Beating The Street by Peter Lynch

Summary

An autobiography of Lynch’s time at Fidelity, focusing on his investment approach and how he learnt the craft. Very practical, easy-to-read and filled with case studies of stock and business analyses.

Key Takeaways

Peter’s Principle #3: Never invest in any idea you can’t illustrate with a crayon.
Peter Lynch’s maxims for investing in stocks:
- A good company usually increases its dividend every year.
- You can lose money in a very short time but it takes a long time to make money.
- The stock market isn’t a gamble, as long as you pick good companies that you think will do well, not just because of the stock price.
- You can make a lot of money from the stock market, but then again you can also lose money, as we proved.
- You have to research the company before you put your money into it.
- When you invest in the stock market you should always diversify.
- You should invest in several stocks because out of every five you pick one will be very great, one will be really bad, and three will be OK.
- Never fall in love with a stock, always have an open mind.
- You shouldn’t just pick a stock – you should do your homework.
- Buying stocks in utility companies is good because it gives you a higher dividend, but you’ll make money in growth stocks.
- Just because a stock goes down doesn’t mean it can’t go lower.
- Over the long term, it’s better to buy stocks in small companies.
- You should not buy a stock because it’s cheap but because you know a lot about it.
- Hold no more stocks than you can remain informed on.
- Invest regularly.
- You want to see, first, that sales and earnings per share are moving forward at an acceptable rate and, second, that you can buy the stock at a reasonable price.
- It is well to consider the financial strength and debt structure to see if a few bad years would hinder the company’s long-term progress.
- Buy or do not buy the stock on the basis of whether or not the growth meets your objectives and whether the price is reasonable.
- Understanding the reasons for past sales growth will help you form a good judgment as to the likelihood of past growth rates continuing.
End discussions by asking: which of your competitors do you respect the most?
Learn to identify the factors that make the earnings rise and fall. Then you can ask the right questions.
90 seconds is plenty of time to tell the story of a stock. If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won’t get bored.

What I got out of it

A very practical book in which Lynch outlines how he learnt the craft, how he evolved his approach and how he values businesses (by including numerous case studies).

A short, to-the-point and pleasant read. I wish there were more investment books like this by a consistently great investor.

Summary Notes

Introduction

There’s a company behind every stock and a reason companies – and their stocks – perform the way they do.

The Miracle of St. Agnes

Peter’s Principle #3: Never invest in any idea you can’t illustrate with a crayon.

Peter Lynch’s maxims for investing in stocks:

A good company usually increases its dividend every year.
You can lose money in a very short time but it takes a long time to make money.
The stock market isn’t a gamble, as long as you pick good companies that you think will do well, not just because of the stock price.
You can make a lot of money from the stock market, but then again you can also lose money, as we proved.
You have to research the company before you put your money into it.
When you invest in the stock market you should always diversify.
You should invest in several stocks because out of every five you pick one will be very great, one will be really bad, and three will be OK.
Never fall in love with a stock, always have an open mind.
You shouldn’t just pick a stock – you should do your homework.
Buying stocks in utility companies is good because it gives you a higher dividend, but you’ll make money in growth stocks.
Just because a stock goes down doesn’t mean it can’t go lower.
Over the long term, it’s better to buy stocks in small companies.
You should not buy a stock because it’s cheap but because you know a lot about it.

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.

More investment maxims:

Hold no more stocks than you can remain informed on.
Invest regularly.
You want to see, first, that sales and earnings per share are moving forward at an acceptable rate and, second, that you can buy the stock at a reasonable price.
It is well to consider the financial strength and debt structure to see if a few bad years would hinder the company’s long-term progress.
Buy or do not buy the stock on the basis of whether or not the growth meets your objectives and whether the price is reasonable.
Understanding the reasons for past sales growth will help you form a good judgment as to the likelihood of past growth rates continuing.

The Weekend Worrier

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.

Keeping the faith and stock picking are normally not discussed in the same paragraph, but success in the latter depends on the former.

A Tour Of The Fund House

Whereas companies routinely reward their shareholders with higher dividends, no company in the history of finance, going back as far as the Medicis, has rewarded its bondholders by raising the interest rate on a bond.

Theoretically, it makes no sense to put any money into bonds, even if you do need income.

Unlike wine and baseball cards, money is cheapened with age.

