Princeton professor Burton Malkiel is the author of the best-selling classic A Random Walk Down Wall Street, now in its eighth revised printing. Malkiel recently chatted with David and Tom Gardner on The Motley Fool Radio Show. We weren't able to broadcast their whole discussion, so we're publishing it in its entirety here, exclusively on Fool.com. Join us May 5-9 to read a new portion of their conversation each day.
TMF: In your book, you lay out some rules for buying stocks. We'd like to have you elaborate a little bit on each of them. Rule No. 1: Buy only companies that are expected to have above-average earnings growth for five years or more.
Malkiel: Well, there is no question about the fact that if you look at the individual stocks that over the long pull have given investors the best returns, they have been stocks like Microsoft
TMF: Rule No. 2: Never pay more for a stock than its firm foundation of value.
Malkiel: What I mean by that is even if you incorrectly thought in 1999 and early 2000 that the Internet was going to be the best thing since night baseball, that everybody was going to go shopping on the Internet, you still would have limited your risk.
What I recommend is that you do not buy very high multiple stocks. By that I mean stocks that are selling at a price/earnings multiple that is very much above that of the market. The market multiple today is somewhere in the vicinity of 20. Maybe for a big growth stock you could pay 25, but during the Internet craze, you had companies like Cisco Systems
TMF: Rule No. 3: Look for stocks whose stories of anticipated growth are the kind on which investors can build castles in the air.
Malkiel: The stock market is not only logical, but also psychological. There is no question about the fact that you will be better off if you get some kind of a stock that really begins to grow and has a story that people will like to talk about so that it will in fact get recognized in the market.
You see, what I like to do is find stocks that I think are going to grow much more than the economy, but that might be selling at price/earnings multiples that are below the market. Then when this gets recognized and the story catches on, not only will you have high returns because of the growth of earnings, but the multiple will expand as well and you will get a double bonus.
What I say on the other side, which goes back to Rule 2, is be very careful of those stocks that have already caught on and that everybody wants and that sell at unusually high multiples because then, as what happened with Cisco, once the earnings don't come through, the stock goes down not only because the earnings go down, but because the multiple collapses as well.
TMF: If you would, walk us through how you would research a company like Krispy Kreme
Malkiel: Well, I tell you what I think I would do on Krispy Kreme. I am not a fan of Krispy Kreme, and I am not a fan for the following reasons. When I say look for stocks that can sustain high rates of growth, I want them to sustain those high rates of growth not only for a few years, but for decades. I worry a lot about stocks that are very popular because they make some sort of fashion product and the fashion product is in vogue now, or they make some kind of food product that everybody loves because I worry that a stock like that, even though it has had a superb record, cannot sustain that kind of rate of growth. And people are very fickle. You know, at some point they may say, hey, these are high cholesterol. They may be delicious, but maybe I ought to stop eating so many. So, I am not a fan of Krispy Kreme.
Wednesday in part three: Malkiel talks about dot-coms and the best mutual funds.