Hi friends,
Today, I wish to write about a book written by one of the best active mutual fund managers of his time - Peter Lynch's One Up on Wall Street. I have written about him before in my investor spotlight, for those that are interested, you can head on to that post to learn more about him. But here is a brief introduction - He is the portfolio manager of Fidelity's Magellan fund from 1977 to 1990, where it had an average return of 29% annual return, growing from US$ 20 million to US$ 14 billion.
So it was interesting to read about his investing approach. What I love about the book is that Lynch offered an interesting perspective on stocks - He classifies stocks into different categories, and for the different categories, he would expect different performances for stocks of that categories. Furthermore, he makes himself more relatable as he wrote about his feelings during the times when markets experience sudden downturns.
What I didn't like about the book is that he would include graphs in the book, which are scanned and includes his handwritings... Let's just say that Lynch's handwritings aren't the most legible? But all in all, reading the book felt that stocks can perform like characters in an RPG game (Which is something that I enjoy playing). Just that for stocks, they can switch their characters during the different phases of their developments.
Without further ado, allow me to give you the main takeaways from the book as well as the investing approach that Lynch takes in choosing stocks (along with the categories that Lynch categorised the stocks in the market):
Takeaway #1:
Amateurs have the edge when compared to professionals in the investing game. This is due to the inherent advantages of the amateur investor. They are:
A) Institutional (or mutual funds managers) investors are limited by supervisions, rules, regulations, size of their funds - When managers find a good stock that has good business prospects, they cannot pour in all the money from their funds into that particular stock due to SEC regulations. But this limitation is not applicable to the amateur investor. We can concentrate our portfolio on that particular stock. Furthermore, if the fund size is too big and the company's size is too small, it would not make much sense for the fund to invest in that company.
B) Amateur investors can find out companies before institutional investors find out. This is as professional analysts would only cover a company after its stock prices rose. But Lynch argues that the amateur investor can find out potential companies just by seeing the most popular shop or products on the market - which gives them a 3-months lead compared to the professionals.
Take away #2:
If there is a "NEXT BIG THING", Lynch advised that the best bet would be to invest in the company that supplies/enables the next big thing to happen. What this means is that if E-commerce is the NEXT BIG THING, it would be better to buy the last-mile operators for delivery like UPS, FEDEX instead of buying the companies doing E-commerce. Just like how the previous big thing was social media/internet, the best thing to do would be to buy the server companies that can benefit from the rise of social media that would result in more traffics.
Categories for Stocks, when to sell/buy them, expectations:
Lynch also tries to divide companies into different categories (This is such that you can have the correct expectations in the stocks that you buy), which is similar to how different RPG characters would perform differently and serve different functions in our portfolio. But the thing is that for stocks, they can transit from one category to another based on their business prospect They are:
A) Slow Growers - These are the companies that are boring, with no more potential for growth in their respective markets (These can be companies in manufacturing, textile in countries whose economy has progressed beyond manufacturing). They are companies that used to be fast growers, their characteristics are steady dividends, slow earnings growth.
When to buy Slow Growers:
1. Consistent/ Increasing dividends
2. Appropriate % of earnings paid out (not too high that it is unsustainable)
When to sell Slow Growers:
1. After a 30-50% appreciation
2. Changes in fundamentals
3. Eroding Market shares
4. No new and attractive products and R&D budget dropped
5. Started to go into bad diversifications (which results in deteriorating balance sheet)
6. Low dividend yield
B) Stalwarts - These companies are the biggest players in their industry (The industry leaders, like Coke - Beverage, Johnson & Johnson - pharmaceutical, Nestle - Consumer Food, Philip Moris - Cigarettes, Facebook - Social Media, Amazon - E-commerce). You can expect a 30-40% stock increase before selling and moving on to others. Their earnings growth is also higher compared to slow growers. Lynch has commented that Stalwarts are especially good during economic downturns, as they are so big that they can weather the bad economic conditions and take advantage of the rise when the economy is doing better.
When to buy Stalwarts
1. Low historical PE ratio, or comparative PE ratio (against the industry)
2. Higher recent growth compared to long-term historical growth
3. Perform well in past downturns
4. Diversify in relevant companies that can improve corporate synergy
When to sell Stalwarts:
1. When the PE ratio increased to a point too high historically and comparatively.
2. Mixed results from new products
3. Lack of insiders buying
4. Recent growth is slowing down compared to long-term historical growth
C) Fast Growers - Fast growers do not mean the hottest industry. Lynch then elaborated that fast growers can be from any industry (yes, even ones that are mature). He then gave a few examples of growth companies in industries like hospitality or even funeral. For him, the fast growers are the small, aggressive, and new companies that can take over the market shares in these old industries by doing something different. These fast growers should also have good balance sheets and substantial profits.
