Walking Down Peter Lynch's Long, Winding, Stock-Filled Street

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Includes: BDBD, FMAGX, FMGKX, FNMA
by: SA Editor Daniel Shvartsman
Summary

I had Peter Lynch's Beating the Street on my 'must-read' list for new investors, but only read the book this summer.

Lynch's approach to invest what you know is one of the more accessible ones for investors, but could use more of a framework than Lynch provides.

Lynch's go everywhere investing style is a helpful complement to more rigid investing philosophies.

His portfolio management approach, though, appears to be the product of his profession rather than one to be followed by most investors.

My brother recently asked me where he should start if he wanted to invest in the stock market. I recommended four books to him:

  • The Intelligent Investor by Benjamin Graham
  • You Can Be A Stock Market Genius by Joel Greenblatt
  • The Little Book That Beats the Market also by Joel Greenblatt
  • Beating the Street by Peter Lynch

I had recommended the last one without having yet read it. A week later, visiting my wife’s grandfather, I came across the book in his library. I viewed that as a providential moment and borrowed it.

I wanted to learn three things in reading the book. First, was it right to put it on the starter list of investing books? Second, how to understand the ‘invest in what you know’ maxim that Lynch is famous for. And third, I anticipated that Lynch’s approach is somewhat different from the ‘Graham family tree’ of investing, and was curious to see how I would find that.

Beating the Street

Source: Simon & Schuster. This was the edition I read.

Is Beating The Street Good For Beginning Investors?

My answer is a little hedged. Lynch’s book is effective as gospel for why to invest in stocks, and it may inspire new investors to realize they can do their own investing. Both of which are good things to preach about (I say to the choir of Seeking Alpha readers), and I hope he achieves that effect.

I wonder though, whether Lynch’s success and approach might intimidate a beginner. He would own hundreds of stocks at a time at Magellan. While he mentions that an investor only need manage five, and even suggests they not overdo it, the impression I might get as a new investor is, ‘wow, that’s a lot of stocks!’ He also repeatedly talks about how he casually called management and happened to find the CEO in the office on December 23 or 26 and chatted them up about the business. And he was also really successful, which sets an imposing standard to consider.

I also wonder whether he does enough to explain the how’s of investing. I suppose there are other books that are more useful on the ins and outs of studying a balance sheet, a stock’s valuation, and so forth, and so maybe it’s fine that this book does not focus on those elements. But the principles of the book beyond 'you can do this!' are not abundant. Lynch repeatedly underlines points with pithy maxims he calls "Peter's Principles," but they're as much an avenue for cracking jokes as a way to unite his philosophy.

The structure of the book may get in the way of both offering clearer guidance and of allowing beginning investors to connect. The book is something of an 'epic' narrative: Lynch's quest to present his favorite stocks to the annual Barron's Roundtable, where crusty Alan Abelson will mock Lynch's abundance of ideas. That framework allows Lynch to go through a relatively active portfolio, so readers can follow his process. It also is a bit distracting and, I would think, hard for a beginner to connect to. Why should they care whether Lynch managed to complete the research before he flew to New York?

I would still recommend the book to beginners, but with the caveat that the book is not meant to be followed, it's meant to give a sense of what the investing process entails. And even there, I'd caution the new investor from running out and 'doing what Peter does'.

What's wrong with investing in what you know?

I offer the following distillation of Lynch's book, using a title from above: "You can be a stock market genius, too, just invest in what you know." If you're a construction worker, you should have insight into the construction industry; a teacher might have a bead on both education tech companies and youth fashion trends, and so forth.

I very much believe in the first part of the claim - anyone with appropriate interest, time, temperament, and basic patience to read about companies in the market can succeed as an investor. And there's something to the idea of using what you observe in the world to discover investment opportunities. But I don't think Lynch does well enough, at least in this book, at laying out the steps beyond that. And without those steps, investing in what you know can be dangerous.

Lynch opens chapter 8 talking about a topic I know quite well: Burlington Mall in Burlington, MA. I grew up 10 minutes drive from the mall and stopped in to pick up some records a few weeks ago when visiting family. Lynch walks through the mall in its 90s peak to explain how he has found ideas there, whether from his own purchases, his observations, or the purchase habits of his wife and daughters. He even drops a Peter principle - "If you like the store, chances are you'll love the stock."

It's not that he literally stops there. He explains how he likes The Body Shop's same-store sales, earnings growth, and balance sheet, and how he dislikes its above market P/E. When he looks at Supercuts, he highlights the positive aspects of the business model - a low employee turnover rate, e.g. But there is still a glib feeling to this, at least as written, that makes it sound too easy. (Supercuts was eventually bought out).

