compiled by Mark Tracy

Shoulders of Giants Investor

Welcome to Shoulders of Giants Investor! Warren Buffett reaped an average annual return of 21.5% over 40 years (1965-2005), while Peter Lynch -- widely regarded as the best stock picker on Wall Street -- averaged a staggering 29.2% annualized return for 13 years during his career managing Fidelity Magellan Fund (1977-1990). Shoulders of Giants Investor presents the investment philosophy of these two great investors on one concise webpage. The aim is to give the typical investor the tools needed to make wise stock market choices.

Unlike most investor services, Shoulders of Giants Investor is provided free of charge, with the goal of setting you on a proven path of knowledge, in the hope of making you a better investor.


No wonder people lose money in the stock market. They spend more time shopping for a good microwave oven than shopping for a good investment. --Peter Lynch

The Giants -- Warren Buffett and Peter Lynch

While there are some differences in the way that Buffett and Lynch analyze stocks, the fundamental principle behind these two giant's investment philosophy is to buy good companies at good (or at least reasonable) prices.

The following Warren Buffet quotes and strategies are from the paperback edition of "The Warren Buffett Way" by Robert Hagstrom, Jr. and "Buffett" by Roger Lowenstein (hardback edition). Peter Lynch's quotes and strategies are from the paperback editions of his two books: "One Up on Wall Street" and "Beating the Street." Another book cited is "The Five Rules for Successful Investing" by Pat Dorsey (hardback edition), which clarifies some of the concepts presented by Buffett and Lynch.

General Principles of the Giants

Warren Buffett: "If a business does well, the stock eventually follows." Peter Lynch: "Often, there is no correlation between the success of a company's operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies." (BtS p.191) "Often ... in the stock market, several years of patience is rewarded in one." (BtS p.179)

"Most of the money I make is in the third or fourth year that I've owned something.... If all's right with the company, and whatever attracted me in the first place hasn't changed, then I'm confident that sooner or later my patience will be rewarded." (OneUp p.272) "It takes years, not months, to produce big results." (OneUp p.293)

"It is wrong to assume that if you are not buying and selling, you are not making progress. In Buffett's mind, it is too difficult to make hundreds of smart decisions in a lifetime. He would rather position his portfolio so he only has to make a few smart decisions." (Hagstrom p.267)

It has been Buffett's experience that the best returns are achieved by companies that have been producing the same product or service for several years. Undergoing major business changes increases the likelihood of committing major business errors. (Hagstrom p.78)

First, Buffett eliminates the financial risk associated with debt financing by excluding from purchase those companies with high debt levels. Second, business risk is reduced, if not eliminated, by focusing on companies with consistent and predictable earnings. "I put a heavy weight on certainty," he says. "If you do that, the whole idea of a risk factor doesn't make any sense to me. Risk comes from not knowing what you're doing." (Hagstrom pp.94-5)

"For a stock to do better than expected, the company has to be widely underestimated. Otherwise, it would sell for a higher price to begin with. When the prevailing opinion is more negative than yours, you have to constantly check and recheck the facts, to reassure yourself that your not being foolishly optimistic." (BtS p.171)

"The part-time stock picker probably has time to follow 8 to 12 companies, and to buy and sell shares as conditions warrant. There doesn't have to be more than 5 companies in the portfolio at any one time." (BtS p.191) "If seven out of ten of my stocks perform as expected, then I'm delighted. If six out of ten of my stocks perform as expected, then I'm thankful. Six out of ten is all it takes to produce an enviable record of Wall Street." (OneUp p.61-2)

"Devote at least an hour a week to investment research. Adding up your dividends and figuring out your gains and losses doesn't count." (OneUp p.235)

"The biggest losses in stocks come from companies with poor balance sheets. Always look at the balance sheet to see if a company is solvent before you risk your money on it." (BtS p.192) Value Line [available at most large libraries] is easier to read than a balance sheet, so if you've never looked at any of this, start there.... It rates companies for financial strength on a simple scale of 1 to 5, giving you a rough idea of a company's ability to withstand adversity." (OneUp p.196)

Warren Buffett: "The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd." Buffett quotes his mentor Benjamin Graham: "You're neither right nor wrong because other people agree with you. You're right because your facts are right and your reasoning is right."

