THE PE INVESTOR

One Up On Wall Street, and Beating The Street, by Peter Lynch

One Up On Wall Street

Beating the Street

Peter Lynch is one of the best performing mutual fund managers and investors of all times. During his 13-year tenure at the helm of the Magellan Fund at Fidelity, which he brought from $18m to $12bn of AUM, his annualized performance reached an outstanding 29% per annum, more than double the return of the S&P 500. He also ran a $1bn employee’s pension fund which had an even better track record (due to lower restrictions on concentration). He retired at age 46 to spend more time with his family. He continues to work part time, mentoring young analysts, and focuses on philanthropy (see Peter Lynch profile on Wikipedia).

I first came across two of his famous books, One Up on Wall Street and Beating the Street (co-authored by John Rothchild), in the summer of 2007, after 3 years of business school and 4 years of practical experience in leveraged finance and private equity.

I had attended various business classes (strategy, marketing, corporate finance, economics, accounting, law, leveraged buyouts), worked on half a dozen LBO deals, and delved into the world of financial statements, credit statistics and loan agreements. But I felt I lacked a clear framework to analyze investments. So where better to look than in the writings of one of the best stock pickers and fund managers of all times?

His books contain so many inspiring investment principles that it is hard to select only a few.

1. Don’t overestimate the skills of investment pros. Contrary to amateurs, investment pros often face obstacles (e.g. fear of looking bad or losing their job) that may impede them from buying the most attractive stocks. You can outperform them by ignoring the herd and using your edge, i.e. investing in companies or industries you already understand.
2. Invest at least as much time and effort in choosing a new stock as you would in choosing a new home or refrigerator. Poke around and ask the right questions, spend months and not minutes choosing the right stocks, hold them for the long term, do not get scared into selling just because the price is down 10%, and if you use leverage avoid margin loans. Investing is dangerous if you don’t do any work.
3. Only invest what you can afford to lose.
4. Predicting interest rates, the direction of the economy or the stock market is a waste of time. If it worked, economists and statisticians would be millionaires. Concentrate on what’s actually happening to the companies in which you’ve invested.
5. Over the long-term, returns from stocks vastly outperform returns from bonds. With stocks you’ve got the company’s growth on your side, whereas with bonds, the best you can hope for is to get your money back with interest. The only exception would be when yields on long-term government bonds exceed dividend yields by 6% or more.
6. An investment is a gamble in which you’ve managed to tilt the odds in your favor, e.g. by asking basic questions, keeping up with the company, and avoiding overpriced stocks. All you need to produce an enviable record is to be right 60% of the time.
7. Behind every stock is a company. Find out what it’s doing.
8. The stock market is just there to see if anyone is offering to do something foolish.
9. In the long-run, the price of a stock tends to move in line with its earnings. In the short term however there may be no correlation between the success of the company’s operations and the success of its stock. The disparity is key to making money. It pays to be patient and to own successful companies.
10. The best place to begin looking for a promising stock is close to home (e.g. the mall, your job, your spouse, your kids). You will get valuable information that may not reach investment pros for months or years.
11. Big stock moves can be expected from small companies, not from big companies.
12. It helps to place the stocks you are researching into one of 6 categories:
    • Fast growers: small, aggressive new businesses growing earnings at high double-digit rates.
    • Stalwarts: large businesses growing earnings at low double-digit rates.
    • Slow growers: ageing companies growing earnings at GDP+ rates.
    • Cyclicals: companies whose sales and profits rise and fall in a regular fashion.
    • Turnarounds: companies which have been battered, sometimes as a result of a poorly managed down cycle.
    • Asset plays: companies sitting on overlooked valuable assets.
13. By putting stocks into categories you’ll have a better idea of what to expect from them, as each category carries different risks and rewards:
    • Fast growers: these are high risk / high gain investments. If chosen wisely, they can generate > 10x multiples. If you are wrong and the company falters, you can lose all your money.
    • Stalwarts: these are low risk / moderate gain investments, which can provide good protection during downturns. Buy them for 30-50% gains, then rotate into other stalwarts. If you are wrong you can lose 20%.
    • Slow growers: these are low risk / low gain investments. There is not much point owning them given the low growth rates, aside maybe for the dividends.
    • Cyclicals: these can be low risk / high gain or high risk / low gain investments depending on how adept you are at anticipating cycles. In the good part of the cycle they can generate > 10x multiples, in the wrong part of the cycle they can lose 80-90%.
    • Turnarounds: these are high risk / high gain investments, which are least related to the general market. The successful ones can make up lost ground very quickly and generate > 10x multiples. If you are wrong and the company has a relapse, you can lose 100%.
    • Asset plays: these are low risk / high gain investments. If you are sure of the assets’ value, you can make a 2-5x multiple. If you are wrong, you probably won’t lose much,
