Making Money in the Stock Market using Common Sense

Here to demystify one of the common misconceptions of investing in the stock market. You DO NOT need to have an IQ of 150 or a finance degree to make money in the stock market. In fact, anyone can out-beat Wall Street. We often overestimate the professional stock picker.

“Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway. “

Warren Buffett

Recently, I have just read a classic investment know-how by Peter Lynch, “One Up on Wall Street”. TBH, I was expecting a rather dry reading but it turned out to be one of the best stock investment books I have ever read. I found the book entertaining and educational, an absolute blast for me. In fact, I would recommend “One Up on Wall Street” over “The Intelligent Investor” for whoever is new to the realm of investing. Despite learning not to judge a book by its cover (literally), I have picked up several timeless investment advice and strategy that I want to share with you guys.

Who is Peter Lynch?

Lynch is no stranger to most investors, he was a legendary fund manager who ran the Fidelity Magellan Fund from 1977 to 1990. Under his management, the Magellan Fund averaged an impressive 29.2% annual return. Beating the market and being one of the best 20-year returns of mutual funds ever.

Who Should Read “One Up on Wall Street”?

Honestly? Every investor.

If you’re a rookie and wondering where you should start, this book is definitely for you. If you have been in the game for quite some while, this book offers refreshing perspectives and entertainment value.

What should you expect from the book?

Do expect insightful sharing from a very experienced fund manager. In “One Up on Wall Street”, Peter Lynch highlights a few limitations of a big fund and why we common investors have more flexibility than a fund manager does.

Also, he points out the top characteristic of stock to avoid and how to find a 10-bagger, a stock that has the potential to deliver a 10-times return. If you have the time, I strongly recommend you to grab this book and read it yourself.

Lesson 1: Have a Game Plan, Understand the Type of Stock

Just like when you’re buying a phone, you ought to spend a little time to understand your products, compare them. Identify what are your needs and price range. Then, list out a few prospects and compare their pros and cons.

Understand the type of stocks that you’re investing in will help in your decision making when to sell/buy/hold. This will help to avoid mistakes driven by emotions.

There are 6 types of stocks as listed out by Lynch,

a. Slow Growers:

Large and established corporation. Pay generous dividends (Since there is no need for capital for an expansion plan). Suitable for conservative investors whose main objective is to retain capital and to receive dividends.

b. Stalwarts:

Grow faster than slow growers but not exactly an agile climber either. 10% to 12% growth in earnings annually. Could be a good play only if you buy it at a good bargain. Good protection during the recession. For example, people don’t spend less on groceries even during bad times.

c. Fast Growers:

20–25% growth annually. This is the land of the 10 or even the 100-baggers. One or two of these can define your investing career. A fast-growing company doesn’t have to necessary belong to a fast-growing industry. It can totally be a fast-growth company in a slow-growing industry, as long as there is an opportunity to grow. These stocks are usually riskier and require more attentive monitoring. One way to find this company is to compare its historical PE and earnings growth. If earning growth outpaces PE growth, that might be a good sign.

Beware of a fast grower that is slowly turning into slow growers. Watch out for declining revenues/rising costs or even increasing inventories or increasing receivables.

d. Cyclicals:

Company that runs a season business. E.g. Aviation, Steel, Automotive play. Most people change their car every 5–7 years. Time the cycle right and you will benefits or vice versa. If you work closely in any of these industries, chances are you might have an edge over the others. For example, you might notice the opportunity earlier if the sales reported over the last 2 months are phenomenal.

At the time of writing, steel stocks are doing quite good as global demand and selling price rebounds while aviation/tourism are still in the slump due to border closing.

e. Asset Plays:

A company that is sitting on something valuable that you’ve discovered but somehow overlooked by the crowd. The asset can be as simple as cash or real estate. Beware of inventories, the more finished the goods is the less worthy it will be in the future. (E.g. Steel that sits in the warehouse can probably still fetch a decent price after 2 years, the same can’t be said for a pair of running shoes or an electronic gadget that would be out of season)

f. Turnaround:

A company that has been battered, depressed, for example facing bankruptcy, scandal. Turnaround stocks make up slow ground very quickly as long they can recover their profitability. However, know the difference between understanding that a company will make a come back vs gambling that it will. That’s a huge difference.

Lesson 2: The Insider’s Advantage

Beating the big player is simple but not easy, they are more resourceful than you and me. For whatever “tips” that we received, chances are they already know it as well, and that’s if the tips are accurate to begin with.

So how do we even compete with the big boys in the league? Simple, by being the INSIDER yourself.

It means investing in what you know, or better yet, in an industry where you can get first-hand information, before the public. For example, if you’re working in the automotive industry, you might notice that sales have picked up in the past 2 months before everyone else. This information is worth so much more than the so-called tips as they are factual.

Even if you can’t get any “insider news” within your working environment, just pay attention to your surroundings as a consumer. One of Peter Lynch’s 10-bagger was Dunkin’ Donuts and he explained that it does not take a genius to know that Dunkin was doing great when most people regularly went there for their Donuts.

Or, as a tech enthusiast, you would already know Apple makes great phones before it became trendy.

Lesson 3: The 2-Minutes Drill

The idea is simple, be a storyteller.

Imagine yourself doing an elevator pitch to a stranger regarding a potential investment opportunity. Explains in a way that even your 12-years old nephew could understand. This not only helps to keep yourself in check from making emotionally based decisions, it also helps you to identify any gap that will require more of your time for further research.