Warren Buffett: "What we do is not beyond anybody else's competence. It is just not necessary to do extraordinary things to get extraordinary results." (Hagstrom p.257) Warren Buffett: "I don't look to jump over 7-foot bars; I look around for 1-foot bars that I can step over."

Warren Buffett: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

"The best business to own ... is a franchise. A franchise is a business that sells a product or service that is needed or desired, that has no close substitute, and whose profits are not regulated.... The worst business to own is a commodity business. A commodity business sells products or services that are indistinguishable from competitors." (Hagstrom p.261) "Commodity businesses, generally, are low-returning businesses and 'prime candidates for profit trouble.' Since their product is basically no different from anyone else's, they can only compete on the basis of price, cutting into profit margins severely." (Hagstrom p.79) "Generally most businesses fall somewhere in between.... Coca-Cola would be considered a weak franchise in this country. But internationally, particularly in markets where there is no close substitute, Coca-Cola has a strong franchise.... One advantage to owning a franchise is that a franchise can endure management incompetence and still survive, whereas in a commodity business, management incompetence is lethal." (Hagstrom p.261)

The Stock Picker Should Employ Fundamental Analysis, Not Technical Analysis -- Warren Buffett: "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer" and "If past history was all there was to the game, the richest people would be librarians." Peter Lynch: "Charts are great for predicting the past."

"In the summation of The Intelligent Investor Benjamin Graham wrote, 'Investing is most intelligent when it is most businesslike.' These words are, Buffett says, 'the nine most important words ever written about investing.'" (Hagstrom p.97)

"Managerial ability may be important, but it's quite difficult to assess. Base you purchases on the company's prospects, not on the president's resume or speaking ability." (OneUp p.235) Peter Lynch: "Go for a business that any idiot can run because sooner or later, any idiot probably is going to run it."

"Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether." (BtS p.192) "If you have the stomach for stocks, but neither the time nor the inclination to do the homework, invest in equity mutual funds." (BtS p.193) "Buffett believes that unless you can watch your stock holdings decline by 50 percent without becoming panic-stricken, you should not be in the stock market." (Hagstrom p.53)

"Nine to ten percent a year is the generic long-term return for stocks, the historic market average. You can get ten percent, over time, by investing in a no-load mutual fund that buys all 500 stocks in the S&P Index, thus duplicating the average automatically. That this return can be achieved without your having to do any homework, or spending any extra money, is a useful benchmark against which you can measure your own performance, and also the performance of the managed equity funds.... If after three to five years or so you find that you'd be just as well off if you'd invested in the S&P 500, then either buy the S&P 500 or look for a managed equity fund with a better record.... Given all the convenient alternatives, to be able to say that picking your own stocks is worth the effort, you ought to be getting a 12-15 percent return, compounded over time." (OneUp p.240)

"I've heard people say they'd be satisfied with a 25 or 30 percent annual return from the stock market! Satisfied? At that rate they'd soon own half the country.... In certain years you'll make your 30 percent, but there will be other years when you'll only make 2 percent, or perhaps you'll lose 20.... If you expect to make 30 percent year after year, you're more likely to get frustrated at stocks for defying you, and your impatience may cause you to abandon your investments at precisely the wrong moment. Or worse, you may take unnecessary risks in the pursuit of illusory payoffs. It's only by sticking to a strategy through good years and bad that you'll maximize your long-term gains." (OneUp p.239-40)

"All these pitfalls notwithstanding, the individual investor who manages to make, say 15 percent over ten years when the market average is 10 percent has done himself a considerable favor. If he started with $10,000, a 15 percent return will bring a $40,455 result, and a 10 percent return only $25,937." (OneUp p.241)

Warren Buffett: "The most common cause of low prices is pessimism -- sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer." (Hagstrom p.54) Hence, Warren Buffet's maxim: "Be fearful when others are greedy, and be greedy when others are fearful." The best time to find bargains in stocks is during an economic recession or market correction. "If you can summon the courage and presence of mind to buy during these scary episodes when your stomach says 'sell,' you'll find opportunities that you wouldn't have thought you'd ever see again." (OneUp p.250) Warren Buffett: "I made by far the best buys I've ever made in my lifetime in 1974. And that was a time of great pessimism and the oil shock and stagflation and all those sorts of things. But stocks were cheap."