Another fallacy about bonds is that it’s safer to buy them in a fund. No doubt it is, if you’re talking about corporate bonds or low-rated junk bonds, because a fund can limit the risk of default by investing in a variety of issues. But a bond fund offers no protection against higher interest rates, which is by far the greatest danger in owning a long-term IOU. When rates go higher, a bond fund loses value as quickly as an individual bond with a similar maturity.

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.

Managing Magellan – The Early Years

Stay on the offensive, searching for better opportunities in companies that are more undervalued than the ones I’ve chosen.

Lynch was attracted to fast-food restaurants because they were so easy to understand.

One of the most important lessons was the value of doing one’s own research. Lynch visited dozens of companies at their headquarters, and was introduced to dozens more at regional investment conferences, and a growing number (200 a year or so in the early 1980s) came to Fidelity.
Fidelity began a policy of taking a corporation to lunch.
These conversations often led to Lynch getting a jump on the latest developments in (cyclical) industries.

Lynch’s personal rule was that once a month he ought to have at least one conversation with a representative of each major industry group, just in case business was starting to turn around or there were other new developments that Wall Street had overlooked. This was a very effective early-warning system.
He always ended these discussions by asking: which of your competitors do you respect the most?

Lynch was always careful to write down the name of everyone he met at the lunches and meetings. Many of these people became valuable sources he called upon repeatedly over the years. In industries with which he was only vaguely familiar, they taught him the basics of what to look for on the balance sheet and what questions to ask.
He learned to identify the factors that make the earnings rise and fall. Then he could ask the right questions.

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

When stocks in good companies are selling at 3-6 times earnings, the stockpicker can hardly lose.

Small is not only beautiful, it also can be lucrative.

Magellan – The Middle Years

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

Lynch’s methods were not much different from those of an investigative reporter:

Reading the public documents for clues;
Talking with intermediaries such as analysts and investor relations people for more clues;
Then going directly to the primary sources: the companies themselves.

After every contact he made, on the phone or in person, he’d scribble a notation in a loose-leaf binder – the name of the company and the current stock price, followed by a one- or two-line summary of the story he’d just heard.

The best way to get the most out of staff is to give people full responsibility. Usually, they will live up to it.

90 seconds is plenty of time to tell the story of a stock. If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won’t get bored.

Peter’s Principle #8: 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.

Lynch’s “secret to success”:

Visit more than 200 companies a year.
Read 700 annual reports a year.
He subscribed to Edison’s theory (of genius) that “investing is ninety-nine percent perspiration”.

Bargains are the holy grail of the true stockpicker.

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.

Magellan – The Later Years

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.

When the weakest of the S&Ls (Savings & Loans, aka “thrift”) collapsed, the prices of the strong ones declined in sympathy.
In contrast, for autos, the favourable economic tide that lifted one was lifting them all.

In Lynch’s first five years he didn’t travel much, but in the second five, he was frequently on the road. Most of the trips were organized around investment seminars held in every region of the country. These were like cram courses in which he could hear from dozens of companies in two or three days.

The investment seminar was the greatest laboursaving device for fund managers ever invented.

Peter’s Principle #11: 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 scary situations, the fund manager won’t have to liquidate stocks at unfavourable 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.

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.

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. The bond market is dominated by conservative investors who keep rather close tabs on a company’s ability to repay the principal. 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 bond.

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

Art, Science, And Legwork

A pile of software isn’t worth a damn if you haven’t done your basic homework on the companies.

The part-time stockpicker doesn’t need to find 50 or 100 winning stocks. It only takes a couple of big winners in a decade to make the effort worthwhile. The smallest investor can follow the Rule of Five and limit the portfolio to five issues. If just one of those is a 10-bagger and the other four combined go nowhere, you’ve still tripled your money.

In a beaten-down market there are bargains everywhere you look, but in an overpriced market it’s hard to find anything worth buying.

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.

Shopping For Stocks

Peter’s Principle #14: If you like the store, chances are you’ll love the stock.

The very homogeneity of taste in food and fashion that makes for a dull culture also makes fortunes for owners of retail companies and restaurant companies as well. What sells in one town is almost guaranteed to sell in another.

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.

The managers of malls have the greatest advantage of all – access to the monthly sales figures that are used to compute the rents.

As much as we like to think our children are unique, they are also part of an international tribe of shoppers with the same taste in caps, T-shirts, socks, and prewrinkled jeans, so when my oldest daughter, Mary, gets her wardrobe from the Gap, it’s a safe assumption that teenagers at all the nation’s outlets are doing the same.

As a rule of thumb, a stock should sell at or below its growth rate – that is, the rate at which it increases its earnings every year.

