One Up on Wall Street: How to Use What You Already Know to Make Money In

by Peter Lynch

  After finishing that second year at Wharton, I reported to the Army to serve my two-year hitch required under the ROTC program. From 1967 to 1969, I was a lieutenant in the artillery, sent first to Texas and later to Korea—a comforting assignment considering the alternative. Lieutenants in the artillery mostly wound up in Vietnam. The only drawback to Korea was that it was far away from the stock exchange, and as far as I knew, there was no stock market in Seoul. By this time I was suffering from Wall Street withdrawal.

  I made up for lost time during infrequent leaves, when I’d rush home to buy the various hot stocks that friends and colleagues recommended. They were buying high-flying issues that kept going up, but for me they suggested conservative issues that kept going down. Actually I made some money in Ranger Oil, but I lost more in Maine Sugar, a sure-win situation that flopped.

  The Maine Sugar people had gone around to all the Maine potato farmers to convince them to grow sugar beets in the off-season. This was going to be extremely profitable for Maine Sugar, not to mention for the Maine farmers. By planting the sugar beets—the perfect companion crop to potatoes—farmers could make extra money and revitalize the soil at the same time. Moreover, Maine Sugar was footing the bill for planting the beets. All the farmers had to do was haul the grown-up beets to the huge new refinery that Maine Sugar had just built.

  The hitch was that these were Maine farmers, and Maine farmers are very cautious. Instead of planting hundreds of acres of sugar beets, the first year they tried it on a quarter acre, and then when that worked, they expanded to a half acre, and by the time they got to a full acre, the refinery was shut for lack of business and Maine Sugar went bankrupt. The stock fell to six cents, so one share could buy you six gumballs from a Lions Club machine.

  After the Maine Sugar fiasco I vowed never to buy another stock that depended on Maine farmers’ chasing after a quick buck.

  I returned from Korea in 1969, rejoined Fidelity as a permanent employee and research analyst, and the stock market promptly plummeted. (Lynch Law theorists take note.) In June of 1974, I was promoted from assistant director of research to director of research, and the Dow Jones lost 250 points in the next three months. In May of 1977, I took over the Fidelity Magellan fund. The market stood at 899 and promptly began a five-month slide to 801.

  Fidelity Magellan had $20 million in assets. There were only 40 stocks in the portfolio, and Ned Johnson, Fidelity’s head man, recommended that I reduce the number to 25. I listened politely and then went out and raised the number to 60 stocks, six months later to 100 stocks, and soon after that, to 150 stocks. I didn’t do it to be contrary. I did it because when I saw a bargain I couldn’t resist buying it, and in those days there were bargains everywhere.

  The open-minded Ned Johnson watched me from a distance and cheered me on. Our methods were different, but that didn’t stop him from accepting mine—at least as long as I was getting good results.

  My portfolio continued to grow, to the point that I once owned 150 S&L stocks alone. Instead of settling for a couple of savings-and-loans, I bought them across the board (after determining, of course, that each was a promising investment in itself). It wasn’t enough to invest in one convenience store. Along with Southland, the parent company at 7-Eleven, I couldn’t resist buying Circle K, National Convenience, Shop and Go, Hop-In Foods, Fairmont Foods, and Sunshine Junior, to mention a few. Buying hundreds of stocks certainly wasn’t Ned Johnson’s idea of how to run an equity fund, but I’m still here.

  Soon enough I became known as the Will Rogers of equities, the man who never saw a stock he didn’t like. They’re always making jokes about it in Barron’s—can you name one stock that Lynch doesn’t own? Since I own 1,400 at present, I suppose they have a point. Certainly I can name plenty of stocks I wish I hadn’t owned.

  Meanwhile, however, the assets in Fidelity Magellan have grown to $9 billion, which makes this fund as large as the gross national product of half of Greece. In terms of return on investment, Fidelity Magellan has done much better than Greece over the eleven years, although Greece has an enviable record over the preceding 2,500.

