The most famous saying of Peter Lynch is "Buy what you know." Peter Lynch managed the Fidelity Magellan Fund for 13 years to the day. He retired from the job on May 31, 1990. His fund consistently beat its benchmark and he is considered to be one of the greatest investors of all time. Peter Lynch wrote the investment classic One Up On Wall Street. I pulled his other book, Beating the Street, off my shelf and reviewed the table of contents before writing this article.
Lynch had a knack for fundamental research. He would buy a single share of stock in a company to receive a prospectus and shareholder information. He told the story of how he was once doing research on Christmas Eve and how impressed he was with the company when its CEO answered the phone. Lynch said that SEC filings made great bedtime reading. Towards the end of an interview with the management of a company, he would casually ask which of their competitors they admired the most. Lynch thought that if even the competition thinks you're doing something right, you probably are. He said that he often chose to invest in companies identified this way instead of the original candidate.
Peter Lynch gave the charming story of a research trip to Supercuts, the hair-styling chain. Although he didn't personally appreciate the haircut he received (it was done too quickly and ended up shorter than he wanted because he didn't have time to give instructions) he liked the business model because he recognized that his regular barber was a dying breed. The anecdote is in Chapter 10 of Beating the Street. Chapter 8 tells how trips with family to the Burlington Mall were opportunities to spot up-and-coming retailers.
Lynch was born in 1944. He was born 13 years before the annual number of births in the U.S. peaked at 4,308,000 in 1957. Lynch was positioned in front of the sharp increase in population that is known as the Baby Boomer Generation. Those born in 1957 are now 57 years old. Lynch is 70 years old. He was born 13 years ahead of the peak on the Boomer Generation's bell curve.
Peter Lynch could buy what he knew because there was a wave of consumers behind him who would need the same thing in their life cycles that he needed at the current time. "Buy what you know" will only give investors an edge if the market for those products is set to expand. The strategy worked for Lynch because he was born in 1944. It would not have worked for someone born in 1961 because the number of births began to sharply decline at that point. The result would have been shrinking markets.
Lynch was born 13 years ahead of his generation's peak. He was able to buy and hold stocks during his thirteen-year career because his time horizon was within the generational peak. Had Lynch stayed in the game a little longer, consumer demand for items made by the companies he held would have declined because there would have been fewer consumers to enter the market. Buy-and-hold worked within the trend. The value of this strategy declines when the trend reverses.
Lynch's children were born ahead of the peak on Generation Y's bell curve, just as Lynch was ahead of the peak on his. Lynch was 30 years old when the first of his three girls arrived in 1974. This year is close to the lowest point in the trough of Generation X. The number of births peaked 16 years later in 1990. Sixteen years is too far ahead of the curve's peak for investment. The number of births did not begin to sharply increase until 13 years before the peak; hence demand did not begin to rise until 13 years before.
Consider that his second daughter arrived four years after the first and his third daughter arrived four years after the second. Peter Lynch had an 8-year window into the future spending habits of the next generation. The window was centered twelve years ahead of the peak in the younger generation's bell curve. The composite demand from his children was in the sweet spot for investing on increased demand ahead of the peak in the number of births that occurred in 1990.
The number of births was at its lowest in 1932. Births had been rising for 12 years when Lynch was born in 1944. He perceived rising demand for the things he knew and extrapolated into the future. Care to duplicate his approach? Invest like a person born 13 years before the peak of Generation Y. The year 1977 is thirteen years before the peak of births in 1990. In other words, for the next 13 years, there will be an uptrend in the number of people turning 37.
Lynch had one key advantage that is not available to someone who is to invest 13 years ahead of the peak in the number of births that occurred in 1990. The number of births had already been rising for 12 years when Lynch was born (see chart). He saw a trend in rising demand for the things he used. A person who wants to invest 13 years ahead of the peak of 1990 must infer rising demand because the number of births did not begin rising until 1977.
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This leaves two options: (1) Invest less than 13 years ahead of the peak in births, to observe rising demand, or (2) Anticipate the spending habits of someone born a full 13 years before 1990. The first option allows for the trend to be identified as it develops. This adds a measure of confidence that the trend is real but the tradeoff is less time to capitalize on it. The second option requires knowledge of consumers to identify the incipient trend before it develops.
A demographics-based approach to the economy helps explain the recent outperformance of the consumer discretionary sector (XLY, PSCD). The number of young adults has been steadily increasing, as shown by the steadily increasing number of births leading up to the year 1990. The disposable income of these young adults caused the rise in nonessential (or discretionary) spending. Demographics indicate there is about to be a shift in the spending pattern. The shift is to consumer staples.
Consumer staples (XLP, FXG) are set to outperform the market average because of the shift in priorities that occur with household formation. The less-structured finances of a single give way to the more-structured finances of a married couple. The budget will prioritize household expenses. The non-negotiable aspect of these expenses favors the staples sector over the discretionary sector.
Anticipate the spending habits of a person born 13 years before 1990 and the spending habits of a 37-year-old are anticipated. Demographics indicate that these people will, predominately, be well into household matters and the associated spending on consumer staples. After another five years of spending on staples, the consumers will be able to turn their attention to large-ticket items like a new car. This subsequent shift will favor the manufacturing sector (NYSEARCA:RGI). Investors can buy what they know if they are between the ages of 33 and 37. The market for products needed by people of this age is set to expand.
Peter Lynch was born 13 years ahead of the peak on his generation's bell curve. Had he been born after the peak, his strategy of buying what he knew would not have worked. His career at Fidelity Investments lasted 13 years. Had it lasted longer than 13 years, the buy-and-hold strategy would have been ineffective. Lynch was either quite lucky or quite perceptive to end his career when he did. The reason he gave was that he wanted to spend more time with his family. And this is how "Buy what you know" became one of the most widely recognized phrases in finance.
Gronbach, Kenneth W. The Age Curve: How to Profit from the Coming Demographic Storm. New York: American Management Association, 2008. Print.
Disclosure: I am long FXG.