Here’re some ideas about what to be included in your 2-minutes pitch, it works for me well.

• Type of company (e.g. Turnaround)
• Business Segments and Pillars
• The trend of revenue/profit in last 5 years
• Financial health (e.g. Healthy cashflow, Heavy Debts, Increasing Receivables, High Capex)
• Dividend trend (Any dividend payout policy?)
• What’s the exciting news?
• What’re the risks?
• Who’re the main shareholders? (How much from the institution)
• Any shareholder changes recently?
• Histroical PE comparison + Competitor Comparison

You will need to at least invest a few hours to gather these information, mostly from the company financial reports and websites like Barron’s.

“Before buying a stock, I like to be able to give a two-minute monologue that covers the reason that I’m interested in it, what has to happen for the company to success, and the pitfalls that stand in its path……Once you’re able to tell the story of a stock to your family, your friends, or the dog, and so that even a child could understnad it, then you have a proper grasp of the situation.”

Peter Lynch in “One Up on Wall Street”

Bonus: Finding the Perfect Stock

1. It Sounds Dull and Does Something Dull

The simple the business is, the better. When somebody says, “Any idiot could run this joint,” that’s a plus. A doughnut business is much simpler to understand say, the microprocessors business. And if you can understand the business, evaluation of the company becomes much easier and less error-prompt.

If a company with terrific earnings and a strong balance sheet also does dull things, it gives you a lot of time to purchase the stock at a discount. Then when it becomes trendy and overpriced, you can sell your shares to the trend-followers.

3. It is a spinoff

A spinoff is the creation of an independent company through the sale or distribution of new shares of the parent company.

A company that is being spun off is usually a good investment prospect as it is expected to be worth more as an independent company. Large companies do not want to spin off divisions and then see those spinoffs get into trouble, because that would bring embarrassing publicity that would reflect back on the parents. Therefore, spinoffs normally have strong balance sheets and are well-prepared to succeed as an independent entity.

4. The Institutions Don’t own it, and the Analyst Don’t Follow It

You want to get there before the big boys. So when they finally discover and decide to invest in it, you are able to ride on the big waves.

5. It is a No-growth Industry

Many people prefer to invest in a high-growth industry but Lynch disagrees. That’s because it is too competitive. That’s because, for every single product in a hot industry, there are a thousand MIT graduates trying to figure out how to make it cheaper in Taiwan. Plus, hot industry usually already attracts a lot of trend-followers.

6. It’s Got a Niche

This is similar to what Warren Buffet will call an economic moat. The business has some competitive advantages that protect them from its competitors. For example, drug companies and chemical companies have niches — products that no one else is allowed to make. It took years and millions of research to get a product patent. Once a patent is approved, it puts up hurdles from rival companies to invade their territory.

Another example closer to home, take a look at Genting Malaysia. It is the only company with the license to operate casinos for the past 50–60 years. Plus, how many big players are there with integrated theme parks and casinos in SEA and Asia? That is what we call an economic moat.

9. People Have to Keep Buying It

In “One Up on Wall Street”, Lynch mentions he’d rather invest in a company that makes drugs, soft drinks, razor blades, or cigarettes than in a company that makes toys.

“In the toy industry somebody can make a wonderful doll that every child has to have, but every child gets only one each. Eight months later that product is taken off the shelves to make room for the newest doll the childer have to have — manufactured by somebody else.”

The smart device might be an equivalent example of what Lynch says for the toy industry (Toy industry is a shrinking industry, take a look at Toys”R”Us. Yes, it is true that most people change their phone every 1–2years, but it is also true that we now have more options for phones with cheaper pricing. The competition in the smartphone world is ferocious. Good for the consumer, not too great for the business. It’s harder now for phone makers to stand out from the crowd today than say, 5 years ago.

10. It’s a User of Technology

I find this a little bit outdated. Almost every business today is inevitably a user of technology. So, in another word, stay away from companies that are not willing to adopt new technology/automation/digitalization. The newspaper industry is a good example.

11. The Insiders are Buyers

When insiders are buying, usually it is a good sign. Better yet, if multiple insiders are buying, pay attention to the stock.

When management owns their own stock, then rewarding the shareholders becomes the first priority, compare this to management that simply collects a paycheck where increasing salaries is their first priority. Logically, you want to invest in a company where the management is your business partner, they want to see the business succeeded more than you do.

12. The Company is Buying Back Shares

If a company has faith in its own future, then why shouldn’t it invest in itself, just as the shareholders do? Through buy-back of shares, it is then taken out of circulation, therefore shrinking the number of outstanding shares. This can have a positive effect on earnings per share, which in turn lower down the PE.

The common alternatives to buying back shares are (1) increasing the dividend, (2) developing new products, (3) starting new operations, and (4) making acquisitions. However, these alternatives are not guaranteed to succeed. Buying back shares is a safer bet for a proven business.

Concluding Remark

“One Up on Wall Street” is all about having common sense and avoid business that you do not understand. Invest only in what you know. Investing is not just about your skills or knowing how to read a technical chart, it is also a test of character and emotions.

If you are new to the stock market, check out these useful articles,

i. How to Invest in Malaysia REITs — Best Guidefor Beginner

ii.Things to consider when choosing Malaysia Stock Brokers

iii. Book Review: “The Psychology of Money” by Morgan Housel