The Misunderstanding of Peter Lynch’s Investment Style

Posted on Posted in Books, General Thoughts

“I’ve never said, ‘If you go to a mall, see a Starbucks and say it’s good coffee, you should call Fidelity brokerage and buy the stock.'” – Peter Lynch

I saw an article in Monday’s Wall Street Journal on Peter Lynch. Basically, it was a very brief piece where Lynch basically says that people are misinterpreting his advice to “buy what you know”.

I like Peter Lynch and I like his writing. Although the first book I ever read on value investing was a book on Buffett that I picked up one day in the library many years ago, I began reading about Peter Lynch and his investment concepts before I really began studying Buffett. His common sense approach that has been so widely attributed to him resonated with me (as it did with so many others as well). I particularly gravitated toward the idea of compounders (or as Lynch called them, 10-baggers, or stocks that were growing and could go up 10-fold or more in value). I don’t tend to own stocks forever, but the concept of finding a great business that can do the heavy lifting for you while you passively let value compound is about as good as it gets. These are very rare birds, but it became interesting to me to study these businesses and begin to focus on identifying some common denominators.

I’ve talked in numerous posts about the value of finding a business that can retain and reinvest capital at high rates of return. The key ingredients to Lynch’s 10-baggers are attributes such as high returns on capital, ample reinvestment opportunities, and a long runway through either unit growth or price increases. A durable competitive position along with shareholder friendly management often provide tailwinds to these 10-baggers also.

This concept has always stuck with me and I have always placed a premium on the quality of a business and its ability to produce attractive returns over time. But although his common sense approach has a lot of merit, I’ve always thought that the most people misinterpreted Lynch’s advice in a way that became a desired short-cut of sorts to achieve investing success. I never really thought this was true. Maybe Lynch was a bit too simplistic and didn’t properly set expectations. But I think part (most) of the onus should be on the reader. There is no free lunch and beating the market is not easy. Investors should know and expect this if they decide to pick their own stocks.

Lynch’s Early Magellan Years

You don’t hear much from Peter Lynch these days. I think he has lived a relatively quiet life (or at least a life out of the limelight) since retiring from Fidelity in 1990. Of course, his fund is probably the most famous mutual fund of all time with probably the best 13 year track record during the time he was running it. Lynch compounded capital at 29% annually during this incredible run, and his fund grew from $18 million to $14 billion by the time he signed off. It’s an impressive run, but even more impressive were his returns in the early years of Magellan when it could still maneuver like a speed boat (it turned into to a supertanker by the end of Lynch’s tenure). Here are the results of Lynch (as mentioned in Beating the Street) when he was just getting the snowball rolling:

  • 1978: 20.0%
  • 1979: 69.9%
  • 1980: 94.7%
  • 1981: 16.5%

I wrote a post earlier this year referencing Lynch and how he was able to achieve these results. He was a very active investor, constantly moving in and out of stocks. I prefer more concentration and less activity in my own investing. That said, turnover is neither good nor bad in and of itself. The benefits/drawbacks are misunderstood. As I mentioned in my post, portfolio turnover (like asset turnover when evaluating a business’s efficiency) is just one part of the equation that determines returns on investment. Some businesses achieve high returns through high profit margins and low asset turns. Other companies can achieve attractive returns despite very low margins by turning over their inventory very rapidly. The same is true for a portfolio of securities… some achieve great returns by owning relatively few stocks that return huge profits over multiple years, others are more active traders who make many different investments and have shorter holding periods and smaller average profits per investment.

Despite being famous for 10-baggers, in the early years Lynch was like a productive grocery store-he got very high returns by achieving relatively small margins on many different items (stocks) but turning over his capital multiple times per year. His turnover exceeded 300% per year during the early years of Magellan. He frantically would buy stocks that were dirt cheap, sell them as they appreciated, and then rotate his funds into other stocks that were cheaper.

You have to put this in context though, as the early years of Magellan were very good years for value investing. Walter Schloss also had the best stretch of his career from 1977-1982, a period where the overall market averages didn’t do much, but bargains were everywhere. The US economy entered a recession in the late 1970’s, and then again (the now often-applied phrase “double-dip recession”) in the early 1980’s. The stock market hadn’t budged in 17 years (it was flat between 1965 and 1982). But for value investors like Lynch (yes, he was a value investor), it was heaven.

Lynch mentioned at the end of chapter four in Beating the Street how good of a market it was in the early 1980’s. What happened according to Lynch?