14. There is no generic formula that applies to all different kinds of stocks: Fast growers should not be sold for a 50% gain if they can generate a 10x multiple. Similarly, while you can put stalwarts away and forget about them for 20 years, you should not sleep on shaky cyclicals through recessions.
15. The perfect stock sounds dull, is in a no-growth industry, has got a “niche”, sells products or services people have to keep buying, is a user of technology, is a spinoff, is not owned by institutions nor followed by analysts, and is being bought by insiders or by the company itself.
16. Stocks to avoid include hot stocks in a hot industry, the “next” something, misguided diversifications, whisper stocks, companies with significant customer concentration or with flashy names.
17. A stock is part ownership of a business, not a lottery ticket. Similar to a private business, what makes it valuable is its earnings and assets.
18. P/E is the number of years it takes to pay back your investment assuming stable earnings.
19. A bargain P/E for a slow grower is not the same as a bargain P/E for a fast grower.
20. Avoid stocks with excessively high P/Es: they must have extraordinary growth to justify their price, and you risk not making any money even if everything goes right.
21. The stock market has its own collective P/E ratio. When all the stocks you are investigating are selling at inflated P/Es, it is likely most stocks are selling at inflated P/Es.
22. It is hard to predict future earnings, but at least you can find out how a company plans to increase its earnings, and check periodically if the plan is working out.
23. You should not confuse earnings with dividends. A company may have terrific earnings yet pay no dividends.
24. After figuring out the stock category, and getting a rough idea of whether the stock is overvalued or undervalued via the P/E ratio, the next step is to learn as much as possible about what the company is doing to bring about added prosperity.
25. There are five ways to increase earnings: sell more existing products in existing markets, raise prices, expand into new products and markets, reduce costs, or revitalize, close or sell a loss-making operation.
26. Know what you own and why you own it: make sure you understand the business, the nature of the company, and the specific reasons for owning the stock (“it’s going up” doesn’t count).
27. Before buying a stock, give a two-minute monologue covering the reasons you are interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its way. You should be able to explain why you like a stock in simple language that a fifth grader could understand.
28. You can get great leads from fellow investors.
29. Do not blindly follow stock tips, even if the tipper is rich and smart.
30. Managerial ability is important but difficult to assess. Base your decision on the company’s prospects, not the CEO’s resume or speaking abilities.
31. When in doubt over an investment opportunity, tune in later.
32. If you can’t find any companies you think are attractive, put your money in the bank until you find one.
33. All the pertinent facts are there to be picked up, even by the amateur investor. Sources of information may include your broker, calling the company, visiting its headquarters, wandering through stores, reading annual reports. Lynch himself visited 200 companies and read 700 annual reports every year!
34. Once a month, have at least one conversation with a representative of each major industry group to keep tabs.
35. End your discussions by asking managers which competitor they respect the most.
36. Write down the names of everyone you meet at business lunches and meetings. You can call them up later and use them as valuable sources of information to teach you the basics of their industry and what to look for.
37. Things worth learning for a stock in general include earnings growth and consistency (What is the record of earnings growth? Are earnings sporadic or consistent?), financial strength (Does it have a strong or weak balance sheet?), valuation (Is the P/E ratio high or low vs historical ranges and vs industry peers ?) and ownership (Is the % of institutional ownership low? Are insiders or the company itself buying stock? Does management have skin in the game?).
38. For a fast grower, the key issues are growth sustainability (What has been the growth rate? Is expansion speeding up or slowing down? Is there still room to grow fast? If so, where and how? Has the company proven the concept can be replicated?), financial strength (Is it profitable? Does it have a strong balance sheet?) and valuation (What is the P/E relative to growth?).
39. For a stalwart, the key issues are price (What P/E is the business selling for? Has the stock had a dramatic run-up recently?), upsides/downsides (What is happening to boost growth? Has the stock held up during recessions and market drops?) and capital allocation (Is the company wasting cash on misguided diversifications?).
40. For a slow grower, the key issues are dividend strength (Have dividends always been paid, including during bad times? Are they routinely increased? Is there potential for the dividend payout ratio to be increased?) and upsides (Are there kickers to the growth rate?).
41. For a cyclical, the key issues are timing (Where are we in the supply-demand and inventory cycles? Are earnings about to turn sharply higher because business is back and costs have been slashed? Are there new entrants which may cause oversupply?) and valuation (anticipate shrinking multiples as the company reaches the top of the cycle).
42. For a turnaround, the key issues are the turnaround plan (Has the company gone about improving its fortunes? If so how and is it working? Has the industry started to show signs of revival?) and liquidity (How long can it operate in the red while working out its problems before going bankrupt?).
