Learn to Earn: A Book for Young Investors
November 7th 2007 09:34 pm
By Peter Lynch and John Rothchild
As appeared in the June 2004 issue of Sound Mind Investing.
[This month's cover article is a little unusual. It's presented not only for its instructive value, but also to introduce you to a great resource for teaching basic principles of investing and business to the teenagers and college students in your life. Learn to Earn, co-authored by legendary mutual fund manager Peter Lynch, is one of the best primers I've seen for whetting a novice's appetite for the challenge of investing. In an entertaining fashion, he speaks to young people in language they can understand. This article is excerpted from chapter two, "The Basics of Investing." — AP]
More than 50 million Americans have discovered the fun and profit in owning stocks. That’s one out of five. These aren’t all whizbangs who drive Rolls-Royces like the people you see on Lifestyles of the Rich and Famous. Most of these shareholders are regular folks with regular jobs: teachers, bus drivers, doctors, carpenters, students, your friends and relatives, the neighbors in the next apartment or down the block.
The stock market is one place where being young gives you a big advantage over the old folks. Your parents or your grandparents may know more about stocks than you do — most likely, they’ve learned the hard way, by making mistakes. Surely, they’ve got more money to invest than you do, but you’ve got the most valuable asset of all — time. People who need to pull their money out in one year, two years, or five years shouldn’t invest in stocks in the first place. There’s simply no telling what stock prices will do from one year to the next. When the stock market has one of its “corrections” and stocks lose money, the people who have to get their money out may be going home with a lot less than they put in.
Twenty years or longer is the right time frame. That’s long enough for stocks to rebound from the nastiest corrections on record, and it’s long enough for the profits to pile up. Eleven percent a year in total return is what stocks have produced in the past. Nobody can predict the future, but after twenty years at 11 percent, an investment of $10,000 is magically transformed into $80,623.
To get that 11 percent, you have to pledge your loyalty to stocks for better or for worse — this is a marriage we’re talking about, a marriage between your money and your investments. You can be a genius at analyzing which companies to buy, but unless you have the patience and the courage to hold on to the shares, you’re an odds-on favorite to become a mediocre investor. It’s not always brainpower that separates good investors from bad; often, it’s discipline.
Young people have the time to invest, but they don’t always have the cash. It’s not just any cash that can safely be put into stocks; it’s cash you can afford to live without for many years while it goes forth and multiplies. If you have a part-time job and can afford to invest a portion of your paycheck, so much the better. If not, perhaps you can drop some hints to family members around the holidays. Here’s where parents, grandparents, aunts, and uncles can play a leading role. The greatest source of investment capital for young people is relatives. When they ask what you want for your birthday, Christmas, Hanukkah, and so forth, tell them you want stocks. Let them know that if it comes down to a choice between owning a new pair of Nikes or owning a share of Nike, which costs about the same amount as the shoes, you’d rather have the share.
This is guaranteed to impress most adults. They’ll be amazed by your foresight and your maturity, and your ratings will soar in the family popularity polls. If they own shares themselves, they can get you started by simply transferring one share, or many shares, over to you. The paperwork is no problem, and they don’t have to pay a fee or a commission to do this. Thousands of young people in each generation are introduced to investing in this fashion, by older people giving them their first stocks. A steady stream of shares trickles down from grandparents to their grandchildren.
Many grandparents have gotten into the habit of giving savings bonds instead of stocks. If you have grandparents of this type, it’s in your best interest to help them understand how much better off you’d be if they dispensed with the savings bonds and sent you shares of good companies at every opportunity.
THAT DIRTY WORD — PROFIT
Companies are in business for one basic reason. No matter whether they are public or private, owned by a single shareholder or a million shareholders, the goal is the same. They want to make a profit.
Profit is the money that’s left over after all the bills are paid. It can be divided among the owners of any business, whether it’s General Electric, Pepsico, Marvel Comics, or the car wash you run on weekends in your driveway. You wouldn’t want to stand out in the hot sun with a bucket and a soapy sponge if you didn’t expect to come away with a profit. Maybe you enjoy washing cars because you can hose yourself down every once in a while and it keeps you cool in the summertime, but that doesn’t mean you’d do it for free.
The same is true of people who own shares in companies. They’re not doing it just for the fun of getting invited to the annual meeting, or getting a copy of the annual report sent to them in the mail. They’re doing it because they expect the company in which they own shares to make a profit and to pass along some of that profit to them, sooner or later.
There’s a mistaken idea still floating around that people who do things for profit are being greedy or underhanded, and they’re trying to pull a fast one on the rest of society, because whenever one person makes a bundle, it’s at the expense of everybody else. A generation ago, there were more subscribers to this idea than there are today, but it’s still lurking in the backs of more than a few minds. That one man’s gain is another man’s pain was the basic doctrine of communism, and it was also fashionable among socialists on college campuses and elsewhere, who never missed a chance to accuse capitalists of putting themselves first and everybody else last, and of getting rich on the sore backs of the wage earners.
