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Anyone can spot multi-baggers
Everyone loves to shop and most people would love to know what their wives are buying. L' Eggs was a pantyhose product that Caroline Lynch bought and found very comfortable. She told her husband Peter about it and, when he checked, he found that it was sold both in supermarkets which women visited about once in six weeks, and in drugstores, which they visited once a week. Further, the company had all the sizes and in a further twist, they didn't advertise the price. They just said, "This fits. You'll enjoy it."
Peter Lynch invested in Hanes the company that made L' Eggs. The product was huge success and Lynch scored yet another alpha. "So I held onto Hanes and it was a huge stock and it was bought out by Consolidated Foods, which is now called Sara Lee, and it's been a great division of that company. It might have been a thirty bagger instead of a ten bagger, if it hadn't been bought out," he says. (PBS.org., Frontline)
Explaining, he adds, "You made ten times your money. Is a ten bagger. I've always been a great lover of baseball. So I've always loved baseball and the ten bagger is two home-runs and a double. It's you run around a lot, so it's very exciting."
Outstanding track record
Peter Lynch headed Fidelity Magellan for thirteen years. He started with a fund of $20 million in 1977. When he ended his career with Fidelity in 1990, he had taken it to $14 billion; an astounding 29% annual return. During this heady period, the fund outperformed the S&P 500 index for all years save two. If you had put $1000 in Magellan on 31st May, 1977, the day Lynch joined, thirteen years later you would have got $ 28,000, on 31st May 1990, the day he quit.
Individual investors are better placed than fund managers
According to Lynch, individual investors are at an advantage compared to institutional investors. Individual investors enjoy much greater latitude in deciding the investments they make, while they are wholly free from quarrelsome committees and interfering higher ups. Thus he uses this matrix to decide his investments. Such investors can identify lucrative opportunities better and get results quicker. The trick, he says, is to analyse each option on its merit, get a feel for the business and study the company's financial profile for profitable growth. He favours small companies as in his view these have greater growth potential, in value terms, than established companies.
"They should buy, hold, and when the market goes down, add to it. Every time the market goes down 10 percent, you add to it, you'd be much -- you would have better return than the average of 11 percent, if you believe in it, if it's money you're not worried about. As the market starts going down, you say, "Oh, it'll be fine. It'll be predictable."
"Investing without research is like playing stud poker and never looking at the cards," he warns.
Invest in what you know
This premise of Lynch is considered to be the most basic of investment principles for the serious investor. He says that before investing, one should know everything about the company, its core strengths, its technology, its products, its current competitors and the potential for the emergence of game changing technologies and competitors. He puts all this down on paper as a 'story'. If the 'story' was good then it was a good company to invest in.
Six types of stories
He built his analysis around six scenarios. These are the Asset opportunities, Slow growers, the Fast-growers, Cyclicals, Turnarounds, and the Stalwarts.
Asset opportunities are the best possible investment options, since these companies posses highly rewarding assets. Further, they are often overlooked by mainstream analysts and can thus be picked up cheaply. Fast growers represent high risks, while slow growth companies should be the last on the list of possible investments. Stalwart companies afford protection to investors, while the performance of turnarounds will not be in sync with market trends and cylicals depend hugely on timing. He advocates the sale of shares in companies whose 'stories' have played out.
Buy a business that any idiot can run
He says that it is imperative to gain a correct understanding of a company's business and its assets to make the right investment decisions. "Go for a business that any idiot can run - because sooner or later, any idiot is probably going to run it."
Lynch believes in long term investments and to stay invested rather than hold cash. "I've found that when the market's going down and you buy funds wisely, at some point in the future you will be happy. You won't get there by reading 'Now is the time to buy.'"
Leader of the PEG approach to valuations
He takes three measures into account whenever he makes investment decisions. They are price, profitability and a good business model. (www.Valuwalk.com.) He chose companies with a good track record of high growth and profitability. He made sure that their P/E ratios were below industry average, as well as below the company's own average. Other factors that he looked into were whether the company's debt is low, whether it has given a growing stream of dividends over the years, even decades. He favoured companies that had high net cash to stock price ratios.