The best way to handle a situation in which you love the company but not the current price is to make a small commitment and then increase it in the next sell-off.

If anybody ever tells you that a stock that’s already gone up 10-fold or 50-fold cannot possibly go higher, show that person the Wal-Mart chart.

In a retail company or a restaurant chain, the growth that propels earnings and the stock price comes mainly from expansion. As long as the same-store sales are on the increase, the company is not crippled by excessive debt, and it is following its expansion plans as described to shareholders in its reports, it usually pays to stick with the stock.

Prospecting In Bad News

A technique that works repeatedly is to wait until the prevailing opinion about a certain industry is that things have gone from bad to worse, and then buy shares in the strongest companies in the group.

It’s senseless to invest in a downtrodden enterprise unless the quiet facts tell you that conditions will improve.

Whenever Lynch is evaluating a retail enterprise, in addition to the factors mentioned above, he always tries to look at inventories. When inventories increase beyond normal levels, it is a warning sign that management may be trying to cover up the problems of poor sales.

One way to estimate the actual worth of a company is to use the home buyer’s technique of comparing it to similar properties that recently have been sold in the neighbourhood.

When a company buys back shares that once paid a dividend and borrows the money to do it, it enjoys a double advantage. The interest on the loan is tax-deductible, and the company is reducing its outlay for dividend checks, which it had to pay in after-tax dollars.

When you or I can buy part of a company for less than the company itself has paid, it’s a deal worth examining. It’s also a good sign when the “insiders,” executives and so forth, have paid more than the current price.

Whenever book value comes up, Lynch asks himself the same question we all ask about the movies: is this based on a true story or is it fictional? The book value of any company can be one or the other. To find out which, he turns to the balance sheet.

What you want to see on a balance sheet is at least twice as much equity as debt, and the more equity and the less debt the better.

My Close Shave At Supercuts

One of the first things you need to know about a retail operation, as mentioned above, is whether it can afford to expand.

Blossoms In The Desert

Peter’s Principle #16: In business, competition is never as healthy as total domination.

Peter’s Principle #17: All else being equal, invest in the company with the fest colour photographs in the annual report.

It’s A Wonderful Buy

Everything you need to know about an S&L:

Current price
IPO price
Equity-to-assets ratio
Dividend
Book value
Price-earnings ratio
High-risk real-estate assets
90-day nonperforming assets
Real estate owned

You don’t have to be an expert to talk to an S&L, but you do have to have a basic idea of how the business works. An S&L needs loyal depositors to keep money in their savings and checking accounts. It needs to make money on that money by lending it out – but not to borrowers who default. And it needs low operating expenses in order to maximize its profits. Bankers like to live on threes and sixes: borrow money at 3, lend money at 6, play golf at 3.

This is the way you look at a long-shot S&L: find out what the equity is and compare that to the commercial loans outstanding. Assume the worst.

Master Limited Partnerships

If a company has raised dividends 13 quarters in a row, as Green Acres had, it has a powerful built-in incentive to continue the string. To break it for the sake of a penny, or a grand total of $100,000, Lynch suspected was symptomatic of deeper troubles.

Buying on the good news is healthier in the long run, and you improve your odds considerably by waiting for the proof.

If there isn’t a real deal, you’ve protected yourself by waiting.

This is a useful year-end review for any stockpicker: go over your portfolio company by company and try to find a reason that the next year will be better than the last. If you can’t find such a reason, the next question is: why do I own this stock?

The Cyclicals

It’s perilous to invest in a cyclical without having a working knowledge of the industry (copper, aluminium, steel, autos, paper, whatever) and its rhythm.

The comeback of a depressed cyclical with a strong balance sheet is inevitable, which leads to Peter’s Principle #19: Unless you’re a short seller or a poet looking for a wealthy spouse, it never pays to be pessimistic.

Lynch often does a sort of thumbnail appraisal of a company’s various divisions, which may represent a sizable hidden asset. This is a useful exercise to perform on any sort of company whose shares you might want to buy. It’s not unusual to discover that the parts are worth more than the whole.
It’s easy enough to find out if a company has more than one division – the annual report tells you that. It also gives you a breakdown of the earnings. If you take the earnings of each division and multiply by a generic p/e ratio (say, 8-10 for a cyclical on average earnings, or 3-4 on peak earnings), you’ll get at least a rough idea of how much the division is worth.

The autos, often misidentified as blue chips, are classic cyclicals.

