Beating the Street

Peter Lynch is an American fund manager who ran the Magellan Fund at Fidelity between 1977 and 1990. In this period he averaged a 29.2% annual return and making it the best performing mutual fund of all time. Lynch consistently beat his critics who often claimed the Magellan Fund was too big and couldn’t keep up, yet assets under his management grew from $8 million to $14 billion. Lynch is known for coining the term ‘multibagger’.

Thesis

Lynch is a big believer that the private investor has a huge advantage over the so called ‘smart money’. This is because we are not restricted to what we can buy, we are allowed full autonomy of our own portfolios, and because we can enter and exit at will (to an extent) unlike an institution which can take weeks to unwind a position.

What is striking about Peter’s methods is that they are actually very simply and advocates that we look for stocks in everyday life. I have experienced missing out on one of these ideas myself; my parents bought me a Gear4 Music wireless speaker for Christmas in 2015 – I liked the product, but didn’t check the stock! G4M went on a tear from around 150p to nearly 900p, so it’s always worth keeping an eye open and being observant for ideas.

Contents

The book shows how he taught a bunch of 7th graders to invest by only selecting stocks they could understand by drawing with a crayon. This is consistent with Warren Buffet, who famously stayed away from technology stocks, and yet still became a multi-billionaire. He describes his first few years at Magellan, and then how he picked his stocks in the retail sector by waiting for the concept to be successful, and then buying the stock as the company rolled out to new territories.

The argument that selecting stocks in depressed industries can be very profitable, as a stock that turns around has the negative price built into it, and as the strategy yields results both the stock price and optimism begin to rise. The important things to look for are described in the book.

The books ends with the six month review. Lynch makes the point that too many investors get scared out of great stocks far too early, because they constantly check their accounts and worry about what could happen. I have experienced this myself, and no doubt you have too!

Key themes

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

Peter is at pains to point out that bonds are missing out. Bonds have a guaranteed yield, but they miss out on all of the upside in equities. Compelling evidence is provided to show that, over the long term, stocks beat bonds all over the shop. The stock market typically averages 6-8% return, and bonds are far below that, so the amateur stockpicker should never be looking at bonds as a way of return. The only exception given is when long term government bonds exceed the dividend yield of 6% or more, as that is an attractive yield and equities must adjust for the new discount rate.

 

Not all common stocks are equally common

Peter believes that the stock market is not efficient (a view I also hold) – this is because there is too much emotion in investing and also because there are plenty of small and micro cap stocks that are not covered or invested in by institutions and professional because they are too small. This can happen often on the AIM market and pricing inefficiencies do exist. Lynch argues that this is where the multibaggers exist – where no one has done any research and the stock is either unloved or unknown.

 

Sometimes the best stock to buy is the one you already own

Many investors like to buy a share that is going down because they get to buy more of the company for cheaper, and they don’t like to average up. This can be wrong as it’s the winners that really drive a portfolio. Lynch gives countless examples where he averaged up for years and made fortunes (for example Walmart) simply because the story kept getting better and he kept buying. Of course, the average private investor struggles to imagine holding a business for two year, never mind ten. The ease of being able to deal and access to all the noise mean it can be surprisingly difficult to resolutely stick to your research and not let any noise or share price movements shake us out.

 

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

This is a good acid test, because if we can’t even draw our investment then do we really know what it does? If we don’t know what it does, then it’s likely we shouldn’t be investing in it! Some stocks have corporate websites with more buzzwords than Bullshit Bingo – unfortunately if I can’t work out what a stock does I’m unlikely to progress any further with it.

 

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

Lynch believes that excellent companies are thrifty. They seek to maximise returns by running efficiently and seeking to be the best at what they do. Companies that splash out on lavish ego-boosting perks such as fancy cars, shiny new offices, and reward themselves with huge salaries unrelated to performance are not companies we should invest in. I do disagree with Lynch to a point here, because nobody wants to go to work in an absolute dump, but there are limits. Ultimately, the lowest cost operator goes bust last.

 

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

Most people reading this will have been in the position where a stock has kept going up, and they’d neglected to either follow up on the story or bank some profit because it kept rising, only for the stock to fall heavily or issue a profit warning that we could’ve seen coming.

 

When insiders are buying, it’s a good sign

This is something to take notice of – especially when insiders are buying large amounts relative to their salaries. Make sure that the stock is purchased with their own private funds, and not salary conversion as some spivvy companies like to make out converting delayed salaries into shares are director buys. In my view, this is one of the most important factors when making an investment decision. On some occasions I’ve had a lot more stock than the CEO, which is ridiculous given that they are usually on healthy six figure salaries. If the board don’t bother buying – why should we?

 

Never invest in a company without understanding its finances

The biggest losses in stocks come from companies with poor balance sheets. Always check the balance sheet to see if the company has cash and is solvent before buying stock. Check the income statement to see if they’re making a profit. Companies that aren’t making profit still need to pay the director’s wages, so they will dilute shareholders with more equity issues and these will almost always be at a discount.

 

With small companies, it’s better to wait until they turn a profit before investing

I wholeheartedly agree with this statement. I have learned this experience the hard way, investing in a stock where the board bought large amounts of stock. But they’re underwater and more importantly – so am I! Waiting for a profit will remove the risk of cash running out because things took longer than expected.

 

 

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