Over the years he evolved his now famous metric of 'PEG', which he uses to determine if the stock price is economical in relation to the growth of the stock. The quicker the company's growth rate, the higher the P/E ratio that an investor can pay for it. He found this out by dividing the P/E ratio by the company's historical growth rate.
Affinity for under-researched companies
He looked for rapidly growing companies, even in slowly growing industries, company spin-offs, and firms making goods with inelastic demand. He also sought companies that were below the radar of analysts, companies with insider buying and those which had low institutional shareholdings. Lynch does not favour buying shares of companies which have not been properly analysed by the investor. Even though he held more than 1,400 stocks in his portfolio, he resisted diversification if it limited his ability to research and study the stocks.
Think like a housewife
He urges investors to check the products of the companies they plan to invest in. For example if one is looking for investing in a hotel, then one should analyse the number of hotels being built, the location of the hotels and basic down to earth stuff like that. When a housewife buys a fridge, she visits several shops, consults neighbours about the performance of particular brands and models, then takes the opinion of technicians to help buy a fridge. "When they look at a house, they're very careful. They look at the school system. They look at the street. They look at the plumbing." Investors should get to this level of detail regarding the companies they aim to invest in.
However when people buy shares, they simply go out and buy, based mostly on 'gut feeling' or worse, the opinions of 'experts'. Then, when the share's price tumbles, they lament that they have been let down. Lynch says that the sort of research one does to buy a simple thing like a fridge or a car should be utilised in making informed choices about stocks. He says that it is important to know exactly where a company is, with reference to its industry and the competition, before buying that company's share. "Now if you buy a -- you make a mistake on a car, you make a mistake on a house, you don't blame the professional investors. But now if you do stupid research, you buy some company that has no sales, no earnings, a terrible financial position and it goes down, you say, "Well, it's because of the programmed trading of those professionals," that's because you didn't do your homework. So I -- I've tried to convince people they can do a job, they can do very well, but they have to do certain things."
Market timing
Timing the market is very difficult, according to Lynch. "The market itself is very volatile," he says. "We've had 95 years completed this century. We're in the middle of 1996 and we're close to a 10 percent decline. In the 95 years so far, we've had 53 declines in the market of 10 percent or more. Not 53 down years. The market might have been up 26 finished the year up four, and had a 10 percent correction. So we've had 53 declines in 95 years. That's once every two years."
"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets."
"There are substantial rewards for adopting a regular routine of investing and following it no matter what, and additional rewards for buying more shares when most investors are scared into selling." (PBS.org., Frontline)
Futility of economic forecasts
He says that trying to forecast economic conditions is useless, for there is always scope for the unexpected to happen, like the oil price spike in the Seventies. Economic forecasting is pure crystal ball gazing and cannot be used for predicting a company's performance, he feels.
On the other hand he keeps a close watch on the financial performance of target companies. Lynch calculates that an eight percent profit growth would lead to doubling in nine years and a six fold increase in 25 years. One can add two or three percent dividend payout to this.
"So you have to say to yourself, "What's gonna happen in the next 10-20-30 years? Do I think the General Electrics, the Sears, the Wal-Marts, the MicroSofts, the Mercks, the Johnson & Johnsons, the Gillettes, Anheiser-Busch, are they going to be making more money 10 years from now, 20 years from now? I think they will." Will new companies come along like Federal Express that came along in the last 20 years? Will new companies come along like Amgen that make money? Will new companies come along like Compaq Computer? I think they will. There'll be new companies coming along that make money. That's what you're investing in." (PBS.org., Frontline)
Final words of wisdom
Many of his insightful ideas are amplified in his books, One Up On Wall Street, Beating the Street and Lear to Earn. His final advice is simple yet profound. "Never invest in any idea you can't illustrate with a crayon."
Content is prepared by Wealth Forum and should not be construed as an opinion of HDFC Mutual Fund.
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Wise Advice
Every equity investor dreams of picking multi baggers with some of his stock bets. The art of picking multi baggers was associated with exceptional skills and rare insight that only experienced fund managers possessed - until Peter Lynch came along and gave us a DIY approach to picking multi baggers. He became hugely famous not just for his outstanding performance, but for the extremely common sense "aam aadmi" oriented approach to identifying promising stocks - which every investor readily relates to. Read on as we distil wise advice from the guru of multi baggers.