Now retired, Lynch secured his reputation as one of the most successful fund managers in history while in charge of the Fidelity Magellan fund between 1977 and 1990.
Highly active investment in a variety of stocks, with special emphasis on growth and recovery stories, and holding periods ranging from a couple of months to several years.
Lynch only ever worked for Fidelity, the international investment management firm based in Boston. He started as an analyst in 1969, was promoted to director of research in 1974, and took over the Fidelity Magellan fund in 1977. At the time, it had $22m in assets. By 1990, when he decided to take early retirement in order to spend more time with his family, its value had swollen to $14bn. No manager in history has ever run so large a fund, so successfully, for so long.
His secret was a punishing work schedule, lasting six and sometimes seven days a week, in which he talked to dozens of company managers, brokers and analysts every day. With a total staff of just two research assistants, he ran a portfolio of up to 1,400 stocks at any one time. Some he bought at an early stage of growth or recovery and held for years. The majority he became dissatisfied with and sold within months, admitting that over half his choices were mistakes.
Although you cannot copy his portfolio management style, Lynch is adamant that any small investor can research stocks better than most professionals, and make smarter decisions about what to buy. This is because he or she is often better placed to spot potentially profitable investments early, and is always free to act independently, rather than constrained by committees, trustees and superiors.
During his tenure at Magellan, Lynch averaged 29% compound over 13 years. This remains a record for funds of this size.
The biggest successes Lynch lists in his book Beating the Street were all small growth companies when he bought them: Rogers Communications Inc, a 16-bagger, Telephone Data Systems, an 11-bagger, and plastic cutlery manufacturer Envirodyne and King World Productions, both tenbaggers. The last of these is Oprah Winfrey’s production company, and also owns the TV rights to Wheel of Fortune and Double Jeopardy.
Method and guidelines
Firstly, keep your eyes and ears open for ideas.
Lynch’s key concept is that you can spot investment opportunities all around you, if only you concentrate on what you already know and are familiar with. Maybe you notice a crowded shop or restaurant, or your neighbours all start buying a new make of car, or a nearby factory suddenly seems to be expanding – all these may be pointers to companies on the stock market that are worth further investigation.
Among your best sources of information are:
Your job, which familiarizes you with your company, its customers and its suppliers
Your hobbies and leisure pursuits, from sport to shopping
Your family and friends, thanks to all their jobs and hobbies
Your observation and experience of companies in your home town.
Secondly, categorize your ideas
Companies can be categorized into 6 main types:
Slow growers – raising earnings at about the same rate as the economy, about 2-4% a year.
Stalwarts – good companies with solid EPS growth of 10-12%
Fast growers – small, aggressive new companies growing 20-25% or more.
Cyclicals – whose earnings rise and fall as the economy booms and busts
Turnarounds – companies with temporarily depressed earnings, but good prospects for recovery.
Asset plays – companies whose shares are worth less than their assets, provided these assets could be sold off for at least book value.
Source: One Up on Wall Street, P Lynch, 1989
Consider concentrating your efforts on finding fast growers. If bought at the right price, some of these can become ‘tenbaggers’ – shares that multiply your investment ten times over. Otherwise, look for turnarounds and perhaps the occasional asset play.
Consider trying to avoid holding cash. It is better to stay fully invested by putting any spare money into stalwarts. That way, you will not miss out on rising markets.
Avoid slow growers (too unprofitable) and cyclicals (too hard to time).
Thirdly, summarize the story behind your stock.
Prepare a 2-minute monologue about the stock you have in mind, describing
The reasons you are interested in it
What has to happen for the company to succeed
The obstacles that might prevent its success.
This is the stock’s ‘story’. Make sure it is simple, accurate, convincing, and appropriate for the category of stock in question. For example, ‘if it’s a fast grower, then where and how can it continue to grow fast?’
Fourthly, check the key numbers.
If you are excited by a particular product or service, check it accounts for a sufficient percentage of total sales to make a significant difference to profits.
Favour companies with a forecast P/E ratio well below their forecast EPS growth rate (i.e. a low PEG ).
Favour companies with a strong cash position.
Avoid companies with a high debt-to-equity ratio (‘gearing’), especially if the debt takes the form of bank overdrafts, which are repayable on demand, rather than bonds, which are not.
In the case of stalwarts and fast growers, look for a high pretax profit margin. In the case of turnarounds, look for a low one with the potential to rise.
Fifthly, base your buy and sell decisions on specifics.
Your profits and losses do not depend on the economy as a whole. They depend on the factors specific to the stocks you hold. So ignore the ups and downs of the market.
Buy whenever you come across an attractive idea, with a compelling story behind it, at an attractive price.
Consider selling stalwarts when their PEGs reach around 1.2-1.4, or when the long-term growth rate starts to slow.
Consider selling fast growers when there appears to be no further scope for expansion, or expansion starts to produce only disappointing sales and profits growth, or when their PEGs reach around 1.5-2.0.
Consider selling asset plays when they are taken over, or when assets that are sold off fetch lower than expected prices.
“If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighbourhood shopping mall, and long before Wall Street discovers them.”
“The very best way to make money in a market is in a small growth company that has been profitable for a couple of years and simply goes on growing.”
“The way you lose money in the market is to start off with an economic picture.”
“You don’t get hurt by what you do own that goes up. It’s what you do own that kills you.”
Lynch has written two extremely accessible books: One Up on Wall Street (1989) and Beating the Street (1993). The first ranks as one of the best investment primers ever for small investors. The second looks more closely at his time at Fidelity Magellan. A simplified account of his methods is given by John Train in The New Money Masters (1989).