Notes on: Learn to Earn - A Beginners Guide to the Basics of Investing and Business

Recently, I have come to the realization that I am in dire need of some knowledge about investing. I’ve been dabbling a bit with stocks, like it seems most people these days are, but with no real idea about what I’m doing - mostly purchasing off of tips or a “gut feeling”. This has not worked out great for me so far. One of the key principles of investing is that you should not involve feelings, but if all you invest on is feeling, that becomes quite difficult.

So I need a strategy. How do I filter for interesting companies? What type of companies should I buy? What market cap should they have? How do I read a balance sheet? How do I calculate the potential future value of a company? These are all questions that I need my strategy to answer because they give a bit more clarity to the two questions that everyone wants to know the answers to; When should I buy and when should I sell?

To start answering these questions and formulating a strategy I have bought a couple of classic investment books. The first one I’ve read is “Learn to Earn” by Peter Lynch and John Rothchild - these are the notes relating to investment that I took from that book.

The five different types of investments and their pros and cons

  1. Savings Accounts, Money-Market Funds, Treasury bills, and Certificates of Deposit

Savings accounts are great places to park money so you can get it quickly, whenever you need to pay bills. They are great places to store cash until you’ve got a big enough pile to invest in elsewhere. But over long periods of time, they won’t do you any good.

p. 101

  1. Collectibles

    They don’t say too much about collectibles, but my takeaway is this: they can be lucrative, but it’s extremely risky and you need to be an expert in the field you are investing in.

  2. Houses and Apartments

A house has two big advantages over other types of investments. You can live in it while you wait for the price to go up, and you buy it ib borrowed money.

p. 102

This quote is then followed up with the following example (the numbers really show the age of the book):

Now let’s say that the value of the house goes up by 3% per year. After one year the house will be worth $103,000. While this looks like we got a return of 3% on investment since we only put up $20,000 of our own money, the actually return on invested capital is 15%. We leveraged our investment.

After 15 years the return will be $$\$100,000*1.03^{15}=\$155,797 $$ or a 279% return on invested capital.

  1. Bonds

    A bond is a glorified IOU. It shows the amount of the loan and the deadline for paying it back. It gives the interest rate that the borrower has to pay. When you buy a bond, you aren’t really buying anything. You’re making a loan. The seller of the bond, also called the issuer, is borrowing money, and the bond itself is proof that it happened.

    The biggest seller of bonds (at least when this book was published) is Uncle Sam. This is what the national debt is all about - it is owed to the people who bought the government’s bonds. This could be individuals, companies, or foreign governments.

    The interest on bonds is higher depending on how far into the future the payback deadline is. A thirty-year bond will pay more interest than a ten-year bond, which in turn will pay more interest than a five-year bond. This is because the chance of inflation nullifying the interest of a bond is higher the longer the payback period is. You get paid according to the riskiness of the bond.

    According to the book, there are three ways you can get hurt by bonds:

    1. If you sell the bond before its due date. By selling early, you take a chance in the bond market. If you sell early, you might get less than you paid for it.
    2. The issuer of the bond goes bankrupt and can’t pay you back. This risk is also something you get paid extra for. Rating agencies will grade the bonds based on their riskiness. The lowest-rated bonds are called “junk” bonds. These bonds are the likeliest to go bankrupt (even if they seldom do), but they also pay the highest interest. The safest bonds are US government bonds.
    3. Inflation. This is the most likely way a bond can become a bad investment. If inflation is higher than your interest, you will steadily lose money.

  2. Stocks

Stocks are likely to be the best investment you’ll ever make, outside of a house.

p.109

…stocks have outdone other investments as far as anyone can remember.

p.110

Invest for the long term

Twenty years or longer is the right time frame. This is long enough for stocks to bounce back from the nastiest of corrections and long enough for returns to pile up. Since 1800 stocks have returned between 6,5 and 7 percent annually (the book uses 11%, but I’ve updated this number to be more conservative)[1]. A 6,5% annual return on a $10,000 investment will result in $35,236, or more than a 150% return - without you having to do anything. This is also without taking into account possible dividends that the stock pays out.