The Stock Picker Should Ignore Macroeconomic Events -- Warren Buffett: "We have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist." (Hagstrom p.231) Warren Buffett: "If [the U.S.] Fed Chairman were to whisper to me what his monetary policy was going to be over the next two years, it wouldn't change one thing I do." (Hagstrom p.56)

"In spite of all the great and minor calamities that have occurred this century -- all the thousands of reasons that the world might be coming to an end -- owning stocks has continued to be twice as rewarding as owning bonds. Acting on this bit of information will be far more lucrative in the long run than acting on the opinion of 200 commentators and advisory services that are predicting the coming depression." (OneUp p.43)

"Recently I read that the price of an average stock fluctuates 50 percent in an average year.... If you're the kind of buyer who cant resist getting in at $50, buying more at $60 ("See, I was right, that sucker is going up"), and then selling out in despair at $40 ("I guess I was wrong. That sucker's going down") then no shelf of how-to books is going to help you." (OneUp p.71)

"A price drop in a good stock is only a tragedy if you sell at that price and never buy more. To me, a price drop is an opportunity to load up on bargains from among your worst performers and your laggards that show promise. If you can't convince yourself 'When I'm down 25 percent, I'm a buyer' and banish forever the fatal thought 'When I'm down 25 percent, I'm a seller,' then you'll never make a decent profit in stocks." (OneUp p.246)

"When people say, 'Look, in two months it's up 20 percent, so I really picked a winner,' or 'Terrible, in two months it's down 20 percent, so I really picked a loser,' they're confusing prices with prospects." (OneUp p.275-6)

"The true investor welcomes volatility. You love the idea of wild swings because it means more things are going to get mispriced. A wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses." --Warren Buffett

"Before you buy a stock, you might want to track its P/E ratio back through several years to get a sense of its normal levels. (New companies, of course, haven't been around long enough to have such records.) If you buy Coca-Cola, for instance, it's useful to know whether what you're paying for the earnings is in line with what others have paid for earnings in the past. The P/E ratio can tell you that. (Value Line is a good source for P/E histories.)" (OneUp p.165) [You can also find P/E histories at -- type in the stock symbol -- click on: Valuation]

"The P/E ratio of any company that's fairly priced will equal its growth rate in net earnings [a.k.a., net income].... [You can calculate a company's historical growth rate] ... by taking the annual earnings from Value Line or an S&P report and calculating the percent increase in earnings from one year to the next...." (OneUp p.198) [ has a 10-year history of net earnings -- type in the stock symbol -- click on: 10-Year Summary. Another good source is, which gives earnings growth, as well as revenue growth, over 1, 3 and 5 year periods -- type in the stock symbol -- click on: Company Profile/Growth Rates] If the P/E of Coca-Cola is 15, you'd expect the company to be growing at about 15 percent a year. A company, say, with a growth rate of 12 percent a year and a P/E ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a P/E ratio of 12 is an unattractive prospect and headed for a comedown. In general, a P/E ratio that's half the growth rate is very positive, and one that's twice the growth rate is very negative. We use this measure all the time in analyzing stocks for the mutual funds." (OneUp p.198)

"All else being equal, a 20-percent grower selling at 20 times earnings (a P/E of 20) is a much better buy that a 10 percent grower selling at 10 times earnings (a P/E of 10).... It's all based on the arithmetic of compounded earnings.... 20-percent growers produce huge gains in the market, especially over a number of years. It's no accident that the Wal-Marts and the Limiteds can go up so much in a decade." (OneUp p.219-20)

