Hello — welcome to Investor's Bookshelf; the book we're discussing in this episode is One Up on Wall Street.
Peter Lynch is one of the most successful mutual-fund managers in the world.
How successful was he? Some have said his contribution to the fund industry is comparable to Michael Jordan's contribution to basketball.
The Magellan Fund, which he managed, achieved a 29% compound annual return — a performance that set a record in the U.S. mutual-fund industry.
In this book Lynch lays out his entire stock-selection philosophy and methodology; in other words, he lays bare the secrets that made him the most successful fund manager.
What Lynch is most famous for is his method of finding “tenbaggers.” A tenbagger is a stock that can rise tenfold over the next ten years — what we commonly call a runaway winner. He explains this method in detail in the book.
Investment great Warren Buffett and Peter Lynch have long held mutual admiration for each other.
Shortly after the book was first published, Lynch received a phone call from Buffett; on that call Buffett said, “I just finished your book — I really liked it.”
That Buffett would praise the book so warmly is evidence that it truly has remarkable merits.
In the time ahead I will explain Lynch’s complete investing method in detail; I will divide it into three guiding principles: the first is how to pick tenbaggers; the second is which stocks you must not touch; the third is how to master the timing of buying and selling.
Part One.
Let’s look at the first principle: picking tenbaggers — that is, stocks that rise more than tenfold in a relatively short period.
In Peter Lynch’s investment career he placed great emphasis on digging up tenbaggers, and this may be related to his experience with the very first stock he ever bought. In his sophomore year of college he bought his first share — Flying Tiger — at $7 a share, and in less than two years Flying Tiger’s share price rose to over $30. You see, the first stock he ever bought turned out to be a five-bagger. That successful first experience reinforced his conviction to keep searching for big winners throughout the subsequent decades of his investing life. In this book Lynch makes a clear and striking claim: ordinary people — that is, amateur investors — actually have an advantage over professional investors when it comes to finding tenbaggers.
At first glance this sounds like a sensational claim. In fact Lynch’s original wording is even bolder; he put it this way: “Twenty years in the investment business have convinced me that any ordinary amateur who uses just three percent of his brainpower can outperform the average Wall Street professional.” For millions of ordinary people those are truly encouraging words. But encouragement alone is not enough. Don’t worry — in the book he goes on to explain in detail why he believes amateur investors have an edge in stock selection.
One very important reason is that Wall Street professionals tend to be late to react. Lynch points out that professional investors on Wall Street usually wait until many well-known analysts begin to recommend a stock and until their peers start buying in large quantities before they act. For example, a clothing retailer went public in 1969 but was ignored at first. Six years after its IPO it had opened 100 specialty stores across the United States, yet only a single institutional investor had bought its shares; four years later there were still only two institutional holders. Fourteen years after the IPO the company had opened hundreds of stores across the U.S. and was booming; its stock had risen to $9, an 18-fold increase from the initial price, yet it still hadn’t attracted major Wall Street attention. Only two years later did institutions on Wall Street begin to pay serious attention — by then the stock was trading at $15, a thirty-fold gain from the original price.
Why are Wall Street professionals so slow? Lynch thinks it’s because professionals are generally unwilling to take the risk of buying shares of obscure small companies. He gives a vivid example: if you buy IBM and it falls, your clients and boss will ask, “What the hell is going on with IBM?” But if you buy shares of an obscure motel chain and they fall, they’ll ask, “What the hell are you doing?” Because purchasing unknown small-company stocks invites enormous pressure, independent thinking is very difficult among professional investors.
So Lynch says he will continue to think about stock picking as much as possible like an amateur investor. But how should an amateur actually pick stocks? Lynch has a famous line: the best place to find tenbaggers is right around your home — and if you can’t find any there, go to the big shopping malls, especially to the places where you work.
Let’s imagine an example: suppose someone lived in rural America in the 1970s, grew their own food, and didn’t even own a television — where would such a person look for tenbaggers? Maybe one day they develop a stomachache and have to see a doctor, because rural life has given them a peptic ulcer — and that turns out to be how they encounter a tenbagger: SmithKline & French (later SmithKline Beecham), the company that launched Tagamet. In America at that time millions of people had heard of or used the stomach remedy Tagamet; after it was introduced it sold extremely well because it worked. The drug company that launched Tagamet thus became a tenbagger.
