Beating the Street

Fidelity’s legendary manager

To invest effectively, it probably helps to learn as much as possible from the very best investors. Fidelity’s Peter Lynch falls right into this category. During his 13 years as money manager for Fidelity’s Magellan Fund, the fund achieved an annual return of 29% per annum. The S&P500 achieved less than half of that during the same period (between 1977 & 1990). Lucky for us, Peter Lynch has generously described his investment style in his 1993 book Beating the Street. The book offers an educational and accessible introduction into constructing a sound investment portfolio. In this post, we will review some of the lessons we took away from Lynch’s book. This includes what he looks for in investment opportunities, where to go prospecting and how he undertakes investment research.

Buy good companies at reasonable prices

“If you like the store, chances are you’ll love the stock”
Peter Lynch, Beating the Street

Like most value-oriented investors, Peter Lynch likes to buy stocks at reasonable prices in companies whose sales and earnings per share are increasing at attractive rates. Lynch says it is difficult to lose when we buy great companies that trade at 3-6 times earnings. Finding undervalued stocks will usually involve looking for great companies in out of favour industries. Lynch’s favourite companies tend to be low-cost, low-leverage operators that avoid boardroom extravagance and managerial hierarchy. They reject corporate bureaucracy, support their staff well, and capture profitable niches in often overlooked industries.

Avoid overpaying for growth

Lynch’s rule of thumb is to look for stocks that sell at or below its earnings growth rate. This can be thought of as a hurdle rate or margin of safety for selecting stocks with upside relative to its purchasable price. He says if we can find a 25% grower at a P/E ratio of 20 or less, it is most likely a buy. The story is even better if the company is well placed to navigate industry downturns, and has a long runway for expansion.

Peter Lynch feels that any growth stock that sells at price to earnings level of 40 and beyond are typically in extravagant territory. However, he says a company with a high P/E ratio that grows at a high rate will typically outperform a slow-growing company that is available at lower P/E ratio.

Similarly, he says it is important to remain vigilent of companies that report phantom earnings. Some companies will report phantom earnings through acquisitions and asset revaluations. As such, looking at past performance to evaluate stocks can be unreliable sometimes. Management teams and economic conditions can change.

Buy into healthy balance sheet

Peter Lynch chooses companies with healthy balance sheets and favourable prospects, but are not of interest to Wall Street at the time. He likes balance sheets with at least twice as much equity as debt given how problematic high leverage can be at the worst of times. Lynch may make some concessions if the debt is not due for many years and/or not owed to banks.

Lynch also prefers to avoid balance sheets with too much inventory or receivables. This is a potential symptom of deferred losses and an overstatement of earnings. Significant accounts payable is okay if the company is paying its bills slowly and using cash in more effective ways.

The Warren Buffett Way

All things considered, Lynch suggests it is probably more reliable to stay with an investment vehicle that is steady and consistent than to attempt to catch the next wave of investment success. He notes for example that capital gains tax will hurt the investor who switches too much.

Lynch’s philosophy shares strong similarities with another legendary investor, Berkshire Hathaway’s Warren Buffett. In his book The Warren Buffett Way, author Robert Hagstrom describes how Buffett seeks companies with stable long-term economic propsects, strong balance sheets, honest and rational managers, and a stock price well below his estimate of intrinsic value.

Fear invites investment opportunity

“People who prefer bonds do not know what they are missing”
Peter Lynch, Beating the Street

At the time of writing (1993), Lynch notes that stocks have been more rewarding than bonds and cash deposits over the long run. He says you only need to select a handful of high-quality stocks after thoughtful research to be successful. There is of course a lot more to this. In particular, successful investors do not allow their day-to-day worries to dictate strategies or make impulsive decisions.

The key he says is not to get scared out of stocks. We are confronted everyday with news that our economic environment is in turmoil. Common examples include changes in interest rates, oil price shocks, trade-wars, terrorist attacks, financial crisis, environmental disasters and economic recessions.

Post-crisis trauma can cause many to over invest in bonds, money markets and savings accounts. A 30-year treasury bond is only safe for example if we have 30 more years of low inflation. Every bear market that creates a temporary loss in earnings is also an opportunity to buy fantastic companies and bargain prices to intrinsic value.

Focus on the big picture

“When in despair about the big picture, focus on the even bigger picture”
Peter Lynch, Beating the Street

Lynch describes how we might miss out on long-term opportunities if we only pay attention to daily media. Without faith in your investment decision making process, you are more likely to believe temporary headlines and lose discipline in your strategy. It can be worthwhile to invest in the best companies of an industry whose news have transitioned from bad to terrible if the quiet facts tell you otherwise about its long-run prospects. Negative news about an industry is less problematic than news about a company’s struggles relative to thriving competitors. It is for these reasons that value-investor Mohnish Pabrai also likes to look for businesses in tempororarily distressed industries, as he describes in his book The Dhandho Investor.

