market folly

A reader sent us an old article from Peter Lynch entitled "Use Your Edge."  If you're unfamiliar, Lynch is a well-known fund manager that ran billions in Fidelity's Magellan Fund for a long time and is also the author of One Up On Wall Street and Beating the Street.  Below we highlight some excerpts from the old article:

Invest In What You Know

Peter Lynch has long preached his old adage of "invest in what you know."  Lynch writes,

"This is where it helps to have identified your personal investor's edge.  What is it that you know a lot about?  Maybe your edge comes from your profession or a hobby.  Maybe it comes just from being a parent.  An entire generation of Americans grew up on Gerber's baby food, and Gerber's stock was a 100-bagger.  If you put your money where your baby's mouth was, you turned $10,000 into $1 million."

Warren Buffett advocates a similar approach in investing in "your circle of competence."


Let Your Winners Run

Lynch then goes on to touch on another old Wall Street Adage: "let your winners run, and cut your losers."  He says that:

"It's easy to make a mistake and do the opposite, pulling out the flowers and watering the weeds.  If you're lucky enough to have one golden egg in your portfolio, it may not matter if you have a couple of rotten ones in there with it.  Let's say you have a portfolio of six stocks.  Two of them are average, two of them are below average, and one is a real loser.  But you also have one stellar performer.  Your Coca-Cola, your Gillette.  A stock that reminds you why you invested in the first place.  In other words, you don't have to be right all the time to do well in stocks.  If you find one great growth company and own it long enough to let the profits run, the gains should more than offset mediocre results from other stocks in your portfolio."


On Growth Stocks

And given the propensity for many investors to focus on growth stocks these days, we thought it worthwhile to share Lynch's thoughts:

"There are two ways investors can fake themselves out of the big returns that come from great growth companies.  The first is waiting to buy the stock when it looks cheap.  Throughout its 27-year rise from a split-adjusted 1.6 cents to $23, Wal-Mart never looked cheap compared with the overall market.  Its price-to-earnings ratio rarely dropped below 20, but Wal-Mart's earnings were growing at 25 to 30 percent a year.  A key point to remember is that a p/e of 20 is not too much to pay for a company that's growing at 25 percent.  Any business that an manage to keep up a 20 to 25 percent growth rate for 20 years will reward shareholders with a massive return even if the stock market overall is lower after 20 years.

The second mistake is underestimating how long a great growth company can keep up the pace.  In the 1970s I got interested in McDonald's.  A chorus of colleagues said golden arches were everywhere and McDonald's had seen its best days.  I checked for myself and found that even in California, where McDonald's originated, there were fewer McDonald's outlets than there were branches of the Bank of America.  McDonald's has been a 50-bagger since."


On When to Exit the Market

Next, we wanted to highlight Lynch's rule for when to exit stocks.  He says that,

"The only time I took a big position in bonds was in 1982, when inflation was running at double digits and long-term U.S. Treasurys were yielding 13 to 14 percent.  I didn't buy bonds for defensive purposes.  I bought them because 13 to 14 percent was a better return than the 10 to 11 percent stocks have returned historically.

I have since followed this rule: When yields on long-term government bonds exceed the dividend yield on the S&P 500 by 6 percent or more, sell stocks and buy bonds."

Applying his rule to the current market, we see that long-term (20 year) Treasuries currently yield around 2.52%.  The S&P, on the other hand, currently yields around 1.9%, so Lynch would advocate staying in stocks. 


Advice For Investing $1 Million

Lynch says to find your edge and put the money to work via the following rules:

- Know the reason you bought the stock
- Pay attention to facts, not forecasts
- Look for a risk-reward ratio of 3:1 or better (know how much you can lose)
- Be patient
- Enter early (investing in growth companies in the 3rd inning)
- Buy cheap stocks not because they're just cheap, but because fundamentals improve


 For more wisdom from the former Magellan Fund manager, check out his books: One Up On Wall Street and Beating the Street.