How Peter Lynch destroyed the market: part 2

(Continuing on from last week…)

Beating the market is about picking a well run business, but it also involves knowing how to avoid the wolves dressed up in sheep’s clothing.

When Peter Lynch took the helm at Fidelity Magellan in 1977 he took a struggling obscure funds management business with a mere $18 million in funds under management, through a recession in 1983 and a stock market crash in 1987, 13 years later to a 14 billion dollar goliath at the time he left in 1990.

But apart from beating the S&P 500 soundly with average yearly returns of 29%, Lynch believed most people who invested in his fund actually lost money.
Many would enter the fund when times were good and returns great and got out at the next negative return that was posted.

Lynch figured had they done the complete opposite and then sat on it for a good couple of years, many would be sitting on significantly higher returns than 29%.
Lynch also firmly believes that individual investors will have a distinct advantage over fund managers and broking houses using his approach.

5. Good management is very important – behind every stock is a company find out what it’s doing.

His most famous Lynch one-liner: “Invest in a business any fool can run because someday one will be.”

Look for the so-easy-a-caveman-can-run-it company.

Lynch was adamant: do your own research, don’t try to predict the growth rate for companies – you can’t – and be sceptical of analyst’s forecasts. Ask “what is the company’s plan to grow and what actions is it taking to do this?”

6. Be flexible, humble and learn from your mistakes.

Lynch has said: “In this business, if you’re good, you’re right six times out of 10. You’re never going to be right nine times out of 10.”

You’re going to be wrong. Diversification and the ability to honestly analyse your mistakes are your best tools to minimise the damage.

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

You have to know what you own and why you own it. “This baby is a sure thing to go up!” doesn’t count.

If you can’t explain what the company does in terms an 11 year old can understand, don’t buy it.

Once this simple thesis starts to break down, it’s time to sell.

8. There will always be something to worry about.

Nobody can predict interest rates or the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s happening to the companies in which you’ve invested.

Because the famous crash was followed by the Depression we’ve learnt to associate a stock market collapse with economic collapse and we continue to believe that the former will lead to the latter. This misguided conviction persists in the public mind. There was a crash in 1972 that was almost as bad as 1929, yet it did not lead to an economic collapse, nor did it in 1987.

In 39 of the last 40 market corrections in modern history, I would have sold my stocks and been sorry.

Lynch’s lesson one. It would also seem so far in Australia’s case this applies for the current credit crunch, ignore a market collapse as an economic indicator and continue to look for opportunities when everyone else is heading out the door.

Although not quite in the same billionaire investor category as Buffett, Soros or Templeton, Lynch’s personal fortune is estimated to be north of US$350 million, putting him clearly in the realm of modern day super investors.

Lynch, like Buffett, was also weary of companies and corporate executives with plush expansive and expensive corporate headquarters that plied themselves with overgenerous incentives that have nothing to do with the return for shareholders.

Lynch also coined the phrase di-worse-if-ication and warned investors to watch out for companies who have lost focus on their core strengths and those that diversify for diversification sake, to create shareholder excitement and buzz and pay handsomely for the privilege to do so.

Some local examples (and there are plenty) are Millers Retail’s (ASX: MRL) disastrous foray into discount variety with the acquisition of Go-Lo and Crazy Clarks. Foster’s (ASX: FGL) foray into the wine business and Vita Group’s (ASX:VTG) purchase of Next-byte stores.

Lynch’s lesson two. Don’t lose focus on your core strengths, don’t overpay too much for a complementary business (merger/acquisitions) and watch out when investing in those that do.

If you don’t have the time to research individual stocks use managed funds, but when it comes to managed funds Lynch has a few golden rules.

Trying to pick tomorrows winning fund based on past performance is futile, concentrate on solid performers and stick to them, constantly switching is an expensive habit to form and in the long run will damage your wealth.

Diversify across different investment styles.

When you add money to your portfolio put it into the sector/fund that has lagged the market for several years.

Summing up

In the long run Lynch firmly believes that a portfolio of well chosen stocks/and or equity mutual funds will outperform a portfolio of bonds or any term deposit account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.

His basic strategy is detailed in his best-selling book One Up on Wall Street, which provides individual investors with numerous guidelines for adapting and implementing his approach. His most recent book, Beating the Street, amplifies the theme of his first book, providing examples of his approach to specific companies and industries in which he has invested. Both books are on my highly recommend reading list.

Nick Christian is a Financial Adviser and planner and authorised representative of Millennium3 Financial Services.

The views and opinions expressed within this letter are those of the author and do not necessarily reflect those of Millennium3 Financial Services Pty Ltd.

The above is general in nature and should not be acted upon without seeking the advice of a professional licensed financial planner.