Sounds simple to pick tenbaggers, right? Don’t be too quick to celebrate, because the truth is most people didn’t do this, and even Lynch himself regretted missing a big familiar winner in his own industry. By 1977 Lynch was working at Fidelity, just when the mutual-fund industry was booming and many firms in the industry were going public. For example, a fund company called Dreyfus was trading at 40 cents and by 1986 had risen to nearly $40 — a 100-fold increase in nine years. You see, Lynch himself worked in that industry and knew it well, yet he didn’t buy Dreyfus’s shares and missed the opportunity.
People’s reluctance to buy stocks in their own industry or in sectors they know well seems to be a common affliction. Lynch describes the phenomenon like this: if you canvassed doctors, I’d bet only a small proportion of them owned pharmaceutical stocks — most would own oil stocks; if you canvassed shoe-store owners, most would own airline stocks rather than shoe companies; conversely, airline engineers might hold shoe stocks. It’s a paradox: stocks are like the lawn in front of your neighbor’s house — everyone thinks the neighbor’s grass is greener. So to find tenbaggers around you, you must first overcome the bias that “the grass is greener on the other side,” and then figure out how to exploit your own advantages.
What exactly should you do? Lynch further divides companies into six types: slow growers, stalwarts (steady growers), fast growers, cyclicals, asset plays (hidden-asset companies), and turnarounds. Six categories may sound dizzying, but don’t worry — the areas most likely to produce tenbaggers are mainly three types: fast growers, asset plays, and turnarounds. Moreover, when we analyze a specific company different types require different methods of analysis. Next we’ll focus on the three types most likely to produce tenbaggers.
First, fast-growing companies — these are the richest soil for tenbaggers and Lynch’s favorite category. These firms are often relatively young, small in scale, and have strong growth, typically growing at 20–25% per year on average. If you can pick the right ones you may discover stocks that rise tenfold or even a hundredfold. These companies are particularly attractive to amateur investors because amateur portfolios are usually small; finding one or two such stocks can dramatically boost overall returns.
On the other hand, be warned that these companies tend to be small and less financially resilient, so their risks are higher and it’s easy to fall into traps. The key to analyzing fast growers is to examine the replicability of their success — whether a company that has succeeded in one place can replicate that success again and again in other places. Walmart during its expansion is a classic example. As the company opened new markets and profits grew rapidly, the stock followed with large gains. Lynch believes the trick to investing in this type is to figure out when the growth phase is likely to end and preferably sell before the rapid-growth period is over.
Next, consider turnarounds — companies that have been badly hit, are near collapse, or almost bankrupt. These companies are dangerous, but once they turn around they can become major winners. An additional benefit of turnaround stocks is that their price movements are often only weakly correlated with the overall market. In the 1980s the famous automaker Chrysler once fell into deep trouble and came close to bankruptcy; later, with government support, it turned around. Lynch bought Chrysler shares for the Magellan Fund and made a large profit. In early 1982 he began buying Chrysler at around $6 a share, and five years later the stock had risen fifteenfold.
Besides fast growers and turnarounds, another category likely to produce tenbaggers is asset plays — companies that own valuable assets that Wall Street professionals have overlooked. Lynch once toured an unremarkable small cattle company in Florida and saw only low scrubby brush, cows grazing in a pasture, and about twenty employees. Where was the hidden asset? In the land itself. Ten years later the value of that land alone made the shares worth over $200 apiece. That’s a classic asset-play company.
Let’s summarize Lynch’s first investing principle: picking tenbaggers. Lynch believes that in the search for big winners amateur investors do not lag professionals — they may even have the edge. The three types of companies most likely to produce tenbaggers are fast growers, turnarounds, and asset plays.
Part Two.
Now we move on to the second investing principle: the stocks you must not touch.
Just now we discussed how to pick the big winners around you; perhaps after that section you feel full of confidence, but here I need to warn you that besides the tenbaggers that can make you tenfold gains, the market also contains many traps that can wipe you out.
How do you avoid those traps? Peter Lynch also summarized his priceless lessons; I have distilled the three most important of them into three commandments for you.
Peter Lynch’s first commandment is: avoid the hot stocks in hot industries.
At first this may seem counterintuitive — similar to the recent slogan “when the wind is right, even pigs can fly,” many people feverishly chase the pigs on the wind; so why does Lynch tell us to stay away from the hottest stocks in the hottest sectors?
