by Peter Lynch
It’s no wonder that portfolio managers and fund managers tend to be squeamish in their stock selections. There’s about as much job security in portfolio management as there is in go-go dancing and football coaching. Coaches can at least relax between seasons. Fund managers can never relax because the game is played year-round. The wins and losses are reviewed after every third month, by clients and bosses who demand immediate results.
It’s a bit more comfortable on my side of the business, working for the general public, than it is for the managers who pick stocks for their fellow professionals. Shareholders at Fidelity Magellan tend to be smaller investors who are perfectly free to sell out at any time, but they don’t review my portfolio stock-by-stock to second-guess my selections. That’s what happens, though, to Mr. Boon Doggle over at Blind Trust, the bank that’s been hired to handle the pension accounts for White Bread, Inc.
Boon Doggle knows his stocks. He’s been a portfolio manager at Blind Trust for seven years, and during that time he’s made some very inspired decisions. All he wants is to be left alone to do his job. On the other hand, Sam Flint, vice president at White Bread, also thinks he knows his stocks, and every three months he casts a critical eye over Boon Doggle’s selections on White Bread’s behalf. Between these strenuous three-month checkups, Flint calls Doggle twice a day for an update. Doggle is so sick of Flint he wishes he’d never heard of him or of White Bread. He wastes so many hours talking to Flint about picking good stocks that he has no time left to do his job.
Fund managers in general spend a quarter of their working hours explaining what they just did—first to their immediate bosses in their own trust department, and then to their ultimate bosses, the clients like Flint at White Bread. There’s an unwritten rule that the bigger the client, the more talking the portfolio manager has to do to please him. There are notable exceptions—Ford Motor, Eastman Kodak, and Eaton to name a few—but in general, it’s true.
Let’s say that the supercilious Flint, in reviewing Doggle’s recent results for the pension fund, sees Xerox in the portfolio. Xerox currently sells for $52 a share. Flint looks across to the cost column and sees that Xerox was purchased for the fund at $32 per share. “Terrific,” Flint enthuses. “I couldn’t have done better myself.”
The next stock Flint sees is Sears. The current price is $34⅞ and the original price was $25. “Excellent,” he exclaims to Doggle. Fortunately for Doggle there is no date attached to these purchases, so Flint never realizes that Xerox and Sears have been in the portfolio since 1967, when bell-bottom pants were the national rage. Given how long Xerox has been sitting there, the return on equity is worse than it would have been in a money-market fund, but Flint doesn’t see that.
Then Flint moves along to Seven Oaks International, which happens to be one of my all-time favorite picks. Ever wonder what happens to all those discount coupons—fifteen cents off Heinz ketchup, twenty-five cents off Windex, etc.—after you clip them from the newspapers and then turn them in at your supermarket checkout counter? Your supermarket wraps them up and sends them off to the Seven Oaks plant in Mexico, where piles of coupons are collated, processed, and cleared for payment, much as a check is cleared through the Federal Reserve banks. Seven Oaks makes a lot of money doing this boring job, and the shareholders are well-rewarded. It’s exactly the kind of obscure, boring, and highly profitable company with an inscrutable name that I like to own.
Flint has never heard of Seven Oaks, and the only thing he knows about it is what he sees on the record—it was bought for the fund at $10 a share, and now it’s selling for $6. “What’s this?” Flint inquires. “It’s down forty percent!” Doggle has to spend the rest of the meeting defending this one stock. After two or three similar episodes, he vows never to buy another off-beat company and to stick to the Xeroxes and the Searses. He also decides to sell Seven Oaks at the earliest opportunity so that the memory of it will be expunged forever from his list.
Reverting to “group think,” and reminding himself that it’s safer to pick companies in a crowd, he ignores the words of wisdom that came either from Aeschylus the playwright, Goethe the author, or Alf, the TV star from outer space:
Two’s a company, three’s a crowd
Four is two companies
Five is a company and a crowd
Six is two crowds
Seven is one crowd and two companies
Eight is either four companies or two crowds and a company
Nine is three crowds
Ten is either five companies or two companies and two crowds
Even if there’s nothing terribly wrong with the fundamentals of Seven Oaks (I don’t think there is because I still own a small amount of it), and later it turns into a tenbagger, the stock will be sold out of White Bread’s pension account because Flint doesn’t like it, just as surely as stocks that ought to be sold will be kept. In our business the indiscriminate selling of current losers is called “burying the evidence.”
Among the seasoned portfolio managers, burying the evidence is done so quickly and efficiently that I suspect it’s already become a survival mechanism, and it will probably be inbred so that future generations can do it without hesitation, the way that ostriches have learned to stick their heads in the sand.
As it is, if Boon Doggle doesn’t bury the evidence himself at the first opportunity, then he’ll be fired, and the whole portfolio will be turned over to a successor who will bury it. A successor always wants to start off with a positive feeling, which means keep the Xerox and wipe out the Seven Oaks.