"Much has been made of Buffett's metamorphosis ... from 'value' stocks to 'growth' companies. To Buffett, the growth/value distinction has always been illusory. He sees the growth potential of a business as a component of its value. At a price, Coca-Cola's potential represents good value; at some higher price, it does not. The point is that Buffett views all investing, and all that he has ever attempted, as 'value investing....' [Buffett asks] 'What is 'investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value -- in the hope that it can soon be sold for a still-higher price -- should be labeled speculation....'" (Lowenstein p.417)

"Market levels do not stop Buffett from making purchases. Although high general market prices might diminish the number of attractive bargains outstanding, they will not prevent Buffett from buying a company that he finds attractive. However, when market prices are down and pessimism is up, the number of attractive bargains increases." (Hagstrom p.52)

"I'm always more depressed by an overpriced market in which many stocks are hitting new highs every day than by a beaten-down market in a recession. Recessions, I figure, will always end sooner or later, and in a beaten-down market there are bargains everywhere you look, but in an overpriced market it's hard to find anything worth buying." (BtS p.47)

"The trouble with the Dr. Feelgood method of picking stocks is that people invariably feel better after the market gains 600 points and stocks are overvalued and worse after it drops 600 points and the bargains abound." (BtS p.42)

"The way you'll know when the market is overvalued is when you can't find a single company that's reasonably priced, or that meets your other criteria for investment." (OneUp p.80) "If no company seems attractive on the fundamentals, you can avoid stocks altogether and wait for a better opportunity." (OneUp p.51)

"If you know why you bought a stock in the first place you'll automatically have a better idea of when to say good-bye to it." (OneUp p.256)

"Insider buying is a positive sign, especially when several individuals are buying at once." (OneUp p.235) "There's no better tip-off to the probable success of a stock than that people in the company are putting their own money into it. In general, corporate insiders are net sellers, and they normally sell 2.3 shares to every one share that they buy.... Although its a nice gesture for the CEO or the corporate president with the million-dollar salary to buy a few thousand shares of the company stock, it's more significant when employees at the lower echelons add to their positions.... There are many reasons that officers might sell. They may need the money to pay their children's tuition or to buy a new house or to satisfy a debt. They may have decided to diversify into other stocks. But there's only one reason that insiders buy: They think the stock price is undervalued and will eventually go up." (OneUp p.134-6) [Insider buying/selling records can be found at:]

If you are interested in a company because of a particular product, find out what percent of sales that product represents. If the percent of sales is large, the product is important to the company. If the percent of sales is small, the product wont have much effect on a company's prospects. (OneUp p.97-8)

"It's usually a good thing when a company buys back its shares, as long as it can afford to do so. Conversely, it's a bad thing when a company increases the number of shares. This has the same result as a government printing more money; it cheapens the currency." (BtS p.116) [ has a 10-year history of shares outstanding -- type in the stock symbol -- click on: Financials/10-Year Summary]

"IPOs of brand-new enterprises are very risky because there's so little to go on. Although I've bought some that have done well over time ... I'd say three out of four have been long-term disappointments. What I try to remind myself (and obviously I'm not always successful) is 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?" (OneUp p.152)

Don't Over-Diversify

"There's no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors. That said, it isn't safe to own just one stock, because in spite of your best efforts, the one you choose might be the victim of unforeseen circumstances. In small portfolios, I'd be comfortable owning between three and ten stocks." (OneUp p.242) "There's no pat way to quantify these risks and rewards, but in designing your portfolio, you might throw in a couple of stalwarts just to moderate the thrills and chills of owning four fast growers...." (OneUp p.244)

Warren Buffett: "If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense to you." (Hagstrom p.266)

The Check Up

"Every few months, it's worthwhile to recheck the company story. This may involve reading the latest Value Line, or the quarterly report, and inquiring about the earnings and whether the earnings are holding up as expected. It may involve checking the stores to see that the merchandise is still attractive, and that there's an aura of prosperity." (OneUp p.223) "As a stock picker, you are trying to get answers to two basic questions: (1) is the stock still attractively priced relative to earnings, and (2) what is happening in the company to make the earnings go up?" (BtS p.197)

