August 17, 2011

Peter Lynch - Beat the stock market with what you already know

Beginning
Peter Lynch was born in a time when most people remembered the Great Depression. Nobody talked about stocks, and when someone talked about it, it was often someone who had lost money when buying stocks. Peter Lynch soon changed his mind about stocks when he was eleven years old and got hired as a caddy. "If you want an education in stocks, the golf course was the next best thing to being on the floor of a major exchange," he said. Members of the golf club often talked about their own investments, and their stories made Peter Lynch change his mind about stocks.
    Peter Lynch worked at the golf club throughout high school and into Boston College where he studied history and philosophy – not math or accounting. "All the math you need in the stock market, you get in the fourth grade," he said.
    The first stock Peter Lynch bought was Flying Tiger Airlines. The stock went from $7 to $32. He sold some of the stock to pay for Wharton School of the University of Pennsylvania. In 1966, the summer before attending Wharton, he applied successfully for a summer job at Fidelity. The reason he got the job was because he had caddied the president of Fidelity previous summers.
    Peter Lynch joined the army in 1967. This was during the Vietnam war, but he was lucky, and served most of the time in Korea. He rejoined Fidelity in 1969 as a research analyst. In 1977, he took over the Fidelity Magellan Fund.

On his own
The number of stocks in the Magellan Fund was 40 when Peter Lynch took over. The number of stocks soon increased to 1400. 200 companies represented 66 percent of the portfolio. The Magellan Fund became the largest mutual fund in history and it had over a million shareholders. The sad thing is that many shareholders didn't make money by owning the fund since they often sold at the bottom of the market. In all, Peter Lynch bought 15,000 stocks and analyzed 150,000 companies. To help him, he had Fidelity's research apartment, but he still made all decisions by himself.
    In 1990, Peter Lynch left the Magellan Fund. The Fund had increased with 29 percent each year. He left because he wanted to spend more time with his family. When running the fund, Peter Lynch worked six days and Sunday mornings each week. He had taken almost no vacations, and on the few vacations he took, he often went visiting companies.
    After he left the company, Peter Lynch worked at Fidelity as a fund trustee, and as an adviser/trainer for young research analysts.

Strategy
Peter Lynch only invests in what he understands. The best place to look for good stocks is close to home, for example at the shopping mall. One can often find stocks at the mall, before Wall Street finds the same stock. When Wall Street has found the stock, it is often to late to invest in it. "I discovered some of my best stocks through eating or shopping," he said. "You didn't have to be a programmer to notice Microsoft everywhere you looked. All new computers came equipped with the Microsoft operating system."
    But finding a promising company to invest in is only the first part. The second part is to do the research the company. "Investing without research is like playing poker and never looking at the cards," he said. To simplify the research, one should follow the steps below.

Step 1. Putting stocks in categories.
First, you need to find the growth of the company. Growth is defined here as that the company should do more of whatever it did last year (make cars, shine shoes, sell hamburgers).
  1. Slow growers. Large and aging companies. 2-4 percent growth each year. Not something Peter Lynch invests in. "Big companies have small moves, small companies have big moves," he said.
  2. Medium growers. 10-12 percent growth each year. Peter Lynch invests in these. Wait for a 30-50 percent gain, then sell and buy other medium growers. Offer a good protection during recessions.
  3. Fast growers. 20-25 percent growth each year. Deserves the most attention. The growth will slow down in the future, but for long as they can keep up, fast growers are the big winners in the stock market. Be suspicious of companies with growth rates of 50 to 100 percent a year – it's too much. When investing in Fast growers, try to make sure that the P/E-ratio is less than the annual growth in earnings.
  4. Cyclicals. Timing is everything in cyclicals, you have to be able to detect the early signs that the business is falling off or picking up. Buy these at the bottom of the cyclical phase.
  5. Asset plays. A company sitting on something valuable you know about, but Wall Street doesn't. May be as simple as a pile of cash.
  6. Turnarounds. These are companies that currently are performing bad, but may turn around, and perform good again.

Step 2. Filling in the details. You will never find the perfect company, but a perfect company has the following attributes:
  1. The name of the company sounds boring, or ridiculous. For example, Automatic Data Processing or Pep Boys – Manny, Moe, and Jack
  2. It does something boring. For example, processes the coupons that you hand in at the grocery store
  3. It does something disagreeable. For example, washes greasy auto parts
  4. It's a spinoff. A big company separates a part of the business into it´s own company
  5. The institutions don't own it, and the analysts don't follow it
  6. The rumors abound: it's involved with toxic waste and/or maffia. A rumor is pressing down the price of the stock
  7. There's something depressing about it. For example, funerals
  8. It's a no-growth industry. Less competition
  9. It's got a niche. For example, products that no one else is allowed to make – drugs
  10. People have to keep buying it
  11. It's a user of technology. New technology the company is using may save money
  12. The insiders are buyers
  13. The company is buying back shares

When you have found the perfect company, the next step is to invest in the company, and then wait. "The typical winner generally takes three to ten years or more to play out," he said. But every stock can't be a winner, but that's not necessary either. "In my experience, six out of ten winners in a portfolio can produce a satisfying result," he said.
    Peter Lynch is not a trader, he holds the stocks as long as the fundamental story of the company hasn't changed. People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Peter Lynch re-check the company story a couple of times each year. This may involve reading the latest annual reports and checking the stores to see that the products are still selling. He also stays in the market forever, because he always rotates the stocks based on fundamentals.
    The type of stocks Peter Lynch doesn't want to invest in is companies without earnings. "It's always better to miss the first move in a stock and wait to see if a company's plans are working out," he said. "If I could avoid a single stock, it would be the hottest stock in the hottest industry. The one that gets most favorable publicity, the one that every investor hears about in the car pool or on the commuter train."
    Peter Lynch doesn't watch the price of the stock during the day and he spends about fifteen minutes a year on economic analysis, such as GNP or unemployment data. He also spends fifteen minutes a year on where the stock market is going.

Conclusions
  • You should use common sense when investing in stocks – use what you already know. If you like to eat at Burger King – find out if Burger King is a good stock to own. If you work at General Motors, and notice that the production of cars is slowing down, sell the stock if you own it.


Sources: One up on Wall Street by Peter LynchMoney Masters of Our Time by John Train

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