43. For an asset play, the key issues are the net asset value (What are the assets? What are they worth? Are there any hidden assets (e.g. real estate, tax loss carry forwards, noncore properties, natural resources)? How much debt and taxes should be deducted from these assets?) and catalysts to close the valuation gap (Is there a raider lurking?).
44. Retailers don’t always succeed but with the homogeneity of taste in food and fashion, what sells in one town is almost guaranteed to sell in another, so it’s easy to monitor their progress. You can get leads from visits to the mall to see the most crowded stores or from checking out the places your spouse and kids love to shop at. And you can wait for a chain of stores to prove itself in several areas before you invest.
45. Look at the stock’s chart book: buy when the stock price is at or below the earnings line. When the price line goes way above the earnings line, stocks have a regular habit of moving sideways or falling in price.
46. If you look into a company because of a bestselling product, check what percentage of sales that product represents.
47. Deduct the net cash position from the market capitalization to compute what multiple the operating business is selling for.
48. Pay attention to the amount of debt and to the debt structure. It’s debt that determines which companies will survive and which will go bankrupt in a downturn. Young companies and troubled companies with heavy debt are always at risk, and the biggest losses come from companies with poor balance sheets.
49. Dividend-paying stocks provide a floor on valuation, and protection against the temptation to “piss away” excess cash in misguided diversifications. But small companies which plow back their earnings into expansion are likely to grow much faster. And slow growers which omit dividends have little going for them.
50. Book value often understates or overstates the real worth of the company by a wide margin. If you buy a stock for its book value, you need to have a detailed understanding of what asset values really are. Undervalued assets can provide good asset plays. Overvalued assets are especially treacherous when there is a lot of debt.
51. You can occasionally find companies with modest earnings which are good investments because of strong free cash flows.
52. When inventories grow faster than sales, it’s a red flag.
53. Factor pension deficits in your analysis.
54. Growth is not synonymous with expansion. Despite decreasing cigarette consumption, tobacco manufacturers have enjoyed growing earnings due to price increases and more efficient machinery.
55. Businesses that can get away with raising prices year after year without losing customers can be terrific investments.
56. A 20% grower selling at a 20x P/E is a much better buy than a 10% grower selling at 10x P/E, due to the arithmetic of compounded earnings.
57. In a given industry, the company with the highest pretax profit margin is the lowest cost operator, and thus has a better chance of survival if business conditions deteriorate. But on the upswing, the companies with the lowest profit margin are the biggest beneficiaries. What you want is a high profit margin in a stock you plan to hold for the long-term, and a low profit margin in a successful turnaround.
58. Every few months it is worthwhile to recheck the story. It takes a few hours a year to keep up with each stock.
59. Searching for companies is like looking for grubs under rocks: if you turn over 10 rocks you’ll find one. If you turn over 20 rocks you’ll find two.
60. It’s best to own as many stocks as there are situations in which (a) you’ve got an edge and (b) you’ve uncovered an exciting prospect that passes all the tests of research.
61. The more stocks you own, (a) the more likely one of them will generate a 10x multiple and (b) the easier it is to rotate funds between them.
62. But owning stocks is like having children: don’t get involved with more than you can handle. The part-time stock picker probably has time to follow 8-12 companies. As for Peter Lynch, while the # of stocks in his portfolio totaled 1,400 at one point, half of the assets were invested in 100 stocks, 2/3 in 200 stocks and 1% in 500 secondary opportunities falling into the “tune it later” category.
63. Spreading your portfolio among several categories of stocks is another way to minimize downside risk. Peter Lynch’s portfolio comprised 30-40% of growth stocks, 10-20% of stalwarts, 10-20% of cyclicals and the rest in turnarounds and asset plays.
64. Instead of selling winners and holding on to losers or vice versa, it is better to rotate in and out of stocks depending on what has happened to the price as it relates to the story.
    1. Keep the fast growers as long as earnings are growing, the expansion is continuing and no impediments have come. Check the story with fresh eyes every few months. Sell if the price has increased and the story starts to sound dubious, typically towards the end of the second phase of rapid growth (same store sales are down, new store results are disappointing, old stores start to look shabby and do not carry fashionable items, all analysts are giving strong buy recommendations, 60% of shares are held by institutions, magazines fawn over the CEO, the stock is selling at a P/E significantly above projected earnings growth). Add if the price has decreased and the story sounds better.
    2. Sell slow growers when (a) there has been a 30-50% appreciation or (b) the fundamentals have deteriorated (the company has lost market share for two consecutive years, is resting on its laurels with no new products and curtailed R&D spend, has made acquisitions in unrelated sectors or at such high prices that the balance sheet has deteriorated, the dividend yield is not high enough to attract much interest).
