Beating the Street

by Peter Lynch

I’ve said before that an amateur who devotes a small amount of study to companies in an industry he or she knows something about can outperform 95 percent of the paid experts who manage the mutual funds, plus have fun in doing it.

Whatever method you use to pick stocks or stock mutual funds, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed.

screen is a computer-generated list of companies that share basic characteristics—for example, those that have raised dividends for 20 years in a row.

Buying what you know about is a very sophisticated strategy that many professionals have neglected to put into practice.

A good company usually increases its dividend every year.

You should not buy a stock because it’s cheap but because you know a lot about it.

Thus, there are substantial rewards for adopting a regular routine of investing and following it no matter what, and additional rewards for buying more shares when most investors are scared into selling.

the fact that if you pick stocks in five different growth companies, you’ll find that three will perform as expected, one will run into unforeseen trouble and will disappoint you, and the fifth will do better than you could have imagined and will surprise you with a phenomenal return. Since it’s impossible to predict which companies will do better than expected and which will do worse, the organization advises that your portfolio should include no fewer than five stocks. The NAIC calls this the Rule of Five.

Hold no more stocks than you can remain informed on.

Invest regularly.

want to see, first, that sales and earnings per share are moving forward at an acceptable rate and, second, that you can b...

It is well to consider the financial strength and debt structure to see if a few bad years would hinder th...

The key to making money in stocks is not to get scared out of them. This point cannot be overemphasized. Every year finds a spate of books on how to pick stocks or find the winning mutual fund. But all this good information is useless without the willpower. In dieting and in stocks, it is the gut and not the head that determines the results.

While catching up on the news is merely depressing to the citizen who has no stocks, it is a dangerous habit for the investor.

The best way not to be scared out of stocks is to buy them on a regular schedule, month in and month out,

Whenever I am confronted with doubts and despair about the current Big Picture, I try to concentrate on the Even Bigger Picture.

In spite of all the great and minor calamities that have occurred in this century—all the thousands of reasons that the world might be coming to an end—owning stocks has continued to be twice as rewarding as owning bonds. Acting on this bit of information will be far more lucrative in the long run than acting on the opinion of 200 commentators and advisory services that are predicting the coming depression.

Moody’s Handbook of Dividend Achievers, 1991 edition—one of my favorite bedside thrillers—lists such companies, which is how I know that 134 of them have an unbroken 20-year record of dividend increases, and 362 have a 10-year record. Here’s a simple way to succeed on Wall Street: buy stocks from the Moody’s list, and stick with them as long as they stay on the list. A mutual fund run by Putnam, Putnam Dividend Growth, adheres to this follow-the-dividend strategy.

A quant is a complex thinker who deals in concepts beyond the grasp of most linear imaginations, and speaks a language that is understood only by other quants.

People who sleep better at night because they own bonds and not stocks are susceptible to rude awakenings. A 30-year Treasury bond that pays 8 percent interest is safe only if we have 30 years of low inflation. If inflation returns to double digits, the resale value of an 8 percent bond will fall by 20–30 percent, if not more. In such a case, if you sell the bond, you lose money.

Anyone who buys an intermediate-term government bond fund and pays the .75 percent in annual expenses for salaries, accounting fees, the cost of producing reports, etc., could just as easily buy a 7-year Treasury bond, pay no fee, and get a higher return.

A study done by the New York bond dealer Gabriele, Hueglin & Cashman concludes that in a six-year period from 1980 to 1986, bond funds were consistently outperformed by individual bonds, sometimes by as much as 2 percent a year. Moreover, the bond funds did worse relative to bonds the longer the funds were held. The benefits of expert management were exceeded by the expenses that were extracted from the funds to support the experts.

During my turn at the helm at Magellan, on the nine occasions when the average stock lost 10 percent of its value the fund sank deeper than the market, only to rise higher than the market on the rebound—as I’ll explain in more detail later. To benefit from these comebacks, you had to stay invested. In letters to the shareholders, I warned of Magellan’s tendency to get swamped in choppy waters, on the theory that when people are prepared for something it may disturb them, but it won’t unnerve them. Most, I think, remained calm and held on to their shares. Some did not. Warren Buffett’s admonition that people who can’t tolerate seeing their stocks lose 50 percent of their value shouldn’t own stocks also applies to stock funds.

throughout the recent decade the index funds beat the managed funds, and often by a wide margin.

The only fair point of comparison is one value fund versus another. Over many years, if Gabelli has achieved a better result than Lindner, that’s an argument for sticking with Gabelli. But if Gabelli has been outperformed by John Templeton, the well-known growth-fund manager, it’s no reflection on Gabelli. It’s a reflection on the value style of investing.

When any fund does poorly, the natural temptation is to want to switch to a better fund. People who succumb to this temptation without considering the kind of fund that failed them are making a mistake. They tend to lose patience at precisely the wrong moment, jumping from the value fund to a growth fund just as value is starting to wax and growth is starting to wane.

The manager’s lack of discipline may produce good results in the short run, but the benefits may be fleeting.

If you are an average investor, you can duplicate this strategy in a simpler way by dividing your portfolio into, say, six parts and investing in one fund from each of the five fund types mentioned above, plus a utility fund or an equity-and-income fund for ballast in a stormy market.