“The stock market fell apart. As is so often the case, just when people began to feel it was safe to return to stocks, stocks suffered a correction. But Magellan managed to post a 16.5% gain for the year (1981) in spite of it. No wonder Magellan had a good beginning. My top 10 stocks in 1978 had P/E ratios of between 4 and 6, and in 1979, of between 3 and 5. When stocks in good companies are selling at 3-6 times earnings, the stockpicker can hardly lose.”

So Lynch in the early years was buying bargains. He remarked in Beating the Street: “I doubt that I was ever more than 50% invested in the growth stocks to which Magellan’s success is so often attributed.” Similar to Buffett in the early years, I think Lynch had more ideas than capital, and the stock market was filled with bargains so there was a constant recycling of capital–buy something cheap, let it appreciate some, notice something even cheaper, swap the capital from the cheap idea to the even cheaper idea. This lasted for a period of years.

Now, Lynch preferred the growth stocks. It’s just that he wanted to buy them at a fair price. But he was always on the lookout for the potential 10-bagger. Some of the stocks that made the most returns for Magellan shareholders were these big winners that played out over multiple years. And Lynch is right in that 2 or 3 of these huge winners (the Walmarts, the Cracker Barrels, the Suburus, the Wells Fargos, etc…) can make a career. So for good reason, Lynch trumpets the merits of looking for these home runs. But while he himself was always on the lookout for them, he also was buying bargains and special situations when they were available.

One strategy is not necessarily better than the other. A lot depends on the investment opportunities available. Right now, there are a lot of great businesses on my watchlist but very few of them seem attractively priced. I think Lynch paid much more attention to value than most people think, but it still pays to heed his common sense advice of buying a good business that you understand (one with good economics that can grow).

Generally, that’s all I’m trying to do. I am always interested in value, bargains, or special situations, but I spend most of my time reading about businesses and building my watchlist of quality companies. The key is waiting for the fat pitch–i.e. the rare opportunity when a large gap between price and value appears. They are rare, but they appear often enough.

Have a great weekend,

John

———

My name is John Huber. I am the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

10 thoughts on “The Misunderstanding of Peter Lynch’s Investment Style

  1. Thanks John for a great post. Speaking of waiting & patience for the quality stocks to go on sale, and bringing that in the current context (Yellen next Wednesday, etc). Do you expect high volatility in the months ahead, a side-ways movement, are you inclined to sit in cash and wait, do you expect a repeat of the August-Sept. correction? I’m curious about your general market outlook for these coming weeks/months…

    1. Hi Giselda, I really have absolutely no idea what the market will do next week or in the next few months (or even in the next year or two for that matter). Over time, it will go up. That’s about the best I can do when it comes to overall stock market prognostication. I really spend no time even thinking about such things, as I feel it’s a difficult game to play and I not one that I particularly enjoy. I’d much rather just try to focus on evaluating businesses and look for bargain stocks of companies I understand, and let the market do whatever it’s going to do. I know this approach sometimes gets ridiculed in bad markets, but I think just focusing on bottom up stock picking is the best way to produce attractive returns over long periods of time. Very, very few people will be the next Soros or Druckenmiller and prove to be adept at dancing in and out of markets, so I choose to play what I think is an easier game (that I happen to enjoy more anyhow).

      That doesn’t mean I’m fully invested. I happen to have a lot of cash currently. But it’s not a market timing call. It is just the natural result of my investment process (sometimes there will be cash, other times I’ll be fully invested).

      Thanks for reading!

  2. My comments might be controversial so just to be clear I think Lynch is good and I like his books. But I really wonder how much is greatness and how much is just pre-reg. FD ‘information advantage’. How could he not outperform with a first look/heads up from management at all those companies?

    1. Interesting comment, but I think the vast majority of his scuttlebutt could be performed by a similarly diligent fund manager today. I think what cannot be overstated is Lynch’s maniacal work ethic and extreme focus on his work. The guy lived and breathed stocks for 13 years. He worked at such a frenzied pace that he sacrificed many other things in life and reached the point of burnout. He realized he was missing family time at the expense of his work. So I think his efforts likely were responsible for his results much more than his position or connections (although those certainly helped also). But there were plenty of other fund managers who had the same or better connections than Lynch who were trounced by his results.

      1. Isn’t there a very real sense in which the main way to get ‘information advantage’ is simply to obsessively research? I’ve come to the belief that ‘buy what you know’ really means ‘invest in what you know an astounding amount about’ — because the rest of the market doesn’t know enough to value it correctly, but you probably do.

  3. John,
    It was well articulated and written with certainly find balance between value and growth, depending on time and situation.

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