I finally finished reading a book’s worth of articles written by Peter Lynch from 1992 to 1999. It was 44 articles to be exact and offered a peek into his thought process during the last seven years of the longest bull market in history.
His articles were a mixture of the typical Peter Lynch advice and case studies where he saw opportunities at the time.
Surprisingly (maybe not), he never mentioned the huge run-up in dot-com stocks. Instead, he focused on business he understood and fit his strategy. So most of the discussion was growth stocks, cyclicals, and turnaround opportunities.
I wanted to share some of my favorite highlights from Lynch’s articles.
(Just a heads up: none of this is online, I found it while digging through the public library database.)
Lynch believed investors have an advantage if they’re willing to think independently of the herd (the herd being Wall Street). Otherwise, they’ll likely fall prey to one of these self-destructive mistakes:
The inferiority complex causes investors to do one of three self-destructive things: (1) imitate the pros by buying “hot” stocks or trying to “catch the turn” in, say, IBM; (2) become “sophisticated” by investing in futures, options, options on futures, etc.; (3) buy what they’ve heard a pro has recommended, either in a magazine or on one of the popular financial news programs. Information on what the pros think is so readily available that the celebrity tip has replaced the old-fashioned tip from Uncle Harry as the most compelling reason to invest in a company.
Lynch mastered cyclical stocks (among others), which helped supplement his growth stock performance. But even he admits cyclical stocks aren’t easy because of the stigma around a recession:
The best time to get involved with cyclicals is when the economy is at its weakest, earnings are at their lowest, and public sentiment is at its bleakest…
Yet even though the cyclicals have rebounded in the same fashion eight times since World War II, buying them in the early stages of an economic recovery is never easy. Every recession brings out the skeptics who doubt that we will ever come out of it, and who predict that we will soon fall into a depression, when new cars will sit unsold in the showrooms forever and houses will stand empty, and the country will go bankrupt. If there’s any time not to own cyclical stocks, it’s in a depression.
“This one is different,” is the doomsayer’s litany, and, in fact, every recession is different, but that doesn’t mean it’s going to ruin us. In order not to get sucked into the gloom, I always remind myself that although we once suffered from chronic depressions leading to the Great Depression of 1929 (in fact, that one was no “greater” than several others), we are no longer the same economy. Today 17 percent of Americans work for federal, state, or local governments, and millions more get Social Security benefits, unemployment compensation, and/or pension payments, so there are enough steady paychecks being cashed every week to keep the economy from slowing to a halt. We have a huge college industry and a huge health-care industry, both of which are immune from recession – colleges do better in recessions. There are many other stabilizing factors – the Fed, deposit insurance, and so forth – that we’ve all heard about.
Cyclicals are also a game of anticipation:
As business goes from lousy to mediocre, investors in cyclicals can make money; as it goes from mediocre to good, they can make money; from good to excellent, they may make a little more money, though not as much as before. It’s when business goes from excellent back to good that investors begin to lose; from good to mediocre, they lose more; and from mediocre to lousy, they’re back where they started.
So, you have to know where we are in the cycle… But it’s not quite as simple as it sounds. Investing in cyclicals has become a game of anticipation, as large institutions try to get a jump on their competitors by buying cyclical companies before they’ve shown any signs of recovery. This can lead to false starts, when stock prices run up and then fall back with each contradictory statistic (we’re recovering, we’re not recovering) that is released. To succeed at investing in cyclicals, you have to have some way of tracking the fundamentals of the industry and the company involved.
***
It’s in the nature of Wall Street to imagine that whenever a company sets a record for earnings, it will go on setting new ones. (This is no different from sports, where last year’s winner is usually picked to repeat.)…In cyclicals, a period of silly prices is followed by a period of sobriety.
***
You can’t go to sleep holding cyclical stocks for a decade and expect to be richly rewarded. The rich rewards are in growth stocks and special situations.
Lynch also used turnaround stories to supplement his performance and offered a few lesson’s there:
It’s one thing for a company’s earnings to decline in a recession or because of a temporary misfortune such as a labor strike or a hurricane or a bad marketing decision. But when there’s a steady and prolonged drop in revenues, then you’re looking at a serious, fundamental setback that won’t be corrected overnight. The key lesson here is, you don’t have to rush in to buy shares. You can afford to wait. In some cases, you can’t afford not to wait.
Once a troubled company faces up to its predicament (this, too, can take time), it will announce a plan for recovery, which usually involves taking an ax to the budget. Here again, the would-be investor must be careful, because while cutting the budget may boost profits in the short run and create the impression that the company has put its troubles behind it, the real work has scarcely begun.
The hard part is winning back customers and reversing the decline in sales. A company that continues to spend less to make less will eventually have nothing to spend and nothing to make…
There’s no harm in taking a “show me” attitude toward turnarounds. Once in a while you’ll miss a few dollars of profit by not getting in at the bottom of the successful cases. But in the unsuccessful cases, you’ll save yourself a lot of money and frustration. Missing the bottom on the way up won’t cost you anything. It’s missing the top on the way down that’s always expensive.
***
The harsh truth is that yesterday’s reinvention doesn’t mean as much as today’s execution and tomorrow’s competition. Just as old companies sometimes have to learn new tricks, new companies have to keep changing.
Like Warren Buffett, Lynch’s ideal business has great management and dominates the market. And if it only has a few competitors, that works too:
My idea of a great business is one that has a shortage of competitors. In America, we grow up thinking that competition is healthy, which in spelling bees, pie contests, and fund management, it is. But in such industries as airlines and computers, competition can lead to lousy earnings and multiple bankruptcies and is hazardous to human wealth. There ought to be a warning label.