You could throw in a couple of index funds to go along with the managed funds. You might, for instance, buy an S&P 500 index fund to cover the quality growth segment; the Russell 2000 index fund to cover the emerging growth stocks; Gabelli Asset, the Lindner Fund, or Michael Price’s Mutual Beacon for the value stocks; and Magellan (is one plug allowed here?) for capital appreciation.

The easiest approach is to divide up your money into six equal parts, buy six funds, and be done with the exercise. With new money to invest, repeat the process.

The more sophisticated approach is to adjust the weighting of the various funds, putting new money into sectors that have lagged the market. This you should do only with new money. Since individuals have to worry about tax consequences (which charities don’t), it’s probably not a go...

Another useful way to decide whether to put more money into the emerging growth sector or to invest in a larger, S&P-type fund is to follow the progress of T. Rowe Price New Horizons. New Horizons is a popular fund created in 1961 to invest in small companies. In fact, whenever a company gets too big, the managers at New Horizons remove it from the portfolio. This is as close as you’ll get to a barometer of what is happening to emerging growth stocks.

Since small companies are expected to grow at a faster rate than the big companies, small stocks generally sell at a higher p/e ratio than big stocks. Theoretically, you would expect the p/e ratio of the New Horizons fund to be higher than the p/e ratio of the S&P at all times.

When the New Horizons indicator approaches the dreaded 2.0, this is a huge hint that it’s time to avoid the emerging growth sector and concentrate on the S&P.

Clearly, the best time to buy emerging growth stocks is when the indicator falls to below 1.2. Once again, to reap the reward from this strategy you have to be patient.

Lipper Analytical Services publishes an index of 30 value funds and an index of 30 growth funds that appears in every issue of Barron’s.

When value underperforms growth for several years, you might want to add money to the value pot.

Thousands of hours are devoted to it. Books and articles are written about it. Yet with few exceptions, this turns out to be a waste of time.

Some people take last year’s biggest winner, the one at the top of the Lipper list of 1-year achievers, and buy that fund. This is particularly foolish. The 1-year winner tends to be a fund managed by someone who bet on one industry or one kind of company in a hot sector and got lucky.

this picking future winners from past performance doesn’t seem to work even when you use a 3-year or 5-year record. A study done by Investment Vision magazine (now Worth) shows the following: if every year between 1981 and 1990 you invested in the fund that had performed the best over the prior 3 years, in the end you would have lagged the S&P 500 by 2.05 percent. If you invested in similar fashion in the funds with the best 5- and 10-year records, you would have beaten the S&P by .88 and 1.02 percent respectively. This would not have made up for the cost of getting in and out of these funds.

What if you had bought the funds with the best 5- and 10-year performances and held on to them for 5 years? In the case of the best 5-year performers, you would have done no better than the S&P index, and in the case of the 10-year performers you would actually have ended up lagging the S&P by .61 percent.

The lesson here is: don’t spend a lot of time poring over the past performance charts. That’s not to say you shouldn’t pick a fund with a good long-term record. But it’s better to stick with a steady and consistent performer ...

One excellent source of information on this subject is the Forbes Honor Roll, published in that magazine every September. To make the Forbes list, a fund has to have some history behind it—two bull markets and at least two bear markets. Forbes grades each fund (from A to F) on how it has fared in both situations. It gives the name of the fund manager and how long he or she has held the post, the fund expenses, the p/e ratio, and the average annual return over ten years. Getting on the Forbes Honor Roll is tough, which is what makes this a good place to shop for funds. You can hardly go wrong by choosing one with an A or B rating in both kinds of markets.

You should not buy a fund because it has a load, nor refuse to buy one for the same reason.

There are certain drawbacks to running a big fund. It’s like a linebacker trying to survive on a diet of petits fours. He has to eat a considerable pile to get any nourishment out of them. A fund manager has the same predicament with shares. He can’t buy enough shares of a wonderful small company for it to make any difference to the performance of the fund. He has to buy shares in big companies, and even with big companies it takes months to amass a meaningful quantity and more months to unload it.

Here’s a good strategy for convertible investing: buy into convertible funds when the spread between convertible and corporate bonds is narrow (say, 2 percent or less), and cut back when that spread widens.

The main difference between a closed-end fund and an open-ended fund such as Magellan is that a closed-end fund is static. The number of shares stays the same. A shareholder in a closed-end fund exits the fund by selling his or her shares to somebody else, the same as if he or she were selling a stock. An open-ended fund is dynamic. When an investor buys in, new shares are created. When the investor sells out, his or her shares are retired, or “redeemed,” and the fund shrinks by that amount.

I’ve never seen a definitive study of whether closed-end funds, as a group, do better or worse than open-ended funds.

There are many drawbacks to the country funds. Fees and expenses are generally quite high. It’s not enough that the companies in which the fund has invested have done well. The currency of the country in question has to remain strong relative to the dollar, otherwise your gains will all be lost in translation. The government can’t ruin the party with extra taxes or regulations that hurt business. The manager of the country fund has to do his or her homework.

Europe is filled with big conglomerates that are the equivalent to our blue chips, but Europe lacks the number of growth companies that we have.