Beating the Street

by Peter Lynch

Japan is the richest country in the universe where the people have trouble making ends meet. The Japanese admire us Americans for our closet space, our low prices, and our weekend homes.

The Japanese predicament reminds me of the story about the man who brags about having once owned a $1 million dog, and you ask him how he knew it was $1 million dog and he says because he traded it for two $500,000 cats.

Put as much of your money into stock funds as you can. Even if you need income, you will be better off in the long run to own dividend-paying stocks and to occasionally dip into capital as an income substitute.

If you must own government bonds, buy them outright from the Treasury and avoid the bond funds, in which you’re paying management fees for nothing.

Know what kinds of stock funds you own. When evaluating performance, compare apples to apples, i.e....

It’s best to divide your money among three or four types of stock funds (growth, value, emerging growth, etc.) so you’ll always have some money invested in the most profitable sector of the market.

When you add money to your portfolio, put it into the fund that’s invested in the sector that has lagged the market for several years.

Fund managers and athletes have this in common: they may do better in the long run if they’re brought along slowly.

The extravagance of any corporate office is directly proportional to management’s reluctance to reward the shareholders.

Some investors, the rumor goes, own a share of Buffett’s Berkshire Hathaway company (these cost $11,000 apiece) simply to get on the mailing list for Buffett’s reports. This makes Berkshire Hathaway the most expensive magazine subscription in history.

It’s possible to lose money even in a successful mutual fund, especially if your emotions are giving the buy and sell signals.

The earliest version of the Quotron required that you type in a stock symbol and push the enter button before the current price would appear. Otherwise, the screen was blank. Later versions, which you’ve probably seen, display an entire portfolio and the prices for all the stocks, which are updated automatically as the day’s trading progresses. The blank screen was a better system because you couldn’t stare at it all day and watch your stocks go up and down, as many contemporary fund managers do. When I got a newfangled Quotron, I had to turn it off because it was too exciting.

This is one of the keys to successful investing: focus on the companies, not on the stocks.

To avoid undermining one another’s confidence, we allowed no feedback at our presentations—the listeners were free to follow up on the leads or ignore them as they chose. I tried to focus on the quality of each idea, as opposed to the quality of the speaker. Often, the most valuable leads came from people whose stockpicking skills far exceeded their forensic skills, and I made it a point to pick the brains of the nonverbal contingent outside the meetings, with the egg timer turner off.

The Rule of 72 is useful in determining how fast money will grow. Take the annual return from any investment, expressed as a percentage, and divide it into 72. The result is the number of years it will take to double your money. With a 25 percent return, your money doubles in less than 3 years: with a 15 percent return, it doubles in less than 5.

now I was beginning to see that some of my favorite stocks did have something in common. These were companies with strong balance sheets and favorable prospects but most portfolio managers wouldn’t dare buy them.

What made it possible for me to deviate from this stultifying norm? In a wide-open fund like Magellan, nobody was looking over my shoulder. In many firms there is a hierarchy of shoulders, with each person judging the work of the person directly in front of him, while worrying about how he’s being judged from behind.

When you have to concern yourself with what the person behind you thinks about your work, it seems to me that you cease to be a professional. You are no longer responsible for what you do. This creates a doubt in your mind as to whether you are capable of succeeding at what you do—otherwise, why would they be monitoring your every move?

Fund managers have enough to worry about in trying to beat the market. We don’t need the added burden of conforming to a plan or explaining our strategies every day. As long as we follow the mandate of the fund as described in the prospectus, we ought to be judged once a year on our results. Along the way, nobody should care if we buy Golden Nugget or Horn & Hardart instead of Reynolds Aluminum or Dow Chemical.

When yields on long-term government bonds exceed the dividend yield of the S&P 500 by 6 percent or more, sell your stocks and buy bonds.

As usual there was plenty to be worried about, beginning with the fact that the Dow had fallen 36 points on the prior Friday. The newspapers had made a big deal of this “worst one-day drop since 1929,” even though the comparison was absurd. A 36-point drop with the Dow at 990 was not the same thing as a 36-point drop with the Dow at 280, which is where it stood before the Crash.

Bargains are the holy grail of the true stockpicker. The fact that 1030 percent of our net worth is lost in a market sell-off is of little consequence. We see the latest correction not as a disaster but as an opportunity to acquire more shares at low prices. This is how great fortunes are made over time.

How much time you spend on researching stocks is directly proportional to how many stocks you own. It takes a few hours a year to keep up with each one. This includes reading the annuals and the quarterlies, and calling the companies for periodic updates. An individual with five stocks can do this work as a hobby. A fund manager of a small- to medium-sized fund can do it as a nine-to-five job. In a larger fund, you’re looking at a 60- to 80-hour week.

This theory that a large fund can only be a mediocre fund is still in vogue today, and it’s just as misguided as it was a decade ago.

Not all common stocks are equally common.

The size of a fund and the number of stocks it contains tell you nothing about whether or not it can excel.

Another way that a lot of fund managers hemmed themselves in was by worrying about “liquidity.” They avoided all the wonderful small companies—a good collection of these could do wonders even for a big portfolio—because the stocks were “thinly traded.” They’d get so absorbed in this problem of finding stocks they could get in and out of in five days or less that they’d lose sight of whether these things were worth owning in the first place.