All employees everywhere ought to be rooting for profit, because if the company they work for doesn’t make one, they’ll soon be out of a job. Profit is a sign of achievement. It means somebody has produced something of value that other people are willing to buy. The people who make the profit are motivated to repeat their success on a grander scale, which means more jobs and more profits for others.
Capitalism is not a zero-sum game. Except for a few crooks, the rich do not get that way by making other people poor. When the rich get richer, the poor get richer as well. If it were really true that the rich get richer at the expense of the poor, then since we’re the richest country in the world, by now we surely would have created the most desperate class of poor people on earth. Instead, we’ve done just the opposite.
There is substantial poverty in America, but it doesn’t come close to matching the poverty you’ll see in parts of India, Latin America, Africa, Asia, or Eastern Europe where capitalism is just beginning to take hold. When companies succeed and become more profitable, it means more jobs and less poverty.
THE GROWTH FACTORY
Every person who owns shares in a company wants it to grow. That doesn’t mean it has to move to a larger building. It means the profits are growing. The company will earn more money this year than last year, just as it earned more money last year than the year before that. When investors talk about “growth,” they’re not talking about size. They’re talking about profitability, that is, earnings.
If you wash three cars for $6 each, and you spent $2 on a plastic bottle of soap and $1 on a new sponge, you’ve earned $15 — the $18 you got for doing the job minus $3 for the materials. Wash another five cars with the same soap and the same sponge, and you’ll earn another $30, with no additional cost for the materials. Your earnings have just tripled. That’s more cash in your pocket so you can buy CDs, movie tickets, new clothes, or more shares of stock.
A company doubling its earnings in twelve months can cause a wild celebration on Wall Street, because it’s very rare for a business to grow that fast. Big, established companies are happy to see their earnings increase by 10 to 15 percent a year, and younger, more energetic companies may be able to increase theirs by 25 to 30 percent, but one way or the other, the name of the game is earnings. That’s what the shareholders are looking for, and that’s what makes the stocks go up.
This simple point — that the price of a stock is directly related to a company’s earning power — is often overlooked, even by sophisticated investors. The tickertape watchers begin to think stock prices have a life of their own. They try to fathom what the “market” is doing, when they ought to be following the earnings of the companies whose stocks they own.
If earnings continue to rise, the stock price is destined to go up. Maybe it won’t go up right away, but eventually it will rise. And if the earnings go down, it’s a pretty safe bet the price of the stock will go down. Lower earnings make a company less valuable, just like the rock band that loses its audience and stops selling records.
This is the starting point for the successful stockpicker: Find companies that can grow their earnings over many years to come. It’s not by accident that stocks in general rise in price an average of about 8 percent a year over the long term. That occurs because companies in general increase their earnings at 8 percent a year, on average, plus they pay 3 percent as a dividend.
Based on these assumptions, the odds are in your favor when you invest in a representative sample of companies. Some will do better than others, but in general, they’ll increase earnings by 8 percent and pay you a dividend of 3 percent, and you’ll arrive at your 11 percent annual gain.
By itself, the price of a stock doesn’t tell you a thing about whether you’re getting a good deal. You’ll hear people say, “I’m avoiding IBM because at $100 a share it’s too expensive.” It may be that they don’t have $100 to spend on a share of IBM, but the fact that a share costs $100 has nothing to do with whether IBM is expensive. A $150,000 Lamborghini is out of most people’s price range, but for a Lamborghini, it still might not be expensive. Likewise, a $100 share of IBM may be a bargain, or it may not be. It depends on IBM’s earnings.
If IBM is earning $10 a share this year, then you’re paying 10 times earnings when you buy a share for $100. That’s a p/e ratio of 10, which in today’s market is cheap. On the other hand, if IBM only earns $1 a share, then you’re paying 100 times earnings when you buy that $100 share. That’s a p/e ratio of 100, which is way too much to pay for IBM.
In general, the faster a company can grow its earnings, the more investors will pay for those earnings. That’s why aggressive young companies have p/e ratios of 20 or higher. People are expecting great things from these companies and are willing to pay a higher price to own the shares. Older, established companies have p/e ratios in the mid to low teens. Their stocks are cheaper relative to earnings, because established companies are expected to plod along and not do anything spectacular.
Some companies steadily increase their earnings — they are the growth companies. Others are erratic earners, the rags-to- riches types. They are the cyclicals — the autos, the steels, the heavy industries that do well only in certain economic climates. Their p/e ratios are lower than the p/e’s of steady growers, because their performance is erratic. What they will earn from one year to the next depends on the condition of the economy, which is a hard thing to predict.
