When it comes to understanding the intricacies of falling stocks, few have the insight and expertise of Peter Lynch. In this article, we delve deep into the wisdom of this investment maestro, uncovering the principles that have guided his decisions in the tumultuous world of stock trading. Whether you’re a seasoned trader or just starting, Lynch’s rules provide invaluable guidance on navigating the often unpredictable waters of declining stocks. Join us as we explore these three cardinal rules and learn how to approach falling stocks with a discerning eye and a strategic mindset.
Peter Lynch’s three rules for falling stocks:
- Don’t Buy Based on Price Alone: Just because a stock’s price has dropped significantly doesn’t automatically make it a good investment. A decline in price doesn’t necessarily indicate value.
- Understand the Company Before Investing: Before purchasing a stock, especially one that has seen a significant decline, it’s crucial to understand the company’s financial health, its business model, and the reasons behind its stock’s decline.
- Avoid the “It’ll Bounce Back” Mentality: Not all declining stocks will recover. Making investment decisions based on the hope or assumption that a stock will return to its previous highs can be a grave mistake. Instead, base decisions on solid research and understanding of the company’s prospects.
Peter Lynch On Stock Investing
The following is a transcript from a talk legendary hedge fund Peter Lynch gave.
“One of the things I find — a rule, a couple of rules I want to throw out that I find useful — excuse me, is a lot of times people buy on the basis the stock has gone down this much. ‘You know, how much further can it go down?’ I remember when Polaroid went from 130 to 100, people said, ‘Here’s this great company, great record. If it ever gets below 100, just buy every share.’ And it did get below 100, and a lot of people bought on that basis, saying, ‘Look, it’s gone from 135 to 100. It’s now 95. What a buy!’ Within a year, it was 18. And this company, with no debt — I mean, as a company, it was just so overpriced — it went down.
I did the same thing in my first or second year at Fidelity. Kaiser Industries had gone from 26 a share to 16. I said, ‘How much lower can it go? It’s 16.’ So, I think we bought one of the biggest blocks ever on the New York or the American Stock Exchange of Kaiser Industries at 14. I said, ‘You know, it’s gone from 26 to 16. How much lower can it go?’ Well, at 10, I called my mother and said, ‘Mom, you’re going to look at this Kaiser Industries. I mean, how much lower can it go? It’s gone from 26 to 10.’ Well, it went to six, it went to five, it went to four, it went to three. And now, I unfortunately acted rapidly — I would probably still be caddying or working at the Stop & Shop — but it happened fast. I was able to realize at three, ‘You know, there’s something very wrong here.’ Because Kaiser Industries owns 40% of Kaiser Steel, they own 40% of Kaiser Aluminum, they owned 32% of Kaiser Cement, they own Kaiser Broadcast, they own Kaiser Sand & Gravel, Kaiser Engineers, they own Jeep, they own business after business, and they had no debt.
Now, I learned this very early: this might be a breakthrough for some people. It’s very hard to go bankrupt if you don’t have any debt. It’s tricky. Some people approach that. It’s a real achievement. But they had no debt, and the whole company at three was selling at about 75 million. At that point, it was equal to buying one Boeing 747. I said, ‘There’s something wrong with this company selling for 75 million.’ I was a little premature at 16, but I said everything’s fine, and eventually, this worked out. And what they did is they gave away all their shares to their shareholders. They passed out shares in Kaiser Cement, they passed out shares in Kaiser Aluminum; they passed out their public shares in Kaiser Steel. They sold all the other businesses, and you got about fifty dollars a share.
But if you didn’t understand the company, if you were just buying on the fact the stock had gone from 26 to 16 and then it got to 10, what would you do when it went to nine? What would you do when it went to eight? What would you do when it went to seven? This is the problem that people have: they sell stocks because they didn’t know why they bought it. Then it went down, and they don’t know what to do now. Do you flip a coin? Do you walk around the block? What do you do? Psychiatrists haven’t worked so far. I’ve never seen them running the Psychiatry Fund. I’ve never seen this listed with the SEC to make it through as a mutual fund. So, they haven’t seemed to help. I’ve tried prayer, that hasn’t worked.
So, if you don’t understand the company, you have this problem when they go down. ‘Eventually, they always come back.’ This one doesn’t work either. People think RCA just about got back to its 1929 high when General Electric took it over. A lot of double knits never came back. Remember those beauties? Floppy disks, Western Union, the list goes on and on. People saying, ‘It’ll come back.’ Well, it doesn’t have to come back.
Here’s another one you hear all the time: ‘It’s three dollars. How much can I lose?’ I’ve had people call me up saying, ‘I’m thinking of buying a stock at three. How much can I lose?’ Well, again, you may need a piece of paper for this, but if you put twenty thousand dollars in a stock at fifty or your neighbor put twenty thousand at fifty into the stock, and you put twenty thousand dollars into it at three, and it goes to zero, you lose exactly the same amount of money: everything. People say, ‘It’s three. How much can I lose?’ Well, if you put a million dollars on it, you can lose a million dollars. Just the fact that it’s three, down from 100, doesn’t mean you should buy it.
In fact, short sellers, people that really make money in stocks, they don’t short Walmart, they don’t short Home Depot, they’re not shorting the great companies like Johnson & Johnson. They short stocks down from 80 to 7. They’d like to short it at 16 or 22, but they’ve figured out at seven, ‘This company is going to go to zero. They just haven’t blown taps on this thing yet. It’s going to zero.’ And they’re selling short at seven; they’re selling short at six, at five, at four, at three, at two, at one and a quarter. And you know, to sell something short, you need a buyer. Somebody has to buy the damn thing. And you wonder, who’s buying this thing? It’s these people saying, ‘It’s three. How much lower can it go?'” 
- Avoid Assumptions Based on Price Alone: Just because a stock has plummeted doesn’t automatically make it a good buy. A low price isn’t an indicator of value; cash flow and assets do.
- Understand Your Investments: Before purchasing, understand the company and its financial health deeply. Stocks decline for various reasons, and not all will recover.
- Beware of the “It’ll Bounce Back” Mentality: Not all stocks rebound. Relying on past highs or assuming that a stock will return to its former glory can be costly.
- Debt Matters: Companies without significant debt have a lower risk of bankruptcy. It’s essential to consider a company’s financial obligations before investing.
- Short Sellers’ Insight: Observing the behavior of short sellers can provide valuable insights. They often target companies they believe will continue to decline, even if the stock price is already low.
Investing in stocks requires more than just observing price trends. Peter Lynch’s insights emphasize the importance of thorough research and understanding the underlying factors influencing a stock’s price. Falling stock prices can be tempting, but investors risk significant losses without a comprehensive understanding of the company’s health and the reasons for its decline. It’s crucial to approach such investments with caution, knowledge, and a clear strategy rather than relying on hopeful assumptions.