Have you ever been asked this question when you tell someone that you are an investor in the stock market?
“Aren’t there many professionals out there who dedicate their lives to the stock market in this area? What makes you think you can beat those guys at their own game?”Says everyone I have ever met
I know I’ve been asked this question countless times, albeit with certain words being paraphrased.
However, the main message is clear.
Can the average retail investor beat the pros at their own game ?
In One Up on Wall Street, the legendary investor, Peter Lynch, revealed how his ‘amateur’ approach in managing Fidelity’s multibillion-dollar Magellan Fund led him to become one of America’s number one money managers, and, one of the most successful investors of all time.
From May of 1977 through May of 1990 Lynch captained Magellan to an annualized return of 29.06% compared to just 15.52% for the S&P 500. To contextualize things, let us see the returns one would have if you invested $1 in Magellan and $1 into the S&P 500.
His mantra is simple:
Average investors can become experts in their own field and can pick winning stocks as effectively as Wall Street professionals by doing just a little research.
In this first section of the 7 part series, we would be talking about the general guidelines to stock investing as presented by Peter Lynch in the book.
This would be followed by 6 comprehensive articles going in-depth on the 6 different categories of stock investments pointed out by Lynch, coupled with some local context and examples.
For this article, the lessons taught by Peter Lynch can be broken down into 5 simple takeaways:
- Why retail investors have an edge over the Pros
- The psychological aspect of Stock Investing
- Traits of the “Tenbagger” (Wall Street Lingo for when you 10x your money)
- The Red Flags in the Market
- The Perfect Stock! I found it! I found it! Now What? (The checklist)
Why Retail Investors Have An Edge Over The Pros
Dumb money is only dumb when it listens to the smart moneyPeter Lynch
The very first rule preached by the book is for one to stop listening to professionals!
That means ignoring the hot tips, the recommendations from brokerage firms and the latest “can’t miss” suggestion from your favourite newsletter – in favour of your own research.
In fact, the amateur investor has numerous built-in advantages that, if exploited, should result them outperforming the experts, and also the market in general.
This is due to the following factors:
- Safe Playing
- Capital is dependent on clients
- Street Lag
- Our On-The-Ground Expertise
1st Advantage of Retail Investors: Size
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”Warren Buffett’s sharing on June 23, 1999 during Business Week
The professionals have very deep pockets due to their access to large sums of capital. This, however, puts them at a disadvantage as they are unable to invest in small to medium market cap stocks. It simply would not have a meaningful impact on the funds overall performance.
This was why Warren Buffett transitioned from investing in small cigar stocks to buying over whole companies later on.
The opportunities available to the average retail investors are much more than that for large investors. It is like picking from an ocean of fish compared to fishing in Pasir Ris pond.
We just need to capitalize on it.
2nd Advantage of Retail Investors: Losing Small vs Winning Big
“You’ll never lose your job losing your clients’ money in IBM”Peter Lynch
Between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the professionals would jump at the latter.
Success is one thing, but it’s more important not to look bad when you fail. This is because fund managers are employees and their job would most likely depend on their performance.
Meanwhile, for the average person, there is no one calling us early in the morning or late into the night to drill us on why we bought a not-so-well-known counter.
We make our own decisions without having to prepare a 20-minute long explanation script to face potential backlash.
Peter Lynch thus encourages us to capitalize on such advantages to perform in the market as we are able to utilize our time more productively.
Worst of all, in the unfortunate event the stock tanks, no one would be there to criticize your prior judgement which might affect one’s investment decisions and actions.
3rd Advantage of Retail Investors: Pros’ Capital is Dependant on Clients
Due to the fact that fund managers manage other people’s money, it is the clients that decide how much capital these fund managers have at their disposal.
These people aren’t usually savvy investors and tend to pull back their money during a bear market and put back their money during bulls. This is exactly the opposite of what one should do. This leaves the fund manager with the dilemma of having too much capital when everything is too expensive and too little when everything is selling cheaply.
Meanwhile, we are our own fund managers and we have the sole power to decide when to put-in and pull-out our capital. This gives us a key advantage should we meaningfully strategize our capital.
There would be no one calling you to pull out your capital when the stock tanks other than your weak heart which you must learn to ignore. (Lynch places a huge importance on the psychological aspect, which would be covered in the next section)
4th Advantage of Retail Investors: Street Lag
Under the current system, a stock isn’t truly attractive until a number of large institutions have recognized its suitability and an equal number of analysts (the researchers who track the various industries and companies) have put it in the buy or add list.
This means that by the time the stock’s analysis report is released, one should be sure that the smart money has already bought the stock at much cheaper and attractive prices as compared to the price they are currently reporting.
Therefore, it is better to not rely on such “buy” or “add” reports released to identify their stocks and should rather screen for their own stocks with one’s own criterion.
This is also due to the fact that such analysis reports have shorter term horizons compared to your own investing horizon. Analysts base their ratings of stocks on price targets they set and usually, these targets are provided in a 12-month(1 year) time frame.
For investors (not swing-traders), owning a stock for a single year is fraught with risk.