"There are five basic ways a company can increase earnings: reduce costs; raise prices; expand into new markets; sell more of its product in the old markets; or revitalize, close, or otherwise dispose of a losing operation. These are the factors to investigate as you develop the story." (OneUp p.168-9) "Stand by your stocks [i.e., don't sell] as long as the fundamental story of the company hasn't changed." (OneUp p.71)

The Stalwarts

"Most of these are huge companies, and it's unusual to get a tenbagger out of a Bristol-Myers or a Coca-Cola. So if you own a stalwart like Bristol-Myers and the stock's gone up 50 percent in a year or two, you have to wonder if maybe that's enough and begin to think about selling.... Stalwarts are stocks that I generally buy for a 30 to 50 percent gain, then sell and repeat the process with similar issues that haven't yet appreciated." (OneUp p.104-5)

"By successfully rotating in and out of several stalwarts for modest gains, you can get the same result as you would with a single big winner: six 30-percent moves compounded equals a fourbagger plus, and six 25-percent moves compounded is nearly a fourbagger." (OneUp p.246)

"Buffett will sell a fairly valued or undervalued security if he needs the proceeds to purchase something else -- either a business that is even more undervalued or one of equal value that he understands better." (Hagstrom p.100)

"I always keep some stalwarts in my portfolio, because they offer pretty good protection during recessions and hard times." (OneUp p.104) "In general, Bristol-Myers and Kellogg, Coca-Cola and MMM, Ralston Purina and Procter and Gamble, are good friends is a crisis. You know they won't go bankrupt, and soon enough they will be reassessed and their value will be restored." (OneUp p.108)

Cyclical Companies

"A cyclical company is a company whose sales and profits rise and fall in regular, if not completely predictable, fashion. In a growth industry, business just keeps expanding, but in a cyclical industry it expands and contracts, then expands and contracts again." (OneUp p.109) "The autos and the airlines, the tire companies, steel companies, and chemical companies are all cyclicals. Even defense companies behave like cyclicals, since their profits' rise and fall depends on the policies of various administrations." (OneUp p.109)

Normally, the time to buy a cyclical company is during an economic downturn. However, fund managers have come to anticipate economic cycles, which means that the P/E ratios of cyclical companies are often driven up early on. This makes it difficult to determine when to invest in a cyclical. Just as knowing when to buy a cyclical is problematic, so is knowing when to sell a cyclical. Unwary investors usually sell too late because earnings are still good; they are further fooled by a drop in the P/E ratio, a result of smart investors heading for the exits. Smart investors realize that business will soon slow along with earnings. "As more investors head for the exits, the stock price will plummet." (BtS p.140)

"It is perilous to invest in a cyclical without having a working knowledge of the industry." (BtS p.141) "If you work in some profession that's connected to steel, aluminum, airlines, automobiles, etc., then you've got your edge, and nowhere is it more important than in this kind of investment." (OneUp p.112)

"Coming out of a recession and into a vigorous economy, the cyclicals flourish, and their stock prices tend to rise much faster than the prices of the stalwarts.... But going the other direction, the cyclicals suffer, and so do the pocketbooks of the shareholders. You can lose more that fifty percent of your investment very quickly if you buy cyclicals in the wrong part of the cycle, and it may be years before you'll see another upswing." (OneUp. p.112)

"It's much easier to predict an upturn in a cyclical industry than it is to predict a downturn." (OneUp p.231)

Should you choose to invest in a cyclical, one of the most important questions to ask "is whether a company's balance sheet is strong enough to survive the next economic downturn." (BtS p.143) "A normal corporate balance sheet has 25 percent debt and 75 percent equity [1:3 ratio].... A weak balance sheet, on the other hand, might have 80 percent debt and 20 percent equity [4:1 ratio]. The debt-to-equity ratio is easy to determine." D/E = Debt(Liabilities)/Equity (OneUp p.201) [ has a 10-year history of Debt/Equity -- type in the stock symbol -- click on: Fundamentals/Key Ratios/10-Year Summary]

Bank debt (which can also be commercial paper) is worse than funded debt (usually regular corporate bonds with long maturities). With bank debt, the lender can ask for its money back at the first sign of trouble. "Funded debt gives companies time to wiggle out of trouble. In one of the footnotes of a typical annual report, the company gives a breakdown of its long-term debt, the interest that is being paid, and the dates that the debt it due." (OneUp p.202-3)