  As for Will Rogers, he may have given the best bit of advice ever uttered about stocks: “Don’t gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”

  2

  The Wall Street Oxymorons

  To the list of famous oxymorons—military intelligence, learned professor, deafening silence, and jumbo shrimp—I’d add professional investing. It’s important for amateurs to view the profession with a properly skeptical eye. At least you’ll realize whom you’re up against. Since 70 percent of the shares in major companies are controlled by institutions, it’s increasingly likely that you’re competing against oxymorons whenever you buy or sell shares. This is a lucky break for you. Given the numerous cultural, legal, and social barriers that restrain professional investors (many of which we’ve nailed up ourselves), it’s amazing that we’ve done as well as we have, as a group.

  Of course, not all professionals are oxymoronic. There are great fund managers, innovative fund managers, and maverick fund managers who invest as they please. John Templeton is one of the best. He is a pioneer in the global market, one of the first to make money all around the world. His shareholders avoided the 1972–74 collapse in the U.S. because he had cleverly placed most of his fund’s assets in Canadian and Japanese stocks. Not only that, he was one of the first to take advantage of the fact that the Japanese Dow Jones (the Nikkei average) is up seventeenfold from 1966 to 1988, while the U.S. Dow Jones has only doubled.

  Max Heine (now deceased) at Mutual Shares fund was another ingenious freethinker. His protégé, Michael Price, who took over after Heine’s death, has continued the tradition of buying asset-rich companies at fifty cents on the dollar and then waiting for the marketplace to pay the full amount. He’s done a brilliant job. John Neff is a champion investor in out-of-favor stocks, for which he’s constantly sticking his neck out. Ken Heebner at Loomis-Sayles sticks his neck out, too, and the results have been remarkable.

  Peter deRoetth is another friend who has done extremely well with small stocks. DeRoetth is a Harvard Law School graduate who developed an incurable passion for equities. He’s the one who gave me Toys “R” Us. The secret of his success is that he never went to business school—imagine all the lessons he never had to unlearn.

  George Soros and Jimmy Rogers made their millions by taking esoteric positions I couldn’t begin to explain—shorting gold, buying puts, hedging Australian bonds. And Warren Buffett, the greatest investor of them all, looks for the same sorts of opportunities I do, except that when he finds them, he buys the whole company.

  These notable exceptions are entirely outnumbered by the run-of-the-mill fund managers, dull fund managers, comatose fund managers, sycophantic fund managers, timid fund managers, plus other assorted camp followers, fuddy-duddies, and copycats hemmed in by the rules.

  You have to understand the minds of the people in our business. We all read the same newspapers and magazines and listen to the same economists. We’re a very homogeneous lot, quite frankly. There aren’t many among us who walked in off the beach. If there are any high school dropouts running an equity mutual fund, I’d be surprised. I doubt there are any ex-surfers or former truck drivers, either.

  You won’t find many well-scrubbed adolescents in our ranks. My wife once did some research into the popular theory that great inventions and great ideas come to people before they reach thirty. On the other hand, since I’m now forty-five and still running Fidelity Magellan, I’m eager to report that great investing has nothing to do with youth—and that the middle-aged investor who has lived through several kinds of markets may have an advantage over the youngster who hasn’t.

  Nevertheless, with the vast majority of the fund managers being middle-aged, it cuts out all the potential genius on the earlier and the later ends of the geriatric spectrum.
/>   STREET LAG

  With every spectacular stock I’ve managed to ferret out, the virtues seemed so obvious that if 100 professionals had been free to add it to their portfolios, I’m convinced that 99 would have done so. But for reasons I’m about to describe, they couldn’t. There are simply too many obstacles between them and the tenbaggers.

  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 respected Wall Street analysts (the researchers who track the various industries and companies) have put it on the recommended list. With so many people waiting for others to make the first move, it’s amazing that anything gets bought.

