe the almighty Microsoft has been a public company for only 11 years. If you bought it during the initial public offering, at 78 cents a share (adjusted for splits), you’ve made 100 times your money. But Apple was the dominant company at the time, so maybe you waited until 1988, when Microsoft had had a chance to prove itself.

By then, you would have realized that IBM and all its clones were using Microsoft’s operating system, MS-DOS. IBM and the clones could fight it out for market share, but Microsoft would prosper regardless of who won. This is the old combat theory of investing: When there’s a war going on, don’t buy the companies that are doing the fighting; buy the companies that sell the bullets. In this case, Microsoft was selling the bullets. The stock has risen 25-fold since 1988.

The next time Microsoft might have got your attention was 1992, when Windows 3.1 made its debut. Three million copies were sold in six weeks. If you bought the stock on the strength of that product, you’ve quadrupled your money to date. Then, at the end of 1995, Windows 95 was released, with more than 7 million copies sold in three months and 40 million copies as of this writing. If you bought the stock on the Windows 95 debut, you’ve doubled your money.

If you missed the boat on Microsoft, there are still other technology stocks you can buy into.

Many parents with children in college or high school (I’m one of them) have had to step around the wiring crews as they installed the newfangled campus wide computer networks. Much of this work is being done by Cisco Systems, a company that recently wired two campuses my daughters have attended. Cisco is another opportunity a lot of people had a chance to notice. Its earnings have been growing at a rapid rate, and the stock is a 100-bagger already. No matter who ends up winning the battle of the Internet, Cisco is selling its bullets to various combatants.

Computer buyers who can’t tell a microchip from a potato chip still could have spotted the intel inside label on every machine being carried out of the computer stores. Not surprisingly, Intel has been a 25-bagger to date: The company makes the dominant product in the industry.

Early on, it was obvious Intel had a huge lead on its competitors. The Pentium scare of 1994 gave you a chance to pick up a bargain. If you bought at the low in 1994, you’ve more than quintupled your investment, and if you bought at the high, you’ve more than quadrupled it.

Physicians, nurses, candy stripers, patients with heart problems – a huge potential audience could have noticed the brisk business done by medical-device manufacturers Medtronics, a 20-bagger, and Saint Jude Medical, a 30-bagger.

There are ways you can keep yourself from gaining on the good growth companies.

There are two ways investors can fake themselves out of the big returns that come from great growth companies.

The first is waiting to buy the stock when it looks cheap. Throughout its 27-year rise from a split-adjusted 1.6 cents to $23, Wal-Mart never looked cheap compared with the overall market. Its price-to-earnings ratio rarely dropped below 20, but Wal-Mart’s earnings were growing at 25 to 30 percent a year. A key point to remember is that a p/e of 20 is not too much to pay for a company that’s growing at 25 percent. Any business that can manage to keep up a 20 to 25 percent growth rate for 20 years will reward shareholders with a massive return even if the stock market overall is lower after 20 years.

The second mistake is underestimating how long a great growth company can keep up the pace. In the 1970s I got interested in McDonald’s. A chorus of colleagues said golden arches were everywhere and McDonald’s had seen its best days. I checked for myself and found that even in California, where McDonald’s originated, there were fewer McDonald’s outlets than there were branches of the Bank of America. McDonald’s has been a 50-bagger since.

These “nowhere to grow” stories come up quite often and should be viewed skeptically. Don’t believe them until you check for yourself. Look carefully at where the company does business and at how much growing room is left. I can’t predict the future of Cisco Systems, but it doesn’t suffer from a lack of potential customers: Only 10 to 20 percent of the schools have been wired into networks, and don’t forget about office buildings, hospitals, and government agencies nationwide. Petsmart is hardly at the end of its rope – its 320 stores are in only 34 states.

Whether or not a company has growing room may have nothing to do with its age. A good example is Consolidated Products, the parent of the Steak & Shake chain that’s been flipping burgers since 1934. Steak & Shake has 210 outlets in only 12 states; 78 of the outlets are in St. Louis and Indianapolis. Obviously, the company has a lot of expansion ahead of it. With 160 continuous quarters of increased earnings over 40 years, Consolidated has been a steady grower and a terrific investment, even in a lousy market for fast food in general.

Sometimes depressed industries can produce high returns.

The best companies often thrive even as their competitors struggle to survive. Until recently, the airline sector has been a terrible place to put money, but if you had invested $1,000 in Southwest Airlines in 1973, you would have had $460,000 after 20 years. Big Steel has disappointed investors for years, but Nucor has generated terrific returns. Circuit City has done well as other electronics retailers have suffered. While the Baby Bells have toddled, a new competitor, WorldCom, has been a 20-bagger in seven years.

Depressed industries, such as broadcasting and cable television, telecommunications, retail, and restaurants, are likely places to start a research list of potential bargains. If business improves from lousy to mediocre, investors are often rewarded, and they’re rewarded again when mediocre turns to good and good turns to excellent. Oil drillers are in the middle of such a recovery, with some stocks delivering tenfold returns in the past 18 months. Yet it took a decade of lousy before they even got to mediocre. Readers of my column in Worth learned of the potential in this long-suffering sector in February 1995.

