by Frederik Vanhaverbeke
In the latest of a series for Master Investor Magazine, Frederik Vanhaverbeke, author of Excess Returns: A comparative study of the methods of the world’s greatest investors, looks at how some of the world’s greatest investors are so successful.
The extravagance of any corporate office is directly proportional to management’s reluctance to reward shareholders.
Few mutual fund managers are better known than Peter Lynch.
Lynch became famous thanks to his popularisation of investment tenets that are unanimously championed by top investors. His investment recommendations also take a central place in my book Excess returns: a comparative study of the methods of the world’s greatest investor, which discusses the investment methods and wisdom that a wide set of top investors share.
Lynch’s track record also gives him every right to teach investing. After all, he has one of the best track records among mutual fund managers ever, with an annual compound return of 29.2% (beating the S&P 500 with dividends reinvested by almost 15 percentage points a year) during his tenure as manager of Fidelity’s Magellan fund between 1977 and 1990.
Interesting to know is that he failed to beat the market in two of these 13 years and that he was never among the 15 best fund managers in any one year over that period. This illustrates that it is unrealistic to expect a top investor to outperform the market in every single year. In fact, as illustrated in my book, it is rather the norm than the exception for top investors (who beat the market over the long term) to lose out from time to time.
Peter Lynch’s investment recommendations cover the entire investment chain that starts with the selection of potential bargains, that goes over the due diligence on investment ideas, and that ends with how to buy and sell wisely. We obviously can only discuss some of his lessons here and refer the reader who is interested in more to my book.
When it comes to investment ideas Lynch recommends people to look in places that most other investors ignore.
For example, companies in dull or lousy (no-growth) industries, companies that are not covered by analysts, or unpopular businesses. Conversely, he points out that the hottest company in the hottest industry is the type of stock that one should avoid at any price. Lynch also advises to stay away from businesses without sufficiently long track records or businesses that still haven’t made their first profit. He argues that buying such stocks is more a leap of faith than a true investment. Lynch also prefers simple-minded businesses with conservative balance sheets that are run with a focus on costs.
To facilitate a thorough due diligence process Lynch is also a fervent champion of “investing in what one knows.” This is the popularised version of the “circle of competence.” It means that investors must realise that they stand the most chance of beating the market when they stick with businesses about which they have more expertise than most other investors. For instance, an insurance professional who has superior knowledge about insurance stands a higher chance to beat other investors with insurance stocks.
Peter Lynch is primarily known as a growth investor who had a predilection for businesses that expand their sales and earnings at rates of about 20% to 30% a year.
Nevertheless, he also felt comfortable investing in many other types of stocks as well such as turnarounds (i.e., stocks of businesses that are in serious trouble), asset plays (i.e., companies with assets that are not reflected in the stock price), and cyclicals (i.e., companies that are very sensitive to business cycles).
This explains the relatively high turnover in his fund compared to that of many other top investors. Indeed, while Peter Lynch fervently promoted a buy-and-hold approach for growth stocks, he also proclaimed that many other types of stocks should be traded actively. Turnaround stocks and asset plays should be sold after the business has turned or after the asset is recognised by the market. Cyclicals should be purchased and sold based on one’s anticipation of industry cycles. And moderately growing, stable businesses with strong franchises that have been bought at a cheap price should be sold once the discount to fair value has shrunk noticeably.
As a teacher of sound investing practices, Lynch openly denounces some common investment mistakes:
– He states that it is a horrible mistake to buy a stock simply because it has gone down a lot. Picking up falling stocks is something that should only be considered when the drop seems completely unjustified after a thorough examination of the situation.
– Another common mistake is to buy a second rate competitor of a star performing stock in the hope that the competitor will catch up with the star performer. Buying a mediocre company out of frustration to have missed the winning stock is likely to cause even more frustration.
– Lynch likens the common practice of “selling the winners and holding on to the losers” to “cutting the flowers and watering the weeds.” He maintains that it is a shame to sell a winning stock as long as the company is doing well, the valuation is not out of whack with reality, and everything in your analysis tells you that the stock will continue its winning streak.
– Lynch doesn’t understand why so many people constantly try to anticipate the market’s moves. He is convinced that more money is lost by investors who prepare for corrections than in the corrections themselves. He also thinks that economic predictions should be discounted heavily when making investment decisions because the economy is too hard to predict.
Peter Lynch’s investment lessons of more than twenty years ago are of course still valid nowadays. Besides, it is fair to say that Peter Lynch is to investing what Stephen Hawkins is to astrophysics. He managed to put investment concepts in a language that is easy to understand, and that appeals to anyone with an interest in investing.
Next up is another master of the popularisation of investing: Joel Greenblatt.