  The Limited is a good example of what I call Street lag. When the company went public in 1969, it was all but unknown to the large institutions and the big-time analysts. The underwriter of the offering was a small firm called Vercoe & Co., located in Columbus, Ohio, where the headquarters of The Limited can also be found. Peter Halliday, a high school classmate of Limited chairman Leslie Wexner, was Vercoe’s sales manager back then. Halliday attributed the disinterest of Wall Street to the fact that Columbus, Ohio, was not exactly a corporate Mecca at the time.

  A lone analyst (Susie Holmes of White, Weld) followed the company for a couple of years before a second analyst, Maggie Gilliam for First Boston, took official notice of The Limited in 1974. Even Maggie Gilliam might not have discovered it if she hadn’t stumbled onto the Limited store at Chicago’s Woodfield Mall during a snow emergency at O’Hare airport. To her credit, she paid attention to her amateur’s edge.

  The first institution which bought shares in The Limited was T. Rowe Price New Horizons Fund, and that was in the summer of 1975. By then there were one hundred Limited stores open for business across the country. Thousands of observant shoppers could have initiated their own coverage during this period. Still, by 1979, only two institutions owned Limited stock, accounting for 0.6 percent of the outstanding shares. Employees and executives in the company were heavy owners—usually a good sign, as we’ll discuss later.

  In 1981 there were four hundred Limited stores doing a thriving business and only six analysts followed the stock. This was seven years after Ms. Gilliam’s discovery. By 1983, when the stock hit its intermittent high of $9, long-term investors were up eighteenfold from 1979, when the shares had sold for 50 cents, adjusted for splits.

  Yes, I know that the price fell nearly in half, to $5 a share in 1984, but the company was still doing well, so that gave investors another chance to buy in. (As I’ll explain in later chapters, if a stock is down but the fundamentals are positive, it’s best to hold on and even better to buy more.) It wasn’t until 1985, with the stock back up to $15, that analysts joined the celebration. In fact, they were falling all over one another to put The Limited on their buy lists, and aggressive institutional buying helped send the shares on a ride all the way up to $52⅞—way beyond what the fundamentals would have justified. By then, there were more than thirty analysts on the trail (thirty-seven as of this writing), and many had arrived just in time to see The Limited drop off the edge.

  My favorite funeral home company, Service Corporation International, had its first public offering in 1969. Not a single analyst paid the slightest heed for the next ten years! The company made great efforts to get Wall Street’s attention, and finally it got noticed by a small investment outfit called Underwood, Neuhaus. Shearson was the first major brokerage firm to show an interest, and that was in 1982. By then the stock was a five-bagger.

  True, you could have more than doubled your money once again by buying SCI at $12 a share in 1983 and selling it at the $30⅜ high in 1987, but that’s not quite as exciting as the fortybagger you’d have had if you’d invested back in 1978.

  Thousands of people had to be familiar with this company if for no other reason than they’d been to a funeral, and the fundamentals were good all along. It turns out that the Wall Street oxymorons overlooked SCI because funeral services didn’t fall into any of the standard industry classifications. It wasn’t exactly a leisure business and it wasn’t a consumer durable, either.

  Throughout the decade of the 1970s, when Subaru was making its biggest moves, only three or four major analysts kept tabs on it. Dunkin’ Donuts was a 25-bagger between 1977 and 1986, yet only two major firms follow it even today. Neither was interested five years ago. Only a few regional brokerages, such as Adams, Harkness, and Hill in Boston, got on to this profitable story, but you could have initiated coverage on your own, after you’d eaten the donuts.

  Pep Boys, a stock I’ll be mentioning again, sold for less than $1 a share in 1981 and hit $9½ in 1985 before it caught the attention of three analysts. Stop & Shop soared from $5 to $50 as the ranks of its analysts swelled from one to four.

  I could go on, but I think we both get the point. Contrast the above with the fifty-six brokerage analysts who normally cover IBM or the forty-four who cover Exxon.