Buying Funds

The book talks a bit about mutual funds and gives the following advice when selecting funds to invest in:

  1. You can buy mutual funds directly from the companies that manage them.
  2. Brokers have to make a living, and they sometimes get a bigger commission when selling the firm’s own products. When a broker recommends anything, always find out what’s in it for them.
  3. If you’re a long-term investor, ignore all the bond funds and hybrid funds and go for the pure stock funds. Stocks have historically outperformed bonds, so if you buy bonds you are selling yourself short.
  4. Picking the right fund isn’t any easier than picking the right auto mechanic, but with funds, at least you’ve got the record of past performance to guide you. But before you invest in a fund based on its record, make sure that the manager that created the record is still in charge.
  5. Over time, it’s been more profitable to invest in small companies than in large companies. However, they are also more volatile. Buyers beware.
  6. Why take the chance on a rookie fund, when you can invest in a veteran fund that’s been through several seasons and has turned in an all-star performance?
  7. It doesn’t pay to be a fund jumper.
  8. Some funds charge an entry fee, called a load. As it turns out, the no-loads (the firms that do not charge an entry fee) have performed, on average, as the funds with the loads. However, the longer you stay in a fund the less the load will matter. The annual expenses are more important than the load, they are taken out of the fund every year.
  9. The goal of a fund is to beat the average, but fund managers often fail to do just this. An index fund might be a better alternative for most people.

How to pick stocks

The book gives us five different methods for picking stocks, beginning with the most idiotic:

  1. Darts. Yeah, don’t…

  2. Hot Tips. The hot stock picks you get from your Uncle Steve. You can be lucky and the stocks go up, but it can just as well go down.

  3. Educated Tips. These are tips that you get from experts that appear on TV or appear in the newspaper or in a magazine. These can be good tips, but the problem is that when the expert changes their mind there is no way for you to find out.

  4. The Broker’s Buy List. Often these recommendations do not come from the broker’s own head. They come from the analyst who works behind the scenes at the head office. This has one big advantage over educated tips: if the brokerage firm changes its mind and moves a stock from the buy list to the sell list, it will inform you about it. If they don’t, put the broker on your sell list.

  5. Doing your own research. The more you learn about investing in companies, the less you have to rely on other people’s opinions and the better you can evaluate other people’s tips.

    You’ll need two kinds of information: The kind you get by keeping your eyes peeled and the kind you get by studying the numbers.

    The first kind you begin to gather every time you walk into a store. Is the operation efficient? Are they understaffed or overstaffed? Is the place full or empty? These details will tell you a great deal about the parent company.

    The second kind of information is found in the annual and quarterly reports. How fast is the company growing, do they pay dividends, how much do they owe the bank, how much did they earn in the future and how much do they expect to earn, etc?

Some words on P/E

P/E is an abbreviation of “price-earnings ratio”. You get the number by dividing the price of a stock by the company’s annual earnings. The P/E helps you figure out if the stock is cheap or expensive.

The easiest way to use this tool is to compare the P/E to the historical norm.

In todays market, the P/E of the average stocks is about 16, and Disney’s P/E of 23 makes it a bit expensive relative to the average stock. But since Disney’s P/E ratio has moved from 12 to 40 over the past fifteen years, a P/E of 23 for Disney is not out of line, historically. It is more expensive than the average stock because the company has been a terrific performer.

p. 150

Some words on technology

When this book was written we were starting to move into the information age. With computers and the internet becoming more prevalent in homes you no longer had to wait for tomorrow’s paper to know the price of your stocks. The book has a nice comment on this that I think is still very relevant:

All this technology has a drawback: It can get you worked up about the daily gyrations. Letting you emotions go up and down in sympathy with stocks can be a very exhaustive form of exercise, and it doesn’t do you any good. Whether Disney rises, falls, or goes sideways today, tomorrow, or next month isn’t worth worrying about if you are a long term investor.

p. 150

Some words on earnings

One thing that stood out to me with all of today’s tech companies was this sentence:

…the name of the game is earnings. That’s what the shareholders are looking for, and that’s what makes the stock go up.

p. 157

However, this is something that I have decided to follow, even if it means losing out on some crazy earnings.

