Along with Warren Buffett and Seth Klarman, I consider Peter Lynch to be one of my favorite investors who I could stand to learn quite a bit from. From 1977 to 1990, Lynch ran Fidelity’s flagship Magellan fund, which grew at a rate of 29.2% annually over the thirteen year stretch that he was in charge. Famous for preferring businesses that had ‘business models he could draw with a crayon,’ Lynch was able to target companies with durable economic advantages and patiently wait for the right price.
If you had invested $10,000 with Lynch during the first year that the fund opened, your initial investment would have compounded into over $250,000 after-tax when Lynch’s thirteen year reign came to a close. Lynch encouraged investors to focus on five factors in particular when evaluating a potential investment, and they form an incredibly helpful checklist to keep in mind when scoping out companies for investment.
(1) The company operates in a boring, or preferably, disagreeable sector. One of Warren Buffett’s most profitable investments of the past twenty five years has been Gillette, now part of Proctor & Gamble (NYSE:PG). For most people, razor blades aren’t an exciting investment, but Buffett considered the value of Gillette’s brand name and the repetitive nature of the product that is relatively immune from technological obsolescence and recessions—people are going to keep shaving no matter what. In Lynch’s case, he believed that companies like Waste Management (NYSE:WM) would tend to trade at a discount because of the disagreeable nature of the business—you rarely hear about people investing chunks of their life savings in a toxic waste hauling company, and Lynch believed this created an undervalued opportunity for investors to exploit.
(2) The company benefits from technological advances. For most of the 20th century, newspapers were considered blue-chip stocks. Heck, if the internet never came along, the New York Times (NYSE:NYT) could be considered a core holding, a company with an indefatigable moat. But we all know what the rise of the internet did to the newspaper business model. Lynch encouraged investors to look at companies that can reduce costs with successive advances in technology. Coca-Cola (NYSE:KO) is now able to offer a machine that can create 100 different flavor combinations with its new mixer machine that automatically transmits the sale order back to HQ in Atlanta, for cataloguing, and this allows the American stalwart to improve cost efficiencies.
(3) The company operates in a niche that would be difficult for other companies to penetrate. When Buffett explained his recent investment in IBM during his CNBC interview last week, he told an anecdote about when tried to start his own tech servicing firm in the 1960s. Buffett was willing to operate at cost in an effort to try to establish market share, but one of his hopeful clients told him, “No one gets fired for going with IBM.” At that moment, Buffett realized that not only could he not compete with IBM in the niche economically (because they were making a profit when he would have to operate at cost), but the company had established such a reputable advantage in the niche of tech servicing that it seemed highly unlikely that anyone would be able to disrupt IBM’s market share.
(4) Whether the economy is undergoing expansion or contraction, customers will buy the product. In 2007, when the Dow Jones (NYSEARCA:DIA) was trading at an all-time high, people were drinking Pep (NYSE:PEP) products and eating Lay’s potato chips. In 2008 and 2009, when the Dow Jones cut in half, people were still drinking Pepsi products and eating Lay’s potato chips. With this in mind, Peter Lynch focuses on companies that can grow earnings in weak environments, because that is where blue-chip companies usually earn their keep. When I read the WSJ in the morning, it seems that for every article lamenting unemployment in the US and economic collapse in Europe, there is an article talking about some company’s record profits. Well, companies with record profits in bad economic environments ought to be a good place to start some investment research—if Proctor & Gamble (PG) is selling more Tide and Gillette razor blades than ever, than who cares if the stock price has been stagnating if earnings are continuing to improve, year-in and year-out, along with the dividend?
(5) The company does not expand into unrelated industries that generate lower profits. To me, this is probably the most discretionary of Lynch’s investment tropes. The best thing that management has ever done for PepsiCo has been purchasing Frito-Lay, and I hated it when Altria (NYSE:MO) broke up with Kraft (KFT) because the grocery and snacks earnings provided a reliable stream of income that served as protection against the theoretical decline of the tobacco industry. But still, Lynch makes a good point—investors should watch out for companies that ‘diworsify’ by entering businesses that have low returns where present management has no comparative advantage. In the 1980s, Coca-Cola began farming shrimp and buying a movie studio—both of these ventures were not successful, and cost shareholders real money. Fortunately for shareholders, Coke is one of the strongest brands in the world—so shareholders still did quite fine—but still, you want to watch out for companies that expand into new industries that have little correlation with the core business.
When his kids would come home from school, Peter Lynch would often grill them about the types of products they prefer. Why did they want Nike (NYSE:NKE) shoes when they went to the shoe store? Why did they prefer Kraft macaroni and cheese to the store brand? Why would they rather drink Coca-Cola? Lynch looked around him at the products those close to him actually preferred, and that provided an initial basis for him to conduct his research—when those companies reached the right price, Lynch was able to bet big and never look back.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.