When to buy Fast Growers:
1. When it launches a new product, and that product contributes a big portion of the total sales of the company
2. When the company can replicate its success from city to city, from country to country. (Lynch emphasized here that it is important that the company shows proof that it is capable of replicating the success before buying)
3. PEG value of <1
4. Entering a phase of rapid expansion of the business
5. Few analysts are covering it and little financial institutions own it
When to sell Fast Growers:
1. When there are no new places to expand the business
2. A lot of analysts are covering the company
3. More institutions are buying into it
4. PE ratios start to become illogical
D) Cyclical - These companies would perform well in a certain economic situation and do badly in another economic situation. One example of which is would be car companies (They would do well in sales in good times - When people have stable jobs and can afford to buy new cars). Hence, by that logic, we would be looking at stocks in the travelling, manufacturing industries, where there are fluctuating demands with respect to time.
When to buy Cyclical:
1. When inventories are decreasing (meaning that the demand is picking up). Cyclicals are the type of businesses where your professional advantage gives you the largest edge against the other investors/analysts.
2. At the beginning of the boom cycle
When to sell Cyclical:
1. When the business has to expend more capital to increase their revenue
2. Inventories start piling up
3. The future price of underlying commodity is lower than current prices
4. Expiring labour contracts leading to unfavourable new contracts
5. Businesses cannot compete with foreign producers
E) Asset Plays - These are the companies in boring or declining industries (Railways, lumber, textile businesses in the US). They do not have a positive future prospect anymore, but they have assets in their possessions that may be more valuable than what the market values them at. Which can be in the form of precious metals, land, mining rights.
When to buy Asset Plays:
1. When there are hidden assets (which may be undervalued due to accounting practises)
2. Corporate raiders and institutions do not take notice of the business
When to sell Asset Plays:
1. Raiders and institutions started to take notice of the business
F) Turnarounds - These are the companies that are in danger of bankruptcy (Like Chrysler, General Motors in the 1970s). Due to the danger of a fail restructuring, the business would be priced low by the market. This would provide a good opportunity for the investors for 2-3 times growth in the prices if the companies can successfully turn their businesses around.
When to buy Turnarounds:
1. High cash positions
2. Low debt structures
3. Proper plans to turn around the business - Selling away unprofitable businesses, cost cuttings
When to sell Turnarounds:
1. After the turnaround was successful
2. Debt increased
3. Inventories started to pile up
4. P/E increased
5. Only one source of income and the client is experiencing a slow down in business
Investing approach:
Lynch separated the investment into 3 phases
1. Being aware of the latest consumer goods that people buy - This would mean keeping an eye out for stores that everyone seems to go to, or looking out for signs of businesses picking up (for the cyclical companies). This can be when the products are getting out of stock, or if the shops' inventory isn't cleared up fast enough
2. Research (using investing metrics) - This can be done through the analysis of the company's fundamentals (think of PE, PEG, assets, dividends payout ratio, net profit margins, debt-to-equity, earning's growth rate, cash position, institution investment, pension plans, inventory, FCF per stock vs price, percentage of sales). As there are a lot of factors, and I am feeling kinda lazy, please go google these metrics yourself. But I guess what Lynch is trying to say here is that: You want to make sure that the company that you are buying into is a strong and healthy company that is poised to take advantage of the recent popularity.
3. Research more (using business analysis) - This is where the amateurs' edge is so important. Lynch has advocated that we stick to the companies that we can understand the business models, the products/services they are selling - essentially staying within our circle of competency. This competency can stem from our understanding of the product as consumers, or if we have professional knowledge that enables us to understand the business' competitive edge against other companies in the industry. Like, as I am an aerospace engineer, with a strong interest in pc components, Lynch would advise me to lean towards the companies that are associated with these fields. This is as I would have knowledge that others would not have, giving me an advantage in determining the business' true value
Expectations of active stock selections:
1. 12% - 15% annual returns after accounting for dividends, bonuses, cost, comms (Which is supposed to be higher than the market returns)
2. A small portfolio of 8-10 stocks would allow for good diversification (against unforeseeable circumstances) without compromising on the returns
Conclusion:
I am sure that Peter Lynch did a fantastic job during his helm as the manager of the Magellan fund. He is definitely one of the best investors of our times and definitely, people have done well in the stock market following the instructions of this book. But again, his method is not really applicable to my way of investing as I really do not have the time or energy to research and find opportunities to invest.
But I do wish people who follow his instructions all the best in trying to identify great buying opportunities in the market.
t