This is the starting point for the successful stockpicker: find companies that can grow earnings over many years to come.

p.158

In general, the faster a company can grow its earnings, the more investors will pay for those earnings. That’s why aggressive you companies can have P/E’s of 20 or higher.

p. 159

One tool that can be useful when evaluating how much investors are willing to pay for earnings at any given time, is the market multiple. If you take a large group of companies, add their stock together, and divide by their earnings, you get an average P/E ratio. you can then use this to compare any company to the average of the market.

Some companies are “erratic earners”. The autos, the steels, and the heavy industries do well in certain economic climates and worse in others. This often results in them having a lower P/E than more steady growers.

What can a company do with their earnings?

According to the book, a company has four choices on how to spend their money. These can be more or less beneficial to the investor.

  1. It can plow the money back into the business, in effect investing in itself. In the long run, this is highly beneficial for the stockholder.
  2. It can waste the money on corporate jets, teak-paneled offices, marble in the executive bathrooms, exorbitant executive salaries, or buying other companies and paying to much for them. This is bad for stockholders.
  3. A company can buy back its own shares and take them off the market. With fewer shares on the market, the remaining shares become more valuable. This can be very good for the stockholder, especially if they do it when the shares are cheap.
  4. The company can pay a dividend. This is not entirely a positive thing, since it is giving up the chance to invest in itself. Nevertheless, a dividend I very beneficial for the stockholder. Besides the monetary benefit, paying a dividend also has psychological benefits. No matter what happens, you will still collect the dividend. This gives you an extra reason not to sell in a panic.

Catching a twelve bagger

If you are going to invest in a stock you have to know the story. This is where most 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 goes down they get bored or they lose faith, so they sell their shares.

p. 161

The book then gives two examples of companies that had a stock that looked quite bleak, but when you read deeper into them turned out to be fantastic investments: Nike in 1987 and Johnson & Johnson in 1994.

Nike

Nike in the 1980s was a company that anyone could understand. It makes sneakers. To know how the company was doing you had to be able to answer three basic questions:

  1. Is the company selling more sneakers this year than last year?
  2. Is it making a decent profit on the sneakers it sells?
  3. Will it sell more sneakers next year, and the year after that?

In the 1980s the prospect of sneakers could not have been brighter: everyone was wearing them. Yet, Nike got into a slump where its sales, earnings, and future sales were declining. Both the Q1 Q2, and Q3 reports showed bad numbers. But then the Q4 report arrived and showed the trend turning. The future sales were especially high, meaning that stores around the country were buying more sneakers - which they wouldn’t be doing if they did not think they were going to be able to sell them. Nike’s Q1 report in 1988 was spectacular: sales up 10%, earnings up 68%, and future sales up 61%.

During this time the share price had claimed $7 to $12.5. Then came the crash of 1987 and Nike’s share price returned to $7. If you were not aware of Nike’s story you might have sold at this point, thinking that the company was doing poorly, when in reality this was the start of a five-year climb to a share price of $90.

Johnson & Johnson

Johnson & Johnson’s 1994 annual report is another instance where the story does not match the stock price. The company had fallen from $57 to under $40 in March 1994. But the numbers in the annual report looked nothing but strong. They had increased their earnings while reducing employees, they had done share buybacks, they had low debt for a company its size, and they invested heavily in R&D. At the time the average company was selling for 16 times its estimated 1995 earnings, while J&J were only selling for 11 - but J&J was a much better than you average company. Why was this?

The reason the stock was low was due to the 1993 “healthcare scare”. In 1993, the US Congress was discussing healthcare reform and investors were selling any and all companies in the healthcare sector. But when you read into J&Js report, you would find that 50% of their revenue came from abroad and 20% came from consumer items, neither of which could be affected by the new regulations.

All in all: the stock price was down while the fundamentals of the company were just improving.

By October 1995, the share price had risen from under $40 to over $80.