One useful indicator for when to buy auto stocks is used-car prices. When used-car dealers lower their prices, it means they’re having trouble selling cars, and a lousy market for them is even lousier for the new-car dealers. But when used-car prices are on the rise, it’s a sign of good times ahead for the automakers.
An even more reliable indicator is “units of pent-up demand.”

After four or five years when sales are under the trend, it takes another four or five years of sales above the trend before the car market can catch up to itself. If you didn’t know this, you might sell your auto stocks too soon.

Timing the auto cycles is only half the battle. The other half is picking the companies that will gain the most on the upturn.

Nukes In Distress

Lynch treated the utilities as interest-rate cyclicals, and tried to time his entrances and his exits accordingly.

Peter’s Principle #20: Corporations, like people, change their names for one of two reasons: either they’ve gotten married, or they’ve been involved in some fiasco that they hope the public will forget.

Utilities are regulated by the government. A utility may declare bankruptcy and/or eliminate its dividend, but as long as people need electricity, a way must be found for the utility to continue to function.

Recoveries of utilities proceed through four recognizable stages:

In the first stage, disaster strikes. The utility is faced with a sudden loss of earnings, either because some huge cost cannot be passed along to customers, or because a huge asset is mothballed and removed from the rate base.
In the second stage, which experts call “crisis management,” the utility attempts to respond to the disaster by cutting capital spending and adopting an austerity budget.
In the third stage, “financial stabilization,” management has succeeded in cutting costs to the point that the utility can operate on the cash it receives from its bill-paying customers.
In stage four, “recovery at last!,” the utility once again is capable of earning something for the shareholders, and Wall Street has reason to expect improved earnings and the reinstatement of the dividend. The shares now sell at book value. How things progress from here depends on two factors…
1. The reception from the capital markets, because without capital the utility cannot expand its rate base.
2. The support, or nonsupport, of the regulators, i.e. how many costs they allow the utility to pass along to the customers in the form of higher rates.

Buy on the omission of the dividend and wait for the good news. Or, buy when the first good news has arrived in the second stage.

This suggests a simple way to make a nice living from troubled utilities: buy them when the dividend is omitted and hold to them until the dividend is restored. This is a strategy with a terrific success ratio.

When a company is deeply indebted, you want it to be a debt that doesn’t have to be paid in full anytime soon.

When a utility adds, say, 10 percent to capacity, it automatically adds 10 percent to its earnings, based on the formula that is applied by the regulators who set the rates. It is a wonderful thing for shareholders when a utility builds a new plant (one that gets a license to operate at least) or takes other steps to increase capacity. When capacity grows, so does the rate base, and so do the earnings.

Uncle Sam’s Garage Sale

Peter’s Principle #21: Whatever the queen is selling, buy it.

The Restaurant Stocks

There are several ways a restaurant chain can increase its earnings:

It can add more restaurants.
It can improve its existing operations.
It can make more money with high turnover at the tables and low-priced meals.
It can have low turnover and higher-priced meals.
Some make their biggest profits on food sales, and some have gift shops.
Some have high profit margins because their food is made from inexpensive ingredients, others because their operating costs are low.

The key elements are growth rate, debt, and same-store sales.

The Six-Month Checkup

A healthy portfolio requires a regular checkup – perhaps every six months or so.

As a stockpicker, you can’t assume anything. You’ve got to follow the stories. You are trying to get answers to two basic questions:

Is the stock still attractively priced relative to earnings?
What is happening in the company to make the earnings go up?

You can reach one of three conclusions:

The story has gotten better, in which case you might want to increase your investment.
The story has gotten worse, in which case you can decrease your investment.
The story’s unchanged, in which case you can either stick with your investment or put the money into another company with more exciting prospects.

25 Golden Rules

Some of Lynch’s rules:

Your investor’s edge is not something you get from Wall Street experts. It’s something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand. (Note: Buffett calls this “Circle of Competence”)
Behind every stock is a company. Find out what it’s doing.
It pays to be patient and to own successful companies.
You have to know what you own and why you own it.
Owning stocks is like having children – don’t get involved with more than you can handle.
If you can’t find any companies that you think are attractive, put your money in the bank until you discover some.
Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets. Always look at the balance sheet to see if a company is solvent before you risk your money on it.
Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.
If you don’t study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards.
Time is on your side when you own shares of superior companies. You can afford to be patient – even if you missed Wal-Mart in the first five years, it was a great stock to own in the next five years.
In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.