The first reason is that the hottest stocks in hot industries already receive the widest attention; you’ll hear people discussing them on the subway during their commute — and once awareness is that high there are few incremental new buyers left, and with fewer new buyers the chance of a price decline grows.
The second reason is that hot stocks are inevitably overvalued, and over time the bubble will burst. For example, U.S. internet stocks in 2000 overheated and then collapsed; the Nasdaq plunged by more than half in a short time and many stocks lost 90% of their value.
The third reason is that hot industries attract massive amounts of capital, which leads to excessive competition and often leaves the industry’s companies unable to make money. For instance, in the 1960s Xerox was the hottest stock in the U.S. market and many analysts were wildly optimistic. In 1972, when Xerox traded as high as $170, analysts proclaimed that Xerox’s growth would continue indefinitely. But then competitors such as Canon, IBM, and Kodak entered the copier business, and soon some twenty companies were producing copiers that matched Xerox’s quality; Xerox’s stock later fell by more than 80%.
Peter Lynch’s second commandment is: be wary of companies being touted as “the next” somebody. Companies are often hyped as the next IBM, the next Intel, or the next Disney — Lynch believes these firms almost never actually become the iconic companies they’re compared to. In many industries the market leader captures most of the rewards, and the runner-up’s profitability is often far inferior to the leader’s; many of the companies hailed as “the next X” do not even become number two.
Peter Lynch’s third commandment is: beware of the whisper stocks. If you have ever bought stocks, you may have encountered a situation in which a friend leans in conspiratorially and says, “I’ll tell you about a dark horse — but don’t tell anyone.” Unfortunately, these whisper stocks almost always brought Lynch painful lessons. For example, National Health Care fell from $14 to $0.50 a share; Sun World Airways fell from $8 to $0.50 a share.
Lynch thought these whisper stocks typically tell a magical story — “our product cures AIDS,” “our technology will solve the oil shortage,” and so on — but the companies themselves have little or no earnings, and the magical stories usually never materialize. So investing in such firms is extremely risky and should be avoided.
In the previous section we heard three commandments: do not touch the hottest companies in hot industries; do not touch companies touted as the next big thing; do not touch whisper stocks. Each of these commandments is a lesson Lynch paid for with a lot of money, and they are worth your careful remembrance.
Part Three
Now we move on to Peter Lynch’s third investing principle: mastering the timing of buys and sells.
First let’s look at two mistaken ways people trade. Some investors habitually sell the “winners” — the stocks that have one up — and cling stubbornly to the “losers” — the stocks that have fallen. Lynch calls this strategy foolish, like pulling up the flowers while watering the weeds.
Would the opposite work better — selling the losers and holding the winners? Lynch says that strategy isn’t much smarter either. By now you may be confused: neither doing it one way nor the other seems right — so what should you do?
The reason both strategies fail is that they treat current price movement as the primary decision criterion. So if you shouldn’t base decisions simply on price action, what should you look at? Lynch says you should analyze the company’s fundamentals and judge whether the stock price is high or low relative to those fundamentals: sell when a stock is overvalued, buy when it is undervalued. That approach is very similar to Warren Buffett’s value-investing philosophy.
Lynch adds two important qualifications: there are two special times when you are likely to find especially cheap stocks. The first is at year-end, when many investors sell losers to harvest tax losses — a phenomenon tied to U.S. tax rules. The second is during market crashes or severe sell-offs, which occur every few years and are often excellent opportunities to pick up bargains.
For example, during the October 1987 market crash almost every stock fell sharply. Earlier we mentioned that Lynch had missed a big familiar winner in his own industry — the Dreyfus fund company — whose business had grown rapidly and whose shares had risen greatly. During the crash Dreyfus’s stock fell with the market; at its nadir the company’s business was being valued at roughly $1 a share, nearly a giveaway. That was an excellent buying opportunity: Lynch seized it and began buying the shares amid the market’s plunge, and a year later the stock was up about 60%.
Having covered when to buy, let’s turn to when to sell. The common mistake investors make when selling is to dispose of a potential tenbagger too soon. Take one of Lynch’s own failures: he sold Toys “R” Us too early and left a lot of profit on the table.