Sometimes a cyclical company's cash flow, even during bad times, exceeds its capital spending. If this is the case, it's a good sign for the company. Indeed, it's capital spending that has ruined many industrial companies. (BtS p.145) To determine whether a company's cash flow exceeds its capital spending, go to a company's cash flow statement and find net earnings. To net earnings, add depreciation, depletion, and amortization charges to get cash flow from operations. Next take cash flow from operations and subtract capital expenditures to get free cash flow (a.k.a., owner earnings). Free cash flow = Cash flow from operations - Capital expenditures [ has a 10-year history of free cash flows -- type in the stock symbol -- click on: Financials/Cash Flow/10 Years]

One Cyclical Industry that is Easier to Evaluate than Most is the Autos

"The autos, often misidentified as blue chips, are classic cyclicals. Buying an auto stock and putting it way for 25 years is like flying over the Alps -- you may get something out of it, but not as much as the hiker who experiences all the ups and downs." (BtS p.146-7) [Along with the other auto companies] Ford stock fluctuates wildly as the company alternately loses billions of dollars in recessions and makes billions of dollars in prosperous stretches. If a stalwart such as Bristol-Myers can lose half its value in a sorry market and/or a national economic slump, a cyclical such as Ford can lose 80 percent. That's just what happened to Ford in the early 1980s. You have to know that owning Ford is different from owning Bristol-Myers." (OneUp p.112)

"When used-car prices are on the rise, it's a sign of good times ahead for the automakers. An even more reliable indicator is 'units of pent-up demand' [information available of the Internet]. After four or five years when sales are under the trend, it takes another four or five years of sales above the trend before the car market catches up. Timing the auto cycles is only half the battle. The other half is picking the auto companies that will gain the most on the upturn. If your right about the industry and wrong about the company, you can lose money just as easily as if you're wrong about the industry." (BtS p.147-9)

"The worse the slump in the auto industry, the better the recovery. Sometimes I root for an extra year of bad sales, because I know it will bring a longer and more sustainable upside." (OneUp p.231)

The Fast Growers

"These are among my favorite investments: small, aggressive new enterprises that grow at 20 to 25 percent a year. If you choose wisely, this is the land of the 10- to 40-baggers, and even the 200-baggers.... A fast-growing company doesn't necessarily have to belong to a fast-growing industry. All it needs is the room to expand within a slow growing industry." (OneUp p.108)

"The best place to begin looking for the [fast grower] is close to home -- if not in the backyard, then down at the shopping mall and, especially, wherever you happen to work." (OneUp p.83)

"There's plenty of risk in fast growers, especially in the younger companies that tend to be overzealous and under financed. When an under financed company has headaches, it usually ends up in Chapter 11.... I look for the ones that have good balance sheets and are making substantial profits." (OneUp p.109)

"[With a fast grower] as long as same-store-sales are on the increase, the company is not crippled by excessive debt, and is following its expansion plans as described in its reports, it usually pays to stick with the stock." (BtS p.65) "If between two fast growers I find that the price of one has increased 50 percent and the story begins to sound dubious, I'll rotate out of that one and add to my position in the second fast grower whose price has declined or stayed the same, and where the story is sounding better." (OneUp. p.246)

"There are three phases to a growth company's life: the start-up phase, during which it works out the kinks in the basic business; the rapid expansion phase, during which it moves into new markets; and the mature phase, also known as the saturation phase, when it begins to prepare for the fact that there's no easy way to continue to expand. Each of these phases may last several years. The first phase is the riskiest for the investor, because the success of the enterprise isn't yet established. The second phase is the safest, and also where the most money is made, because the company is growing simply by duplicating its successful formula. The third phase is the most problematic, because the company runs into its limitations. Other ways must be found to increase earnings. As you periodically recheck the stock, you'll want to determine whether the company seems to be moving from one phase into another." (OneUp p.223-4)

