Peter Lynch was one of the most successful stock pickers of the 20th
Century. From 1977 to 1990, his Magellan Fund had an average return of
29%. Just let that soak in for a minute: each $1 put into the fund in 1977 would have grown to over $27 by 1990!
In his book, One Up On Wall Street: How To Use What You Already Know To Make Money In The Market, Lynch describes some of the principles that helped him achieve his great success, along with a few anecdotes. For example, he made his way into the world of money management by making contacts with executives when he worked as a caddie at a high end golf club. The lesson on the importance of networking in life is one that can pay dividends far beyond the investing world. Below are some key takeaways from the book.
Paid Professionals Aren’t Always Right
Lynch points out that professional investment advisers often have bad habits
that prevent them from achieving above average returns. For example,
professionals often recommend stocks after they have run up, for fear of not
holding the top performing names in the market. Conversely, they often
downgrade stocks, telling investors to sell, after a stock has already lost
significant value. Funds frequently sell poor performing stocks just before
they report their holdings so that they can eliminate evidence that they held
the under-performing stocks. Selling a losing position isn’t necessarily a bad thing if done for the right reasons, but doing so strictly for appearances is a sure way to lose money over the long term.
Signs That You Are Ready To Invest
Lynch lists three key questions that he believes determine whether a person is ready to invest in the stock market on their own:
- Do you own a house? Housing represents a large expense in most
household budgets, so it is important to make sure that the expense has
been addressed before sinking money into investments. Part of his
rationale is that even if housing prices decline, you can still live in your
home. - Do I need the money in the near-term? The stock market can easily
decline by 20% or more in a short amount of time, so it is not a good
place to put money that you need to cover bills next month, or even next
year. A good rule of thumb is to have at least six months of living
expenses in short term assets, like a bank account or money market
fund so that the money is readily available and there is little risk of a
financial loss. Six months of expenses may be more than your typical
budget for six months, as health insurance premiums might go up if you lose employer provided insurance or you might have a medical emergency that requires a large deductible payment. - Do you have the right personal mindset to succeed? As noted above,
stocks can easily decline by 20% or more in a short amount of time, so a long-term mindset is a must. As Lynch says in his book,
“To me, an investment is simply a gamble in which you’ve managed to tilt the
odds in your favor.”
-Peter Lynch in One Up On Wall Street
Building on this thought, Lynch states that six correct stock picks out of ten
would be a good result relative to most Wall Street investors. He goes on to
list some of the factors that can help an investors have better odds of picking
winners.
Lynch’s Tips For Picking Winners
One suggestion that Lynch is most famous for is finding investment ideas in
your everyday life, especially if it is a new store or food trend. He believes
that personal experience with a new brand can be a good early indicator of a
company’s quality. Once you have the investment idea, the key is to
investigate the company in more detail, by reading reports and presentations,
contacting the company for more information, etc. Lynch mentions that it
becomes exceedingly difficult to grow as a company gets larger, so it is
important to spot trends as early as possible.
Other tips include the following:
-Look for companies that are easily overlooked or not in attractive industries,
like sewage treatment and funeral homes.
-Consider companies that are spun out of larger companies, as these new
entities are often not well understood and are not usually held by professional
money managers.
-Look for companies that are hard to compete with due to some sort of
inherent advantage. He gives the example of a rock quarry, where
competitors from outside the area would not be able to encroach on the local
market due to transportation costs.
-Companies with large insider buying and few institutional shareholders also
represent opportunities.
Stocks To Avoid
Lynch also has advice for avoiding bad companies, which can be just as
important as finding the best stocks. After all, Warren Buffett’s number one
rule of investing is not to lose money. Lynch recommends avoiding the
trendiest investments, with recent examples including 3D printing and meme stocks. He also suggests avoiding companies that people talk about a stock in terms of an existing fast mover, with phrases like “the next Uber for market XYZ” .
Companies that acquire unrelated businesses also draw Lynch’s ire. He gives
the example that General Mills once owned Parker Brothers, Izod, and a
travel company. More recently, Campbell Soup struggled with Bolthouse Farms fresh food business model and had to divest.
He also draws attention to the risk of investing in a company that depends on
one customer for a large percentage of their sales, as they are particularly
vulnerable to disruption. A good example of this principle can be seen in
the failure of GT Advanced Technologies after a supply contract with Apple
failed to materialize.
Lynch states the free cash flow (FCF) is the best measure of a company’s value, as things like book value and reported earnings can be manipulated to make a company look better than it otherwise would. While cash flow can be manipulated, it is harder to do, especially if you average it over several years. Good companies have free cash flows that are comparable to their reported earnings over time.
Other warning signs that he mentions to look out for include inventory growth
that is faster than sales growth and unfunded pension liabilities. Pension
liabilities are particularly troubling because many companies overestimate
their pension fund returns and underestimate their future pension expenses.
Lynch recommends portfolio diversification to both reduce volatility and
increase the odds of having a stock that has excess returns.
He also emphasizes the importance of staying in the market, even when times are tough. However, he recommends selling mistake stocks right away so that the money can be redirected to better opportunities. He points out that one of the biggest mistakes investors can make is assuming a stock can’t fall below a certain point if it has already had a significant fall. For example, Walgreen’s (WBA) has continually fallen over the last three years as their business has been undercut by disruptors like Amazon (AMZN) and Cost Plus Drugs.
Lynch concludes by recommending investors avoid stock options,
futures, and shorting stocks. These instruments are complex and can lead to
large losses in a short amount of time, even if you have the right investment thesis. As Keynes is famed for saying, the market can stay irrational for longer than you can stay solvent.
Parting Thoughts
One Up On Wall Street is a timeless investment book and an easy read,
especially for new investors. It is one of my favorite investment books, and
one that I come back to every few years to reinforce key principles.
What are some of the valuable lessons you have learned from reading Peter
Lynch’s work?
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