Master Class in Investing with Peter Lynch

Value investing – Lessons investing and for Business

Peter Lynch ran the Fidelity Magellan Fund for more 20 years, during which time Magellan was the number one ranked general equity fund in America. His books One Up on Wall Street and Beating the Street are filled with his accumulated wisdom and in Beating the Street he gives a fairly detailed account of how he did his analysis.

The first thing that will strike new investors as strange is that Lynch’s methods are actually so simple that mostly an amateur could use them entirely unchanged and with the same results. Lynch does not use any gimmicky computer programs, either to pick stocks or optimize the portfolio for volatility. Each and every company invested in by Magellan was considered on its own individual merits, and the managers of Magellan generally did their very best to completely avoid investing in anything that consensus opinion from the average Wall Street analyst declared was a good thing.

Lynch sums up his points in Beating the Street with a number of humorous “Peter’s Principles”, which appear here. Do take the time to read Beating the Street in its entirety though, as he makes a number of very interesting points throughout.

Peter’s Principle #1

Gentlemen who prefer bonds don’t know what they are missing.

Lynch makes the point out that bonds are an inferior investment to shares. They are the Risk free alternative. If there is not risk, you don’t deserve a reward. Anyone can do that! it is the same in business. Your status quo business is the risk free alternative. if your in business, innovate, find the risk, manage it and make a return.

Peter’s Principle #2

Never invest in any idea you can’t illustrate with a crayon.

A class of seventh graders at an American primary school did a social studies project on stocks, the kids had to do their own research and dig up stocks for a paper portfolio. They sent their picks to Lynch, who later invited them to a pizza dinner at the Fidelity executive dining room, illustrating their portfolio with little drawings representing each stock. Lynch just loved this because it illustrates the principle that you should only invest in what you understand, the kids portfolio consisted of toy manufacturers, makers of baseball swap cards, clothing manufacturers and outlets, Playboy Enterprises (a couple of boys chose that one), Coke, and other stocks of that ilk. With a portfolio notably lacking in glamorous technology ventures and entrepreneurial risk taking they went for solid stocks with excellent profits, their portfolio returned 69.6% against a background of a 26.08% gain in the S&P500 in 1990/91.

Given the era in which Peter was outperforming almost every other guy on the street, it is hard to argue that this is not correct. However, I would argue that the tech stocks of today would have been ruled out by Peter’s 2nd principal. BUT…. If you consider “Never invest in an software who’s benefit you cant illustrate with a crayon.”

Peter’s Principle #3

You can’t see the future through a rearview mirror.

Over the years, Peter talked a lot about “weekend worriers”, those pundits that always have a thousand reasons why the economy is bad and it is not a good time to invest in stocks. He points out that even he is guilty of this, appearing on the prestigious Barren’s panel on the state of the economy to prognosticate and outdo the other panelists on why the market is about to crash.

Lynch advocates looking at stocks for their own value, not to go in for top-down analysis in some futile attempt to predict the state of the economy and their effects on stock prices. The market crashes when stocks are way over valued, and doesn’t usually crash again until stocks have become over valued again. His point comes down to the old saying, “buy in gloom, sell in boom”. When the experts are bearish is the time to buy.

I couldn’t agree more, the difficulty comes when you hear the old boys of investing saying things like “its about the time in the market”, and “stop trying to time the market”. Given that gloom comes every 2-3 years and event bigger gloom 7-10, sitting idle in the middle is a hard place to be psychologically when you want to be in the market making money.

Peter doesn’t cover it in his books, however trend following, or timing the market trends, through understanding the Business, stock market and economic Cycles, you are able to make informed decisions of when you should be in what stocks.

Take a look at our blog on Economic Cycles and Kondratieff’s work on Market trends.

Peter’s Principle #4

The extravagance of any corporate office is directly proportional to management’s reluctance to reward shareholders.