"Sooner or later every popular fast-growing industry becomes a slow-growing industry, and numerous analysts and prognosticators are fooled. There's always a tendency to think that things will never change, but inevitably they do." (OneUp p.101)

"Wall Street does not look kindly on fast growers that run out of stamina and turn into slow growers, and when that happens, the stocks are beaten down accordingly.... The trick is figuring out when they'll stop growing, and how much to pay for the growth." (OneUp p.109)

"Another sure sign of a slow grower is that it pays a generous and regular dividend.... Companies pay generous dividends when they can't dream up new ways to use the money to expand the business. This doesn't mean that by paying a dividend the corporate directors are doing the wrong thing. In many cases it may be the best use to which the company's earnings can be put." (OneUp. p.101) Indeed, paying a dividend is much preferred to a company using its cash to embark on diversification schemes (or as Peter Lynch calls it "diworseification" schemes) -- a strategy that usually leads to a decline in profitability. (OneUp p.146-50)

The Restaurant Stocks

"As long as Americans continue to eat 50 percent of their meals outside the home, there will be new 20-baggers showing up ... and the observant diner will be able to spot them." (BtS p. 190)

"A restaurant chain, like a retailer, has 15-20 years of fast growth ahead of it as it expands." (BtS p.188)

For a restaurant chain: "You'd like to see the same store sales increasing every quarter. The growth rate should not be too fast -- above 100 new outlets a year, the company is in a potential danger zone. Debt should be low to nonexistent, if possible." (BtS p.189)

     Advantages of Restaurant Stocks:

--Easy to Understand: "If it's a choice between investing in a state-of-the-art computer chip and the state-of-the-art bagel, I'll take the bagel any time." (BtS p.190) "During a lifetime of eating donuts or buying tires, I've developed a feel for the product line that I'll never have with laser beams or microprocessors." (OneUp p.122) Or, to paraphrase Warren Buffett: Invest only in companies you understand. "To date, Buffett has not owned a technology company; he admits he would be unable to understand the company well enough to make an informed judgment." (Hagstrom p.64)

--Homogeneity of Culture: "What sells in one town is almost guaranteed to sell in another.... You can wait for a chain of stores to prove itself in one area, then take its show on the road and prove itself in several different areas, before you invest." (BtS p.58) Once proven, "the expansion into new markets results in the phenomenal acceleration in earnings that drives the stock price to giddy heights." (OneUp p.109)

--Easy to Monitor Progress: "We all know which places are popular and well maintained, which are disheveled and passe, which have reached the saturation point and which have room to grow." (BtS p.58, p.187)

The restaurant business is typically thought of as highly competitive, but a fledgling restaurant company is protected from competition in a couple of ways. "If there's a new fish-and-chips chain in California and a better one in New York, what's the impact of the New York chain on the California chain? Zero.... [Moreover] Dennys or Pizza Hut never has to worry about low-cost Korean imports." (BtS p.188)

"Any time you can find a 25 percent grower selling for 20 times earnings, it's a buy. If the price dropped any further, I'd back up the truck." (BtS p.190)

     Red Flags:

"When a company tries to open more than 100 new units, it's likely to run into problems. In its rush to glory, it can pick the wrong sites, or the wrong managers, pay too much for the real estate and fail to properly train the employees. Slow but steady may not win the Indianapolis 500, but it wins this kind of race." (BtS p.188)

The Retail Stocks

     Advantages of Retail Stocks -- Largely the Same as Restaurant Stocks:

--Easy to Understand

--Homogeneity of Culture

--Easy to Monitor Progress

     Red Flags:

--Keep an Eye on Inventories: "There's a detailed note on inventories in the section called 'management's discussion of earnings' in the annual report. I always check to see if inventories are piling up. With a manufacturer or a retailer, an inventory buildup is usually a bad sign. When inventories grow faster than sales, it's a red flag." (OneUp p.215) "Companies must now publish balance sheets in their quarterly reports to shareholders, so that the inventory numbers can be regularly monitored." (OneUp p.217) "When inventories increase beyond normal levels, it is a warning sign that management may be trying to cover up the problem of poor sales." (BtS p.70)

