Peter Lynch is known for his versatility. He deployed a wide range of strategies during his career to earn market-beating returns.
As described in his book, One Up on Wall Street, he’d invest in anything — slow growers, stalwarts, fast growers, cyclicals, turnarounds, and asset plays. He even borrowed Ben Graham’s net-net strategy to invest in Dot-com stocks after the bubble burst.
But how did he put that skill to use regarding portfolio construction?
In a 1985 interview, he described how he constructed the Magellan Fund. Lynch divided the fund into three buckets — conservative stocks, growth stocks, and special situations:
I’ve divided the fund into three sections. I put generally 25%-35% of the fund in conservative stocks — by which I mean stocks that, after I make 30% or 35% in them, I want to sell and buy another that hasn’t done much lately… As long as the fundamentals are fine and I think they’re cheap, I’ll keep adding to my positions… You don’t do this with growth stocks and cyclicals. You could lose 50% for starters on those and you don’t do that with the hope of making just 30% or 40%. That’s not a way to win. But since, in most of the portfolio, I’m taking quite a bit of risk, I put some part of my fund into stocks that will hold up, even if the market is going down. And when the market roars, the conservative stocks don’t beat the market by much, if at all, but they do okay…
Then 30% or 45% of the fund is always in growth stocks. Now, some of these might be growth stocks like Philip Morris that has had 40 years of up earnings that are selling at seven or eight times earnings — what some people might consider conservative stocks… What I call growth stocks are companies that every year sell more widgets; have more stores open. The stock may not go up in any one year but generally you’re taking more risk with growth stocks and you’re hoping to own them for several years and maybe get a double or triple or more… Usually, I’m looking for a company that has done something right for several years. If you and I took it over, you wouldn’t notice any difference for three or four years. I want a company that’s simple. They don’t have to make seven brilliant decisions every six months to keep going. There’s something inherent in this business that can keep it going for five, 10, 15 years and I can understand it.
The final section of the fund would be in cyclicals and special situations.
Portfolio construction in the simplest terms is about offense and defense. With a basic allocation of stocks and bonds, the bulk of the returns come from the stock side of the portfolio, i.e. the offense. Bonds, the defense, help you lose less when stocks perform their worst.
Lynch replicated the idea of offense and defense but without bonds. Each bucket fills a specific role, depending on the market cycle. Collectively, the portfolio tilts enough to be different than the market. And in Lynch’s case, he created a market-beating portfolio.
Lynch’s conservative stocks offered downside protection if the market turned south. Special situations, typically the most detached from market behavior since their often tied to an event, helped the portfolio lose less too. The growth stocks did the opposite, providing the potential to outperform in a bull market.
Buffett used a three-bucket approach back in his partnership days too. He divided his portfolio into generals (play a similar role as Lynch’s growth stock bucket), workouts (i.e. special situations), and control situations (ie. an activist bucket). The buckets are different but have similar reasoning behind them.
The first section consists of generally undervalued securities (hereinafter called “generals”) where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself… Sometimes these work out very fast; many times they take years…
The generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market.
Our second category consists of “work-outs.” These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs.
This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout a year with a large portion of our portfolio in workouts, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year. Over the years, work-outs have provided our second largest category.
The final category is “control” situations where we either control the company or take a very large position and attempt to influence policies of the company. Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it. These situations, too, have relatively little in common with the behavior of the Dow.
Lynch and Buffett took a unique approach to portfolio construction to get the best returns possible. Their three buckets offer a template for diversifying a stock portfolio that works throughout a market cycle.
Buffett Partnership Letters
- Looking Back at the First Roaring Twenties – R. Shiller
- Why Should Equities Be Fairly Valued? – Behavioural Investment
- Three Takeaways From the Archegos Disaster – J. Rekenthaler
- The Two Most Underappreciated Forces Driving Markets Today – A Wealth of Common Sense
- Master Series: Chatting with Francois Rochon – Investment Master Class
- The Challenges of Avoiding Value Traps And Some Criteria That Might Help – ValIdea
- The Corporate Tax Burden: Facts and Fiction – Musings on Markets
- Daniel Kahneman: A Remarkable Life, Fast and Slow (podcast) – The Psychology Podcast
- Mathematics for Gamblers – Aeon