HOW TO CATCH A TWELVE-BAGGER
If you’re going to invest in a stock, you have to know the story. This is where investors get themselves in trouble. They buy a stock without knowing the story, and they track the stock price, because that’s the only detail they understand. When the price goes up, they think the company is in great shape, but when the price stalls or goes down, they get bored or they lose faith, so they sell their shares.
Confusing the price with the story is the biggest mistake an investor can make. It causes people to bail out of stocks during crashes and corrections, when the prices are at their lowest, which they think means that the companies they own must be in lousy shape. It causes them to miss the chance to buy more shares when the price is low, but the company is still in terrific shape.
The story tells you what’s happening inside the company to produce profits in the future — or losses, if it’s a tale of woe. It’s not always easy to figure this out. Some stories are more complicated than others. Companies that have many different divisions are harder to follow than companies that make a single product. And even when the story is simple, it may not be conclusive.
But there are occasions when the picture is clear and the average investor is in a perfect position to see how exciting it is. These are the times when understanding a company can really pay off. To illustrate this, let’s consider what happened to Nike in 1987. Nike is a simple business. It makes sneakers. Along with fast food and specialty retailers, this is the sort of company that anybody can follow. There are three key elements: First, is Nike selling more sneakers this year than last year? Second, is it making a decent profit on the sneakers it sells? Third, will it sell more sneakers next year, and the years after that? In 1987, investors got some definite answers, which arrived in the quarterly reports and the annual report sent to every shareholder.
Since going public in 1980, Nike stock had been bouncing all over the place — jumping from $5 in 1984 to $10 in 1986, falling back to $5, rebounding to $10 in 1987. Looking at the scenery for this story, the prospects for sneakers couldn’t have been brighter. Everybody was wearing them: toddlers, teenagers, even adults who hadn’t worn sneakers since they were kids. There were different sneakers for tennis, jogging, basketball, you name it. It was obvious the demand for sneakers was growing, and Nike was a big supplier.
Yet the company had run into a rough stretch where its sales, earnings, and future sales were all declining. This was a very depressing turn of events, as shareholders found out when they received their first-quarter 1987 report. (As is the custom with many companies, Nike’s year begins in June, so the first quarter of 1987 ends in August 1986.) If you owned Nike, you got the news in the mail in early October 1986. Sales were down 22 percent, earnings down 38 percent, and “Futures” (future orders) down 39 percent. This was not a good time to buy more shares of Nike.
The second-quarter report was mailed out January 6, 1987. The results were just as bad as those in the first quarter, and the third quarter wasn’t much better. Then lo and behold, in the fourth-quarter report, which arrived in late July 1987 along with the annual report, there was a positive note. Sales were still down, but only by 3 percent; earnings were still down; but future orders had turned up. This meant that stores around the world were buying more Nike sneakers. They wouldn’t be doing that unless they thought they could sell more Nike sneakers.
By reading the annual report of that year, you would also have learned that in spite of its several quarters of declining earnings, Nike was still making a nice profit. That’s because sneakers are a very low-cost business. It’s not like the steel business, where you have to build and maintain expensive factories. In the sneaker business, all you need is a big room and a bunch of sewing machines and relatively inexpensive materials. Nike had plenty of cash on hand and was in excellent financial shape.
When you opened the first-quarter report of 1988, which arrived in late September 1987, you could hardly believe your eyes. Sales were up 10 percent, earnings up 68 percent, and future orders up 61 percent. This was proof that Nike was on a roll. In fact, the roll lasted for five more years: twenty straight quarters of higher sales and higher earnings.
In September 1987, you didn’t know yet about the twenty straight quarters. You were happy the company had turned itself around, but you weren’t rushing out to buy more stock. You were worried about the price, which had moved up sharply from $7.00 to $12.50 per share. So you awaited further developments, and this time you got lucky. Stock prices came tumbling down in the Crash of October 1987. Investors who confuse the stock price with the story were selling everything they owned, including their Nike shares. They heard commentators on the nightly news predict a worldwide collapse of the financial markets.
In the midst of this pandemonium, you kept your head, because you realized the Nike story was getting better. The Crash gave you a gift: the opportunity to buy more shares of Nike at a bargain price. The stock dropped to $7 after the Crash and sat at that level for eight days, so you had plenty of time to call your broker. From there, it began a five-year climb to $90, while the story kept getting better. By the end of 1992, Nike shares were worth twelve times more than you’d paid for them in 1987. That’s your twelve-bagger.
Even if you missed buying Nike for $7 a share after the Crash, you could have bought it three months, six months, or a year later as the quarterly reports you received in the mail continued to show good numbers. Instead of making twelve times your money, you would have made ten, or eight, or six times your money. 
From Learn To Earn by Peter Lynch and John Rothchild. Copyright © 1995 by Peter Lynch. Reprinted by permission of Fireside Books/Simon & Schuster, Inc.