--Keep an Eye on Debt: Heavily indebted retailers frequently go out of business during recessions. (BtS p.70). You want to see at least twice as much equity as debt. (BtS p.78-9)

November and December are Good Months to Look for Bargains in Small Caps

Reason: Annual tax loss selling by disheartened investors along with an extended holiday period. With extra time to worry, investors often become bearish on stocks, especially small caps. (BtS p.39, p.48) "Institutional investors also like to jettison the losers at the end of the year so their portfolios are cleaned up for the upcoming evaluations." (OneUp p.250) "If you have a list of companies that you'd like to own if only the stock price were reduced, the end of the year is a likely time to find the deals you've been waiting for." (OneUp p.250)

Bargains in small caps in November and December are reflected in the later "January effect" where, over the last 60 years, small caps have rebounded an average of 6.86% in January, compared to only 1.6 percent to stocks in general. (BtS p.48)

When Growth Stocks Become Over-Priced

"Any growth stock that sells for 40 times its earnings for the upcoming year is dangerously overpriced and in most cases extravagant." (BtS" p.63) "In 1972, McDonald's was the same great company it had always been, but the stock was bid up to $75 a share, which gave it a P/E of 50. There was no way that McDonald's could live up to those expectations, and the stock price fell from $75 to $25, sending the P/E back to a more realistic 13. There wasn't anything wrong with McDonald's. It was simply overpriced at $75 in 1972." (OneUp p.165-6)

However, "selling an outstanding fast grower because its stock seems slightly overpriced is a losing technique." (OneUp p.293)

"Sometimes the market will quickly confirm Buffett's judgment that a company is a good investment. When that happens he is not compelled to sell just because of short-term appreciation.... Buffett says that he is 'quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.' If the stock market does significantly overvalue a business, [Buffett] will sell." (Hagstrom p.99-100)

"The best way to handle a situation in which you love the company, but not the current price, is to make a small commitment and then increase it in the next sell-off." (BtS p.64)

Evaluating Management Performance

Return on equity is a great overall gauge of a company's profitability, because it measures how efficient the company is at earning a decent return on shareholder money. (Dorsey p.87-8) Buffett says: "The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry etc.)...." (Hagstrom p.87-8) [To calculate return on equity, divide net income (from the income statement) by owners' equity (from the balance sheet); or go to -- type in the stock symbol -- click on: Fundamentals/Key Ratios/10-Year Summary]

"As a rule of thumb, firms that are able to consistently post ROE above 15 percent are generating solid returns on shareholder's money.... And if you can find a company with the potential for consistent ROEs over 20 percent, there's a good chance you're really on to something." (Dorsey p.24, p.90) [Note: The long-term average return on equity of an American business is 12 percent] (Hagstrom p.160) There are "three levers that can boost ROE -- net margins, asset turnover, and financial leverage [i.e. taking on debt].... Unlike net margin and asset turnover -- for which higher ratios are almost unequivocally better -- financial leverage is something you need to watch carefully. As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster." (Dorsey p.89) Buffett says: "Good business or investment decisions will produce quite satisfactory economic results with no aid from leverage. Furthermore, highly leveraged companies are vulnerable during economic slowdowns." (Hagstrom p.88) Finally, in calculating ROE, exclude any unusual items from the net income part of the equation, such as capital gains or losses. (Hagstrom p.88)

"High profit margins reflect not only a strong business, but management's tenacious spirit for controlling costs.... Over the years, Buffett has observed that companies with high-cost operations typically find ways to sustain or add to their costs, whereas companies with below-average costs pride themselves on finding ways to cut expenses." (Hagstrom p.263-4) "There's not much to be gained in comparing pretax profit margins across industries, since the generic numbers vary so widely. Where it comes in handy is comparing companies within the same industry...." (OneUp p.220) [To calculate pretax profit margin, take annual sales (from the income statement) and subtract all costs, including depreciation and interest expenses to get income before tax. Then divide income before tax by net sales (a.k.a., net revenue) to get pretax profit margin; or go to -- type in the stock symbol -- click on: Fundamentals/Key Ratios/Profit Margin]

My Stock Picks

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