    3. Sell stalwarts if the price has gone up 40% and there are no positive surprises ahead (the P/E ratio strays too far beyond the normal range, similar quality companies have lower P/Es, newly introduced products have had mixed results, management has not bought shares in the last year, a major division is vulnerable to an economic slump, growth rate has been slowing down, and/or future cost-cutting opportunities are limited).
    4. It’s important to get out of cyclicals at the right time, otherwise they’re bound to take all your profit. Sell them towards the end of the cycle (if you can detect that) or when something has started to go wrong (costs have started to rise, the company starts spending to add capacity, inventories are building up, commodity prices are falling or have future prices below spot prices, outsiders are cutting prices, demand is slowing down, labor unions ask for in wage and benefits raises). Add into situations in which the fundamentals are better and the price is down.
    5. Sell turnarounds (a) after the troubles are over, price has increased, shareholders aren’t embarrassed to own the stock anymore and the company is back to its old self, and/or (b) when the fundamentals have worsened (debt has started to rise again, inventories are rising significantly faster than sales, P/E is inflated relative to earnings prospects, top customers are suffering from a sales slowdown). Add into situations in which the fundamentals are better and the price is down.
    6. Sell asset plays (a) after a raider shows up and there is a takeover, a bidding war or an LBO to double or quadruple the stock price or (b) management announces a share issue at a discount to finance a diversification, a division gets sold for a price below expectations, a reduction in the CIT rate makes the tax-loss carryforward significantly less valuable, or institutional ownership has risen from 25% to 60%.
65. There’s no shame in losing money on a stock. What is shameful is to hold on to a stock or buy more of it when the fundamentals are deteriorating. Containing your losses is an important aspect of portfolio management.
66. When the bonds sell at a steep discount, the bond market is trying to tell us something.
67. The best time to buy stocks is the day you’ve convinced yourself you’ve found solid merchandise at a good price.
68. There are two periods where bargains are likely to be found: (a) at the end of the year due tax selling and portfolio cleaning and (b) during stock market drops and collapses.
69. Do not pay attention to external economic conditions, except in cases where you are sure a specific business will be affected in a specific way.
70. Below is a list of silly and dangerous misconceptions about stock prices:
    1. “It’s gone down this much already, it can’t go much lower”: there is no rule that tells you how low a stock can go in principle.
    2. “You can always tell when a stock’s hit bottom”: trying to catch the bottom is like trying to catch a falling knife, you inevitably catch it in the wrong place. If you are interested in a turnaround, it ought to be for a more sensible reason than the stock’s gone down so far it looks ready to bounce back.
    3. “If it’s gone this high already, how can it possibly go higher”: if the story is still good, the earnings continue to improve, and the fundamentals haven’t changed, “can’t go much higher” is a terrible reason to snub a stock.
    4. “It’s only $3 a share, what can I lose”: the ultimate downside of picking the wrong stock is always 100%.
    5. “Eventually they always come back”: there are thousands of bankrupt companies, solvent ones that never regained their former prosperity or that get bought out at prices far below their all-time highs.
    6. “It’s always darkest before dawn”: sometimes it’s always darkest before pitch black.
    7. “When it rebounds to $10, I’ll sell”: unless you’re confident enough to buy more shares, you ought to be selling.
    8. “Conservative stocks don’t fluctuate much”: companies are dynamic and prospects change, so there isn’t a stock you can afford to ignore.
    9. “It’s taking too long for anything to ever happen”: where the fundamentals are promising, patience is often rewarded.
    10. “Look at all the money I’ve lost because I didn’t buy it”: regarding someone else’s gains as your own personal losses leads people to play “catch up” by buying stocks they shouldn’t buy.
    11. “I missed that one, I’ll catch the next one”: the next one rarely works.
    12. “The stock’s gone up, so I must be right” or “The stock’s gone down so I must be wrong”: this is confusing price with prospects. A stock’s going up or down after you buy it only tells you that somebody was willing to pay more or less for identical merchandise.
71. Options attract small investors who do not want to get rich slowly and opt for getting poor quickly. Unlike stocks, they are a zero-sum game, are valid for a short time, regularly expire worthless, end up costly as they need to be renewed, entail fat broker commissions, and have failed to provide adequate insurance during market crashes due to automatic sell-offs.
72. Shorting stocks requires the conviction that the company is falling apart, but also the patience, the courage and the resources to hold on if the stock price doesn’t go down, or worse, goes up.
73. The market, like individual stocks, can move in the opposite direction of the fundamentals over the short term.
74. There is always something to worry about (epidemics, inflation, recession, interest rates, budget deficit, trade deficit, weak currency, strong currency, real estate prices, etc.). Your success will depend on your ability to ignore these worries long enough to allow your investments to succeed.
75. Corrections are an opportunity to acquire more shares at low prices.
76. You don’t have to kiss all the girls. You can miss your share of ‘tenbaggers’ and still beat the market.

I hope you have enjoyed this article. To support this blog, remember to order your copy of Peter Lynch’s books using the links below.

Peter Lynch – One Up on Wall Street

Peter Lynch – Beating the Street