Retail and restaurants haven’t been performing well – but they’re two of Lynch’s favorite areas.

Retail and restaurants are two of the worst-performing industries in recent memory, and both are among my favorite research areas. I’ve taken a beating in a number of retail stocks (some of which I still like and have continued to buy), but the general decline hasn’t stopped Staples, Borders, Petsmart, Finish Line, and Pier 1 Imports from rewarding shareholders. Two of my daughters and my wife, Carolyn, have continued to shop at Pier 1, reminding me of its popularity. The stock has doubled in the past 18 months.

A glut in casual-dining outlets didn’t hurt Outback Steakhouse, and a surplus of pizza parlors didn’t bother Papa John’s, whose stock was a double last year. CKE Restaurants – whose operations include the Carl’s Jr. restaurants – has been a profitable turnaround play in California.

You can even find bargain stocks in this market that have been overlooked.

So far, we’ve been talking about growth companies on the move, but even in this so-called extravagant market, there are plenty of bargains among the laggards. Of the nearly 4,000 IPOs in the past five years, several hundred have missed the rally on Wall Street. From the class of 1995, 37 percent, or 202 companies, are selling below their IPO price. From the class of 1996, 33 percent, or 285, now trade below their offering price. So much for the average investor’s never having a chance to profit from an offering. In more than half the cases, you can wait a few months and buy these stocks cheaper than the institutions that were cut in on the original deals.

As the Dow has hit new records week after week, many small companies have been ignored. In 1995 and 1996, the Standard & Poor’s 500 Stock Index was up 69 percent, but the Russell 2000 index of smaller issues was up only 44 percent. And while the Nasdaq market rose 25 percent in 1996, a lot of this gain can be attributed to just three stocks: Intel, Microsoft, and Oracle. Half the stocks on the Nasdaq were up less than 6.9 percent during 1996.

That’s not to say owning these laggards will protect you if the bottom drops out of the market. If that happens, the stocks that didn’t go up will go down just as hard and fast as the stocks that did. I learned that lesson in the 1971 – 73 bear market. Before the selling was over, companies that looked cheap by any measure got much cheaper. McDonald’s dropped from $15 a share to $4. I thought Kaiser Industries was a steal at $13, but it also fell to $4. At that point, this asset-rich conglomerate, with holdings in aluminum, steel, real estate, cement, fiberglass, and broadcasting, was trading at a market value equal to the price of four airplanes.

Wondering when you should exit the market? Use Lynch’s rule of thumb.

Should we all exit the market to avoid the correction? Some people did that when the Dow hit 3000, 4000, 5000, and 6000. A confirmed stock picker sticks with stocks until he or she can’t find a single issue worth buying. The only time I took a big position in bonds was in 1982, when inflation was running at double digits and long-term U.S. Treasuries were yielding 13 to 14 percent. I didn’t buy bonds for defensive purposes. I bought them because 13 to 14 percent was a better return than the 10 to 11 percent stocks have returned historically. I have since followed this rule: When yields on long-term government bonds exceed the dividend yield on the S&P 500 by 6 percent or more, sell stocks and buy bonds. As I write this, the yield on the S&P is about 2 percent and long-term government bonds pay 6.8 percent, so we’re only 1.2 percent away from the danger zone. Stay tuned.

So, what advice would I give to someone with $1 million to invest? The same I’d give to any investor: Find your edge and put it to work by adhering to the following rules:

With every stock you own, keep track of its story in a logbook. Note any new developments and pay close attention to earnings. Is this a growth play, a cyclical play, or a value play?

Stocks do well for a reason and do poorly for a reason. Make sure you know the reasons.

*Pay attention to facts, not forecasts.

*Ask yourself: What will I make if I’m right, and what could I lose if I’m wrong? Look for a risk-reward ratio of three to one or better.

*Before you invest, check the balance sheet to see if the company is financially sound.

*Don’t buy options, and don’t invest on margin. With options, time works against you, and if you’re on margin, a drop in the market can wipe you out.

*When several insiders are buying the company’s stock at the same time, it’s a positive.

*Average investors should be able to monitor five to ten companies at a time, but nobody is forcing you to own any of them. If you like seven, buy seven. If you like three, buy three. If you like zero, buy zero.

*Be patient. The stocks that have been most rewarding to me have made their greatest gains in the third or fourth year I owned them. A few took ten years.

*Enter early – but not too early. I often think of investing in growth companies in terms of baseball. Try to join the game in the third inning, because a company has proved itself by then. If you buy before the lineup is announced, you’re taking an unnecessary risk. There’s plenty of time (10 to 15 years in some cases) between the third and the seventh innings, which is where the 10- to 50-baggers are made. If you buy in the late innings, you may be too late.

*Don’t buy “cheap” stocks just because they’re cheap. Buy them because the fundamentals are improving.

*Buy small companies after they’ve had a chance to prove they can make a profit.

*Long shots usually backfire or become “no shots”

*If you buy a stock for the dividend, make sure the company can comfortably afford to pay the dividend out of its earnings, even in an economic slump.

*Investigate ten companies and you’re likely to find one with bright prospects that aren’t reflected in the price. Investigate 50 and you’re likely to find 5.

(Originally printed in 1997 Worth Magazine.)