Follow your investing nose

Lynch believes there are large benefits to having an investment routine that we can apply consistently. With that said, the author himself did not have an overall strategy to investing. He preferred to move between cases as he learned about the merits of each oppoprtunity. Here it is important to note that Lynch focuses on the company and not the stock price. He is interested in understanding the nuances of a company’s growth and earnings story, and less so about whether he is over- or under-weighted in any given sector. Lynch is always looking for new companies that are more undervalued than the holdings he currently owns. Like Warren Buffet, he avoids investing in companies that he does not understand.

Patience is king

“The best stock to buy may be the one you already own”
Peter Lynch, Beating the Street

Peter Lynch endeavours to stick with companies whose prospects are getting better. He cautions against “pulling out the flowers and watering the weeds”. Furthermore, Lynch reminds readers that they should not feel like they are in a rush to buy shares. For example, it is sometimes worthile to wait on distressed investments to provide more clarity on their prospects. Similarly, Lynch believe it is wise to hold cash if we cannot find good companies at good prices. One strategy he suggests to handle overpriced companies we love is to buy a small stake and to increase our commitment only during a major sell-off.

Do your own research

Investing is dangerous without research. Lynch emphasises that it is important to understand the company behind the stock you are buying. Your edge in investing does not depend on Wall Street opinions but you know yourself about a company. Since it is difficult to predict interest rates, economic directions or the stock market, it is more fruitful to focus on companies than on economic forecasts. Again, this is very much like Warren Buffett. It also bares similarities as well to other investors like Howard Marks, that prefers to think about markets in cycles and tendencies than discrete, knowable events.

Nothing beats hardwork

Peter Lynch attributes his success in part to hard work. During his time at Magellan, he would visit more than 200 companies and read around 700 annual reports a year. He would meet with company representatives across industry groups once a month to learn about major developments and turnarounds, and potential facts overlooked by Wall Street. Lynch also likes to ask managers about competitors that they respect the most. It is a strong endorsement when a CEO that reveals positive information about a competitor.

Record all your ideas

Lynch keeps a notebook with two-sentence summaries of company stories observed and his reasons for buying, avoiding and selling any holding. Otherwise it is difficult to remember and review a company’s story and our decisions. Additionally, Lynch notes that the time spent on research is proportional to the number of stocks you own. It takes Lynch several hours a year to keep tabs on each company. This includes a review of annual and quarterly reports, and callings for regular updates. This is manageable for a hobby investors with around five stocks in their portfolio. For a small to medium sized fund, this could be a nine-to-five job. By contrast, for a large fund with many holdings, this could become a 60 to 80-hour week.

Looking for grub

Lynch parallels the search process to looking for grubs under rocks. For every 10 rocks we turn over, we are likely to find one grub. The hobby stock picker does not need 100 winning stocks, but only a handful of big winners in a decade to make his or her investment process worthwhile. Similarly, for every 10 inquiries at 10 different companies he made, he would discover at least 1 development that was unexpected.

Passing the 90 second test

“Never invest in any idea you cannot illustrate with a crayon”
Peter Lynch, Beating the Street

This is a short, simple but critical idea that resonated strongly with us. Peter Lynch emphasises that if you are going to invest in a company, you should be able to explain, in simple language and in 90 seconds, why you are buying that stock. He says you need to know whether your stocks are priced attractively relative to earnings, how company earnings are likely to change and why. You also need to understand the company’s financial strength and debt structure to see if the company can navigate unexpected down-turns or surprises. Since investing in companies that we know little about is dangerous, we should hold no more stocks than we can remain informed about. He emphasises that those without interest or time to undertake research should refrain from stock selecting themselves.

Reviewing the story

“A sure cure for taking a stock for granted is a big drop in the stock price”
Peter Lynch, Beating the Street

Since investments are not disconnected events, we have to review them regularly to ascertain whether the next few years for the company is likely to be better or worse than its preceding years (and why). Lynch says if we cannot identify any good reasons for the company, than we should ask why we continue to own the stock. He also says that there is always something to worry about when investing. Lynch emphasises that successful investors must know the company’s story better than their peers and hold faith when the crowd turns against you. Such contrarian investors must be able to avoid extreme pessimism or optimism, and reacting emotionally as the company’s story changes with time.

Peter Lynch tells us that there are no guarantees or formulas to investing. You can never be certain that an investment will reward you, regardless of how well you understand the company and its underlying story. However, he believes it is possible to make good decisions with favourable odds through effort and thoughtfulness.

Beating the Street – Peter Lynch on his investment approach