Behavioural economists De Bondt and Thaler came to the realisation that people do not make decisions rationally. Their decisions were distorted by the vast amount of cognitive errors they have to contend with.
Thus, having a one year holding period exposes the investor to market fluctuations as it takes time for the market to eventually function as the proverbial weighing machine.
Read more about holding periods in our Factor-Based Investing Guide.
5th Advantage of Retail Investors: Our On-The-Ground Expertise
“The best place to begin looking for the ten-bagger is close to home – if not in the backyard then down at the shopping mall, and especially wherever you happen to work”Peter Lynch
We all have the chance to say, “This is great; I wonder about the stock” long before the professional analysts got its original clue.
We all have certain industries, products and services that we know more about than the average person does. Perhaps you know more about the gaming industries because you are a level 99 magician ninja and dominate every game you touch. Perhaps you are working in the fashion industry and are in sync with the latest trends.
Lynch states that the average person comes across a likely prospect two or three times a year – sometimes more.
The bottom line is that we all have valuable and relevant information on publicly listed companies through our everyday lives. This is information that the professionals either do not know about yet or have spent 100 hours of research to attain.
The psychological aspect of Investing
Human emotions make us terrible stock market investors, Peter Lynch states.
The ignorant investor continually passes in and out of three emotional states:
- Capitulation (the action of ceasing to resist)
He/She is concerned after the market has dropped or the economy has seemed to falter, which keeps him/her from buying good companies at bargain prices
Then, as the next bull run arrives, he/she re-enters at higher prices and gets complacent because their holdings are going up. This is precisely the time he/she ought to be concerned enough to check the fundamentals vis-a-vis the current price, to determine whether it is overvalued and inflated (but he/she doesn’t).
Finally, when his/her stocks fall on hard times and the prices fall below what he/she paid, they capitulate and sells in a snit.
Many people term themselves as “Long-Term Investors” but only until the next big drop (or tiny gain), at which point they quickly become short-term investors and sell out for huge losses or the occasional minuscule profit.
The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.
Lynch promises that if you ignore the ups and downs of the market, and the endless speculation on interest rates, in the long term, your portfolio will reward you should you make the correct selections fundamentally.
Even one of Warren Buffet’s greatest ever long term investments (Washington Post) looked like a complete loser for the first few years.
The Washington Post’s stock tanked by around 20% after Buffett’s purchase and had remained there for three years! That was a paper-loss of around $2.2 Million dollars. However, Warren revisited the financial statements and found out that there was no significant change in business fundamentals. He thus decided to hold and wait for the market to realize the Post’s true value. By the end of 2007, his stake in the Post had grown to US$1.4 Billion which is a gain of more than 10,000%.
Stocks with great long term returns can be really agonizing investments over the short term.
P.S. This just came in today from Yahoo Finance. Sounds all too familiar ?
Traits of the “Tenbagger”
The legendary ‘Tenbagger’ is the expression Lynch uses to describe a stock that has appreciated tenfold your purchasing price. In One Up on Wall Street, he lists down several traits that such Tenbaggers should encompass.
In his book, Peter Lynch comes up with the Greatest Company Of All – An Ideal Lynch Tenbagger.
This mythical company is named Cajun Cleansers.
It was the magical company Peter Lynch described in the chapter about attributes of a dream enterprise.
Cajun Cleansers is engaged in the boring business of removing mildew stains from furniture, rare books, and draperies that are victims of subtropical humidity. Not one analyst from New York or Boston ever visited Cajun Cleansers, nor has any institution bought its shares.
Mention Cajun Cleansers at a cocktail party and soon you’ll be talking to yourself. It sounds ridiculous to everyone within earshot.
While expanding quickly through the country, Cajun Cleansers has had incredible sales. These sales will soon accelerate because the company just revealed a patent on a new gel that removes all sorts of stains from clothes, furniture, carpets and bathroom tiles. The patent gives Cajun the niche it’s been looking for.
The company is planning to offer lifetime prestain insurance with annual installments, who can pay in advance for a guaranteed removal of all the future stain accidents they ever cause on any surface.
The stock opened at $8 in an IPO seven years ago and soon rose to $10. At that price the important corporate directors bought as many shares as they could afford.
I visit the company and find out that any trained crustacean could oversee the making of the gel.
While Cajun Cleansers is a fictional business, you can have a sensing of what a tenbagger looked like in the eyes of the legendary Magellan fund manager. The aforementioned story description is not too far off the business models and existing environments of several companies in our midst.
The Red Flags in the Market
“If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favourable publicity, the one that every investor hears about in the carpool or on the commuter train- and succumbing to social pressure, often buys”Peter Lynch
Hot stocks can go up fast, usually out of sight of any known landmarks of value, but since there’s nothing but hope and thin air to support them, they fall just as quickly.
Let us take a look at Best World, a hot stock that tumbled after Bonitas Research published a 28-page report that questioned the authenticity and legality of the premium skincare firm’s profits.