***
If it’s a choice between investing in a good company in a great industry, or a great company in a lousy industry, I’ll take the great company in the lousy industry any day. Good management, a strong balance sheet, and a sensible plan of action will overcome many obstacles, but when you’ve got weak management, a weak balance sheet, and a misguided plan of action, the greatest industry in the world won’t bail you out. Here’s my investment motto of the month: It’s the company, stupid.
Rather than trying to pick the winner of a highly competitive industry, pick the main suppliers to the highly competitive industry:
Usually, my favorite method for investing in high-growth areas where the competition is fierce is the pan-and-shovel technique. This technique gets its name from the 19th-century owners of general stores who got rich selling equipment to the prospectors who went bust in the Gold Rush. When I see a mania, such as computers, where dozens of companies are struggling to sell the same thing, I look for a supplier who provides them all with some basic gizmo they all need.
***
This is the old combat theory of investing: When there’s a war going on, don’t buy the companies that are doing the fighting; buy the companies that sell the bullets.
And there is always something to worry about:
With every company, there is something to worry about, but the question is, which worries are valid and which are not?
***
There’s no such thing as a worry-free investment. The trick is to separate the valid worries from the idle worries, and then check the worries against the facts.
***
The very existence of doubt creates the conditions for a big gain in the stock once the fears are put to rest. The trick is to put your fears to rest by doing the research and checking the facts – before the competition does.
Corrections are normal. Acknowledging that stocks move up and down, is the first step in accepting your market timing problem:
The only problem with market timing is getting the timing right. I haven’t met many people who’ve done it successfully. Maybe once in a row, but not consistently. There’s no telling how many timers miss big gains in stocks by making ill-timed exits.
***
Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.
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People have more time than they think to ride out corrections, which is the main reason we shouldn’t be worried about the next one, or the one after that.
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Corrections are unpredictable. By selling stocks to avoid pain, you can miss the next gain.
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As soon as you realize you can afford to wait out any correction, the calamity also becomes an opportunity to pick up bargains.
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Ask yourself this: If stock prices dropped 10 to 25 percent, would you add to your positions in stocks and mutual funds, or would you cash out and cut your losses? If the answer is that you’d cash out, then do it now and avoid the misery that is sure to come later.
Ultimately, it always comes down to earnings:
I can’t say enough about the fact that earnings are the key to success in investing in stocks. No matter what happens to the market, the earnings will determine the results. In 30 years, Johnson & Johnson’s earnings are up 70-fold, and the stock is up 70-fold. Bethlehem Steel earns less today than it did 30 years ago, and guess what? The stock sells for less than it did 30 years ago.
In a bear market, the Johnson & Johnsons will suffer right along with the Bethlehems (although perhaps not as much), and nobody will be happy. But between Bethlehem with its spotty record and Johnson & Johnson doubling its earnings every six or seven years and raising its dividend like clockwork, which would you like to have in your portfolio a decade from now?
***
What makes stocks valuable in the long run isn’t “the market.” It’s the profitability of the shares in the companies you own. As corporate profits increase, corporations become more valuable, and sooner or later, their shares will sell for a higher price…Ultimately, to be an investor in stocks, you have to believe that American business has a decent future, as well as business worldwide, and that corporations will continue to increase their profits. If you are as convinced of this as I am, then you’ll never panic in a correction.
Finally, despite all the recessions, the bad news, and the doomsayers, it’s progress and innovation that sets the American economy apart:
Job insecurity has been a problem for as long as people have depended on a paycheck. In the last century, half the U.S. population lived and worked on farms, so we’ve already lost two-thirds of the farming jobs. At one time, there were more than 200 manufacturers in the auto industry; at another point, the steel industry employed one of every 100 workers. Today, we have a handful of auto companies and two-thirds of the steel jobs have disappeared, but somehow the country has managed to survive and prosper.
…
Again and again, new opportunities have arisen to take the place of the lost opportunities. This is the way the capitalist ecology works. Industries decline, old companies wither away, and young companies rise up to replace them. This process is hard on many, but ultimately, it is healthy. The strength of our economy is that it is dynamic and always adapting to changing conditions. That’s our advantage in the world. That’s the reason we’re as creative as we are as a nation.
A Few One Liners
If you cut enough losses, sooner or later there’s nothing left to cut.
Cyclicals are very forgiving. They always give you a second chance.
When the calamity makes the front page of the Times, it’s a signal to start your research.
Art may be the “window to the inner soul,” but like cement or oil, it’s also a commodity. It has its cycles of low prices and high prices and the occasional bubble followed by a bust.
Stocks and singers may start out in the hinterlands, but if they keep making beautiful noises, they’re bound to be discovered sooner or later.
In my investing career, the best gains usually have come in the third or fourth year, not in the third or fourth week or the third or fourth month.
There’s a psychological benefit to tossing the bums out: The names disappear from the monthly brokerage statements; we’re no longer reminded of our mistakes.
It’s worth reminding ourselves from time to time that gyrations in a stock price may tell us absolutely nothing about the prospects of the company involved.
As long as people are willing to pay foolish prices for things, no plan is foolproof.
If your only reason for picking a stock is that an expert likes it, then what you really need is paid professional help.
Buy only what you understand, believe in, and intend to stick with – even when others are chasing the next miracle.
Gold, much more so than any other commodity, is about sentiment and psychology.
Source:
Peter Lynch via Worth Magazine 1992 – 1999 (check your local library)
Related Reading:
10 Lessons Learned from Peter Lynch