I may be hyper sensitive to this in a post Moneyball, FiveThirtyEight.com world where extrapolating from personal insights appears prone to lead one to the wrong track. I may also be sensitive since I usually live abroad, where trends are harder to relate to the US market I still primarily invest in. Each time I return to the states, like for this summer, I find myself looking for new ideas each time I go to the grocery store. "If it's made it in small-town Michigan, surely this is a winning brand/company/idea!" I think to myself. And then I add the appropriate caution to my thoughts and go back to the drawing board.

(The one case I remember investing this way worked okay; I bought shares in Boulder Brands (BDBD) for my wife's account on the following grounds: Smart Balance peanut butter was more natural than Jif (SJM) or Skippy's (UL), but I still liked it. If they could convince me to venture outside the duopoly on peanut butter, they must be doing well. Eventually, they were bought out at a premium. But this is more lucky than good, I think.)

I go back to the first question in answering this one - I don't think there's anything wrong with starting your investing process with what you observe or know from your day-to-day life. But that has to just be the seed to start the process, and investors need a deeper approach to be successful. Lynch has that approach, and is a much more successful investor than I ever will be, but I don't think he conveys that approach effectively in this book.

Growth may trump value, but for how many stocks?

Lynch's selection of The Body Shop typifies that he is not looking for cigar butts or work-outs, at least not exclusively. Time and again he points to two keys for success - let winners run, and get on board for great companies. He points to Warren Buffett's appropriation (with permission) of his "pulling out the flowers to water the weeds" saying to describe the practice of selling great companies too soon. The line is a good explanation for Buffett 2.0, focused on great companies at a fair price.

The Body Shop store front

Source: Shopwestfarms.com, via Google. L'Oreal just sold The Body Shop to Natura for 880M pounds after buying it for 652M in 2006.

Lynch's approach spans the gamut. He talks up savings and loans issues and mutual holding companies, a favorite hunting ground for dyed-in-the-wool value investors like Seth Klarman. He looks at turnaround companies, oversold stocks due to economic problems, and spends a lot of time on Fannie Mae (OTCQB:FNMA), which was Fidelity Magellan's most important stock in the 80s.

His go everywhere approach is laudable, and worth emulating even for investors focused on a given style. It would be overly black/white to say this is out of step with the Graham school of investing, but it is certainly at least its own branch - value not defined by strict measurement of the balance sheet, or not even by the concept of margin of safety.

I struggle more with his portfolio management. Obviously, Lynch was subject to the constraints of managing a mutual fund during his time at Magellan, meaning he could put no more than 5% of his fund in a single position at a single time. And he fought against the realities of Magellan's AUM expanding over the decade, which meant he had to invest his capital somewhere, even as he liked smaller issues. But the whole approach of buying a large number of firms in a given sector rather than his favorite one or two, for example, strikes me funny.

Lynch does summarize his investing style in 20 maxims at the end of the book. While I don't think the rest book naturally points to these 20 maxims as a concluding philosophy, they are helpful guidelines. Two maxims stand out as part of this discussion:

"Owning stocks is like having children - don't get involved with more than you can handle. The part-time stockpicker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don't have to be more than 5 companies in the portfolio at any one time."

"If you study 10 companies, you'll find 1 for which the story is better than expected. If you study 50, you'll find 5. There are always pleasant surprises to be found in the stock market - companies whose achievements are being overlooked on Wall Street."

That first maxim jars with the rest of the discussion. Even post-Magellan, he presented 21 stocks to the Barron's Roundtable. And I may read too much into this but I hear a patronizing note - 'you only have time to follow 8-12 companies, and that's fine.' The linear relationship he points out may or may not be true directionally, but the implication is that one should keep finding and adding companies.

Maybe this is appropriate humility - buy the best ideas you have at the time, even as you keep looking for better ones. But after a book length's retelling of managing a portfolio of 100s of stocks, it doesn't seem like Lynch is waiting on fat pitches to swing.

How to beat the Street?

Peter Lynch is on the short list of the most well-known and successful investors in the world. If Beating the Street was subtitled 'If I Did It,' the book might be a more straightforward read. Riding sidecar with Lynch as he walks through the key stocks and patterns that drove Magellan's success over the 80s and Lynch's approach through the early 90s is certainly educational, and someone with the inclination to dig deeper based on his approach and learn from his examples could do very well. Maybe the fault is mine for viewing it through the beginner lens.

The investing gospel can be sparked from unlikely sources. The first investment book I read was Jim Cramer's Real Money, after hearing about how my self-educated father-in-law and aforementioned grandfather-in-law managed their own money. And that was a fine book for where I was, as a basic framework to adopt until I could learn more.

I'm sure Lynch's would have been more useful. And I'll keep it on the shortlist of 'where to start one's investing education'. But what I will emphasize I would get out of this is not the how's of equity investing but the why's, and that they might look past Lynch's bravado to see the fun in investing. And I would then hope that they got enough out of it to start reading more.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: My brother ended up reading the Little Book That Beats The Market, which is the most efficient way among those listed to figure out whether investing is for you. He found that it was not.

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