Other than the sexiest stock in the hottest industry, here are 4 other traits of the stocks Peter Lynch would definitely avoid:
- The “Next Amazon”, The “Next Facebook” and the “Next Google”
- The Whisper Stock
- Reliant on a single/few customers
The “Next Amazon”, The “Next Facebook” and the “Next Google”
Beware when someone terms the stock as the next “Facebook” or the next “Google” because it is almost never is.
In fact, these are merely marketing tactics and click baits tactically placed to entice you to read on further.
“This stock, company ABCXYZ, could be like buying Facebook for $2 a share”
More often than not, they liken such stocks to the big players to make it relatable and to attract the ignorant investors who buy on hearsay.
This, in turn, entices them and the next thing you know, he commits half of his savings for retirement into buying shares of ABCXYZ, smugly touting to his friends that he got on the boat early.
Some call it diversification, but Lynch likes to term bad decisions as Diworseifying.
Instead of buying back shares or raising dividends, profitable companies often prefer to blow their money on foolish acquisitions.
More often than not, one must ask themselves whether the company’s expansion is related to the core operations.
A few fictional (exaggerated) examples would include:
- Genting Singapore acquiring ST Engineering
- DBS buying over Koufu
- Singtel taking over Sheng Siong
Now, that would sound silly, leaving you wondering to yourself how the idea of such acquisitions managed to pass through the vetting of the management and leadership. The hard truth is that such lousy expansions exist.
If we draw upon people’s painful lesson of Hyflux, we could evidently see a jarring case of diworseification as the company expanded from innovating water solutions to generating power and energy.
Being the first in Singapore and Asia, the Tuaspring Integrated Water and Power Project was expected to raise efficiency levels and reduce the cost of desalination.
The power plant was opened in 2016 and it was Hyflux’s first venture into the energy business.
Notice how Hyflux chooses to report their profits and earnings by excluding Tuaspring?
This was because Tuaspring was a drag on the company’s earnings and profits, Hyflux stated that the “prolonged weakness” in the local energy market as one of the main reasons for its losses.
Read more about that fateful lesson here.
Avoid Whisper Stocks
These stocks are termed as the “Longshots”.
They are often thought of as being on the brink of doing something miraculous such as curing every type of cancer, solve global warming or create world peace.
Whisper stocks have a hypnotic effect, and usually the stories have emotional appeal. This is where the sizzle is so tantalizing that you forget to notice there’s no steak.
Sounds a whole lot like a MLM scheme where the Moringa Elixir promises to solve any kind of illness
What all these longshots had in common besides the fact that you lost money on them was that it had a great story with no substance.
Avoid Businesses Reliant on a Single/Few customers
The company that has 25 – 50% of its sales reliant on a single customer is in a precarious situation.
If the loss of one customer would be catastrophic to a supplier, having a huge toll on its top line, Lynch would be wary of investing in the supplier.
In 2018, AEM Holdings was heavily reliant on its one major customer, while not specifically identified by the company, is believed to be Intel, one of the largest chip makers in the United States, which contributed around 93% of total revenue
This is also a weak bargaining position to be in and the company could potentially be squeezed by this only customer and be subjected to its influence.
I found it! I found it! Now What? (The Lynch checklist)
In the final chapters of the book, Lynch discloses a summary checklist of some (not all) of the important things he’d like to learn about stocks before delving deeper.
- The p/e ratio. Is it high or low for this particular company and for similar companies in the industry?
- The percentage of institutional ownership. The lower, the better.
- Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs.
- The record of earnings growth to date and whether the earnings are sporadic or consistent. (The only category where the earnings may not be important is in the asset play.)
- Whether the company has a strong balance sheet or a weak balance sheet (debt-to-equity ratio) and how it’s rated for financial strength.
- The cash position. With $16 net cash, I know Ford is unlikely to drop below $16 a share. That’s the floor on the stock.
Don’t be confused by Peter Lynch’s homespun simplicity when it comes to doing diligent research – rigorous research was a cornerstone of his success.
When following up on the initial spark of a great idea, Lynch highlights several fundamental values that he expected to be met for any stock worth buying.
One Up on SGX?
As one would notice, Peter Lynch identifies a stock using Qualitative Analysis before diving into the Quantitative.
However, at Dr Wealth, we believe that one should perform quantitative analysis on a stock before dwelling into the qualitative.
That way, we can ignore any emotional biases which can do you harm.
We would like to highlight that both approaches would do the job, just remember not to forget either in your research.
All stock research is borne of a Quantitative and a Qualitative component.
We hope that you enjoyed the first article of the 7-part Peter Lynch Investing Playbook series!
In the next 6 articles, we would dive deeper into the 6 general categories Peter Lynch uses to cover all of the useful distinctions that any investor has to make.
- Slow growers
- Fast growers
- Asset plays
- The turnarounds
Also, if you are as impressed and moved by America’s number-one money manager just as I am, you could consider purchasing his book. Kindle versions can be cheaper if reading books electronically is more your style.
We removed the backstory on Tiger Balm as it was adopted from Fool SG. We’d like to sincerely apologize for the misappropriation.
By the way, we hold regular introductory courses to share our structured investing strategy. If you’d like to know how we have combined several of our own strategies overtime to find our own growth stocks, you can get a free ticket here.
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