Excellent companies are thrifty. They seek to maximize returns by running their operation efficiently and seeking to be the best at what they do. Companies that buy themselves glamorous skyscraper office towers with indoor waterfalls and gold plated toilet seats, award executives with fat salaries not linked to performance, corporate jets, massive advertising campaigns aimed purely at sprucing up the corporate image, changing a sensible old name to something flashy and techy and other such excesses are not companies you want to invest in. To Lynch, such behavior indicates the management may well be far too concerned with self-aggrandizement rather than trying to maximize returns for shareholders. Some of the very best investments Lynch has made are cyclical companies in difficult industries that turn out to be the last man standing when all their rivals have gone broke, leaving the market all to them, and the credit goes to thrifty policies which ensure that these companies become the lowest cost competitors in the market.

Peter’s Principle #5

When yields on long-term government bonds exceed the dividend yield of the S&P 500 by 6 percent or more, sell your stocks and buy bonds.

Lynch recommends this as a kind of value-contrarian-safety type of strategy, making the claim that when this situation occurs you should enjoy the “risk-free” investment of bonds, they are either yielding exceptionally well or the stock market is over-valued. Either way they make more sense than stocks at that time, this is the only exception to Lynch’s assertion that stocks are always better than bonds.

Now the valuation may have changed, given that Peter’s views were aired in a period of higher inflation and higher interest rates. In the later parts of the second decade of the 21st century this may be more like, when government bonds are 1% – 2% higher than S&P 500, sell and Hold cash!

Peter’s Principle #6

The best stock to buy may be the one you already own.

Many stocks which later became major holdings started out as minor purchases by Magellan. Often it is unnecessary to run around looking for the perfect stock, you may already have it in your portfolio, the number of really brilliant companies is finite, so when you do have one it might be better to buy more than to go out to find something else.

Peter’s Principle #7

A sure cure for taking a stock for granted is a big drop in the price.

Like many people who trade shares with great initial success, Lynch had attained something of a God complex thinking he was immune to the lumps and bumps of the market. He is referring to the shocks of 1978 and 1987, where big falls provided the necessary kick in the pants to remind him of who the real boss is. This point should be made to everyone who just got a Sanford account in the middle of the last bull market, sometimes good luck can mask bad skill.

Peter’s Principle #8

Never bet on comeback while they’re playing “Taps”.

For those that don’t get it, “Taps” is the name of that bugle tune they play at military funerals. This point deals with the idea of buying something just because the share price has fallen. Carefully investigate each purchase as if it were a new stock, ignore the history if the situation has obviously changed. As Lynch says, there is no shame in losing money on a stock. Everybody does it. What is shameful is to hold on to a stock, or worse, to buy more of it, when the fundamentals are deteriorating.

Peter’s Principle #9

If you like the store, chances are you’ll love the stock. 

One of Lynch’s favorite stock picking techniques is to take his wife and kids shopping at a large shopping centre. There you can see for yourself what chains are doing well, before the annual report. Many shops that are starting out as franchises have not yet been noticed by the stock market, even if they are listed. To do this kind of research he’d give his daughters some pocket money and see where they spend it, which usually led him to a discount clothing store like the Gap (an American jeans store turned popular general clothing store), which was always packed with kids making big purchases. What better operation could there be than an extremely profitable store just going franchise that is about to expand all over the country? Lynch loves these stocks, retail operations that go absolutely wild after a few years listing producing what Lynch aptly names “Ten-Baggers” – stocks with a 1000% price increase or better! His kids also help him by telling him what drinks are popular these days, leading him often to some small operation making a niche range of products that gains similarly. Of course once he gets back to the office he always checks up on the PE ratio and debt levels, which is what stopped him investing in “The Body Shop”, on a 40+ PE which was too rich for his tastes even with such rapid expansion. Clearly investing in this sort of thing beats buying some riverboat casino or speculative technology issue recommended by a generic Uncle Harry.

Peter’s Principle #10

When insiders are buying, it’s a good sign – unless they happen to be New England bankers. 

When management people make large purchases of their own stock with private funds, you know that the insiders feel the company is undervalued, or that something big is about to happen. The bankers comment refers to the silliness of the management of a number of Texas and New England banks who violated principle #13, buying substantial holdings almost right up to the day the banks closed their doors for good.

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