Toys “R” Us was an excellent specialty toy retailer that expanded rapidly in the U.S. during the 1980s. After doing thorough research, Lynch bought a large position at roughly $1 a share. Not long after his purchase he read in the paper that a retail titan had bought 20% of Toys “R” Us, and that heavy buying pushed the price up. Lynch reasoned that once the titan stopped buying, the stock might fall, so he sold his holdings at about $5 a share. By 1985 Toys “R” Us had climbed to $25 a share — indeed, a super stock that rose twenty-fivefold in a few years. Regrettably, Lynch only captured a fivefold gain. By contrast, his colleague Peter deRoetth, who had originally tipped him to the company, held on and reaped the full twenty-fivefold return.
That episode teaches that if you have a long-term conviction about a company, don’t sell it for short-term reasons — once you sell you may not be able to repurchase at the same price. You might wonder whether there’s a way to always sell at the absolute top. Unfortunately, no such method exists. But Lynch offers his selling rule: think about when to sell the same way you thought about when to buy.
Timing a sale really comes down to two points. First, revisit the reasons you bought the stock in the first place: if those original reasons no longer hold, it’s time to sell. For example, if you bought a fast-growing company because it was rapidly opening new markets and enjoying explosive earnings growth, you should sell once growth slows and the original thesis is invalidated. Or if you bought a turnaround company because it was in crisis yet poised to recover, you should sell once the company has clearly recovered and the problems have been solved and the stock has risen substantially.
That’s the first point. The second is to compare the value proposition of the stock you hold with other stocks: if there are other companies whose price is far more attractive relative to fundamentals, you should sell and redeploy the capital. Lynch’s thinking here echoes Sir John Templeton and Sir John Templeton’s disciples: when asked when to sell, Templeton replied, “When I find a better bargain.” The “value proposition” referred to is simply how undervalued the stock is relative to its fundamentals — the more undervalued, the better.
Let’s recap Lynch’s third investing principle: mastering buy-and-sell timing. Deciding when to sell is really about returning to your original investment thesis — does it still stand? — and about opportunity cost — are there better bargains elsewhere?
Conclusion
This brings us to the end of the book — let’s summarize today’s episode.
We covered Peter Lynch’s three investing principles in total.
The first principle: pick tenbaggers. At the very start of this book Lynch gives amateur investors a shot of adrenaline — he argues that ordinary investors, far from being at a disadvantage, can actually have an edge over professionals when it comes to finding big winners.
Of course, to exploit that edge you need to learn a complete stock-picking method — for example, classifying companies into different types for analysis — and that method is far less difficult than you might imagine.
The second principle: these stocks you must not touch. While learning how to find tenbaggers, you also must know how to avoid the traps that can ruin you. In that section we described several kinds of stocks you should absolutely avoid — steer clear of those traps and you’re already halfway to success.
The third principle: master the timing of buys and sells. We’ve explained how to choose stocks and how to avoid pitfalls; the remaining key question is timing. There’s a saying in the market: “the apprentice knows how to buy; the master knows how to sell” — selling is often harder than buying. In this part we presented Lynch’s hard-won lessons about selling: two core rules are (1) sell when the reasons you bought the stock no longer hold, and (2) consider selling when you’ve found another stock with a materially better value proposition.
Finally, let’s look at where Lynch’s method sits within the investing world. Globally, Peter Lynch is best known for investing in growth stocks and, in particular, for his ability to find tenbaggers — which tend to arise among fast growers, turnarounds, or asset plays. By contrast, Warren Buffett — who is also renowned for stock-picking — generally focuses more on steady growers and consumer businesses. Moreover, the two differ markedly in portfolio concentration: when Buffett finds a company he likes he often concentrates his position heavily, sometimes buying so much that he effectively controls the company; Lynch’s approach was much more diversified — at one point the Magellan Fund held well over a thousand stocks. That said, for an amateur investor Lynch’s suggestion that holding roughly three to ten stocks is usually sufficient is not far from Buffett’s emphasis on concentrated, high-conviction holdings.
Peter Lynch announced his retirement after thirteen years managing the Magellan Fund, saying he wanted to spend more time with his family; over those thirteen years the fund produced an extraordinary compound annual return of about 29%. After retiring from day-to-day fund management he devoted much of his time and resources to philanthropy, including work through the Lynch Foundation.
In investing, sometimes “what not to do” is more important than “what to do”; knowing when to walk away gracefully is a kind of wisdom in itself.
Finally, let’s recall one of Lynch’s most memorable lines: “I want to think as much as possible like an amateur when I pick stocks.” This book is written for amateur investors — so if you are an amateur, congratulations: you already have a head start.
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