In stocks as in romance, ease of divorce is not a sound basis for commitment. If you’ve chosen wisely to begin with, you won’t want a divorce. And if you haven’t, you’re in a mess no matter what.

So the expert who decided not to invest in something because “it only trades ten thousand shares a day” is looking at things cockeyed. For one thing, 99 percent of all stocks trade fewer than 10,000 shares a day, so fund managers who worry about liquidity are confined to 1 percent of all publicly traded companies. For another thing, if a company is a loser, the fund manager is going to lose money on the stock no matter how many shares it trades, and if it’s a winner, he or she will be delighted to unwind a position in the stock leisurely, at a profit.

The best stock to buy may be the one you already own.

shareholders play a major role in a fund’s success or failure. If they are steadfast and refuse to panic in the scary situations, the fund manager won’t have to liquidate stocks at unfavorable prices in order to pay them back.

When your best-case scenario turns out to look worse than everybody else’s worst-case scenario, you have to worry that the stock is floating on a fantasy.

I did some research and learned that game shows generally have a 7- to 10-year run. This is actually a very stable business—a lot more stable than microchips.

There’s no shame in losing money on a stock. Everybody does it. What is shameful is to hold on to a stock, or, worse, to buy more of it, when the fundamentals are deteriorating.

Meanwhile, people from all over Boston, many of them sophisticated investors, were advising me to buy Bank of New England at the bargain price of $15, and then $10, and when the stock got to $4 they said it was a stupendous opportunity that couldn’t be overlooked. I reminded myself that no matter what price you pay for a stock, when it goes to zero you’ve lost 100 percent of your money.

If a company turns out to be solvent, its bonds will be worth 100 cents on the dollar. So when the bonds sell for only 20 cents, the bond market is trying to tell us something.

Since bonds come before stocks in the lineup of claimants on the company’s assets, you can be sure that when bonds sell for next to nothing, the stock will be worth even less. Here’s a tip from experience: before you invest in a low-priced stock in a shaky company, look at what’s been happening to the price of the bonds.

Cyclicals are like blackjack: stay in the game too long and it’s bound to take back all your profit.

Finally, I note with no particular surprise that my most consistent losers were the technology stocks, including the $25 million I dropped on Digital in 1988, plus slightly lesser amounts on Tandem, Motorola, Texas Instruments, EMC (a computer peripherals supplier), National Semiconductor, Micron Technology, Unisys, and of course that perennial dud in all respectable portfolios, IBM. I never had much flair for technology, but that didn’t stop me from occasionally being taken in by it.

Professional investors are missing the point. They’re scrambling to buy services like Bridge, Shark, Bloomberg, First Call, Market Watch, and Reuters to find out what all the other professional investors are doing when they ought to be spending more time at the mall.

Stocks that are priced higher than their earnings lines have a regular habit of moving sideways (a.k.a. “taking a breather”) or falling in price until they are brought back to more reasonable valuations.

There’s no quicker way to tell if a large growth stock is overvalued, undervalued, or fairly priced than by looking at a chart book (available in libraries or a broker’s office). Buy shares when the stock price is at or below the earnings line, and not when the price line diverges into the danger zone, way above the earnings line.

You could make a nice living buying stocks from the low list in November and December during the tax-selling period and then holding them through January, when the prices always seem to rebound. This January effect, as it’s called, is especially powerful with smaller companies, which over the last 60 years have risen 6.86 percent in price in that one month, while stocks in general have risen only 1.6 percent.

Don’t pick a new and different company just to give yourself another quote to look up in the newspaper or another symbol to watch on CNBC!

With a stock you once owned, especially one that’s gone up since you sold it, it’s human nature to avoid looking at the quote on the business page, the way you might sneak around the aisle to avoid meeting an old flame in a supermarket. I know people who read the stock tables with their fingers over their eyes, to protect themselves from the emotional shock of seeing that Wal-Mart has doubled since they sold it. People have to train themselves to overcome this phobia.

Along the way, I’ve also learned to think of investments not as disconnected events, but as continuing sagas, which need to be rechecked from time to time for new twists and turns in the plots. Unless a company goes bankrupt, the story is never over. A stock you might have owned 10 years ago, or 2 years ago, may be worth buying again.

To keep up with my old favorites I carry a large wire-bound, campus-style notebook, a sort of Boswell’s Life of Johnson & Johnson, in which I record important details from the quarterly and annual reports, plus the reasons that I bought or sold each stock the last time around. On the way to the office or at home late at night, I thumb through these notebooks, as other people thumb through love letters found in the attic.

As an investment strategy, hanging out at the mall is far superior to taking a stockbroker’s advice on faith or combing the financial press for the latest tips.

If you like the store, chances are you’ll love the stock.

I’ve been partial to retailers since I was introduced to Levitz Furniture early in its 100-fold rise—an experience I never forgot. These companies don’t always succeed, but at least it’s easy to monitor their progress, which is another attractive quality they have. You can wait for a chain of stores to prove itself in one area, then take its show on the road and prove itself in several different areas, before you invest.