  INSPECTED BY 4

  Whoever imagines that the average Wall Street professional is looking for reasons to buy exciting stocks hasn’t spent much time on Wall Street. The fund manager most likely is looking for reasons not to buy exciting stocks, so that he can offer the proper excuses if those exciting stocks happen to go up. “It was too small for me to buy” heads a long list, followed by “there was no track record,” “it was in a nongrowth industry,” “unproven management,” “the employees belong to a union,” and “the competition will kill them,” as in “Stop & Shop will never work, the 7-Elevens will kill them,” or “Pic ’N’ Save will never work, Sears will kill them,” or “Agency Rent-A-Car hasn’t got a chance against Hertz and Avis.” These may be reasonable concerns that merit investigation, but often they’re used to fortify snap judgments and wholesale taboos.

  With survival at stake, it’s the rare professional who has the guts to traffic in an unknown La Quinta. In fact, 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 normal mutual-fund manager, pension-fund manager, or corporate-portfolio manager would jump at the latter. Success is one thing, but it’s more important not to look bad if you fail. There’s an unwritten rule on Wall Street: “You’ll never lose your job losing your client’s money in IBM.”

  If IBM goes bad and you bought it, the clients and the bosses will ask: “What’s wrong with that damn IBM lately?” But if La Quinta Motor Inns goes bad, they’ll ask: “What’s wrong with you?” That’s why security-conscious portfolio managers don’t buy La Quinta Motor Inns when two analysts cover the stock and it sells for $3 a share. They don’t buy Wal-Mart when the stock sells for $4, and it’s a dinky store in a dinky little town in Arkansas, but soon to expand. They buy Wal-Mart when there’s an outlet in every large population center in America, fifty analysts follow the company, and the chairman of Wal-Mart is featured in People magazine as the eccentric billionaire who drives a pickup truck to work. By then the stock sells for $40.

  The worst of the camp-following takes place in the bank pension-fund departments and in the insurance companies, where stocks are bought and sold from preapproved lists. Nine out of ten pension managers work from such lists, as a form of self-protection from the ruination of “diverse performance.” “Diverse performance” can cause a great deal of trouble, as the following example illustrates.

  Two company presidents, Smith and Jones, both of whom have pension accounts managed by the National Bank of River City, are playing golf together, as they always do. While waiting to tee off, they chat about important things such as pension accounts, and soon they discover that while Smith’s account is up 40 percent for the year, Jones’s account is up 28 percent. Both men ought to be satisfied, but Jones is livid. Early Monday morning he’s on the phone with an officer of the bank, demanding to know why his money has underperformed Smith’s money, when, after all, both accounts are handled by the same pension department.
“If it happens again,” Jones blusters, “we’re pulling our money out.”

  This unpleasant problem for the pension department is soon avoided if the managers of various accounts pick stocks from the same approved batch. That way, it’s very likely that both Smith and Jones will enjoy the same result, or at least the difference will not be great enough to make either of them mad. Almost by definition the result will be mediocre, but acceptable mediocrity is far more comfortable than diverse performance.

  It would be one thing if an approved list were made up of, say, thirty ingenious selections, each chosen via the independent thinking of a different analyst or fund manager. Then you might have a dynamic portfolio. But the way it usually works is that each stock on the list has to be acceptable to all thirty managers, and if no great book or symphony was ever written by committee, no great portfolio has ever been selected by one, either.

  I am reminded here of the Vonnegut short story in which various highly talented practitioners are deliberately held back (the good dancers wear weights, the good artists have their fingers tied together, etc.) so as not to upset the less skillful.

  I’m also reminded of the little slips of paper that say “Inspected by 4” that are stuck inside the pockets of new shirts. The “Inspected by 4” method is how stocks are selected from the lists. The would-be decision-makers hardly know what they are approving. They don’t travel around visiting companies or researching new products, they just take what they’re given and pass it along. I think of this every time I buy shirts.