Before too many of my colleagues cry “foul,” let me once again praise the notable exceptions. The portfolio departments of many regional banks outside of New York City have done an outstanding job picking stocks for an extended period of time. Many corporations, especially the medium-sized ones, have distinguished themselves in managing their pension money. A nationwide review would certainly turn up dozens of outstanding stockpickers who work for insurance funds, pension funds, and trust accounts.
OYSTERS ROCKEFELLER
Whenever fund managers do decide to buy something exciting (against all the social and political obstacles), they may be held back by various written rules and regulations. Some bank trust departments simply won’t allow the buying of stocks in any companies with unions. Others won’t invest in nongrowth industries or in specific industry groups, such as electric utilities or oil or steel. Sometimes it gets to the point that the fund manager can’t buy shares in any company whose name begins with r, or perhaps the shares must be acquired only in months that have an r in their name, a rule that’s been borrowed from the eating of oysters.
If it’s not the bank or the mutual fund making up rules, then it’s the SEC. For instance, the SEC says a mutual fund such as mine cannot own more than ten percent of the shares in any given company, nor can we invest more than five percent of the fund’s assets in any given stock.
The various restrictions are well-intentioned, and they protect against a fund’s putting all its eggs in one basket (more on this later) and also against a fund’s taking over a company à la Carl Icahn (more on that later, too). The secondary result is that the bigger funds are forced to limit themselves to the top 90 to 100 companies, out of the 10,000 or so that are publicly traded.
Let’s say you manage a $1-billion pension fund, and to guard against diverse performance, you’re required to choose from a list of 40 approved stocks, via the Inspected by 4 method. Since you’re only allowed to invest five percent of your total stake in each stock, you’ve got to buy at least 20 stocks, with $50 million in each. The most you can have is 40 stocks, with $25 million in each.
In that case you have to find companies where $25 million will buy less than ten percent of the outstanding shares. That cuts out a lot of opportunities, especially in the small fast-growing enterprises that tend to be the tenbaggers. For instance, you couldn’t have bought Seven Oaks International or Dunkin’ Donuts under these rules.
S
ome funds are further restricted with a market-capitalization rule: they don’t own a stock in any company below, say, a $100-million size. (Size is measured by multiplying the number of outstanding shares by the current stock price.) A company with 20 million shares outstanding that sell for $1.75 a share has a market cap of $35 million and must be avoided by the fund. But once the stock price has tripled to $5.25, that same company has a market cap of $105 million and suddenly it’s suitable for purchase. This results in a strange phenomenon: large funds are allowed to buy shares in small companies only when the shares are no bargain.
By definition, then, the pension portfolios are wedded to the ten-percent gainers, the plodders, and the regular Fortune 500 bigshots that offer few pleasant surprises. They almost have to buy the IBMs, the Xeroxes, and the Chryslers, but they’ll probably wait to buy Chrysler until it’s fully recovered and priced accordingly. The well-respected and highly competent money management firm of Scudder, Stevens, and Clark stopped covering Chrysler altogether right before the bottom ($3½) and didn’t resume coverage until the stock hit $30.
No wonder so many pension-fund managers fail to beat the market averages. When you ask a bank to handle your investments, mediocrity is all you’re going to get in a majority of the cases.
Equity mutual funds such as mine are less restricted. I don’t have to buy stocks from a fixed menu, and there’s no Mr. Flint hovering over my shoulder. That’s not to say that my bosses and overseers at Fidelity don’t monitor my progress, ask me challenging questions, and periodically review my results. It’s just that nobody tells me I must own Xerox, or that I can’t own Seven Oaks.
My biggest disadvantage is size. The bigger the equity fund, the harder it gets for it to outperform the competition. Expecting a $9-billion fund to compete successfully against an $800-million fund is the same as expecting Larry Bird to star in basketball games with a five-pound weight strapped to his waist. Big funds have the same built-in handicaps as big anythings—the bigger it is, the more energy it takes to move it.
Yet even at $9 billion, Fidelity Magellan has continued to compete successfully. Every year some new soothsayer says it can’t go on like this, and every year so far it has. Since June, 1985, when Magellan became the country’s largest fund, it has outperformed 98 percent of general equity mutual funds.
For this, I have to thank Seven Oaks, Chrysler, Taco Bell, Pep Boys, and all the other fast growers, turnaround opportunities, and out-of-favor enterprises I’ve found. The stocks I try to buy are the very stocks that traditional fund managers try to overlook. In other words, I continue to think like an amateur as frequently as possible.
GOING IT ALONE
You don’t have to invest like an institution. If you invest like an institution, you’re doomed to perform like one, which in many cases isn’t very well. Nor do you have to force yourself to think like an amateur if you already are one. If you’re a surfer, a trucker, a high school dropout, or an eccentric retiree, then you’ve got an edge already. That’s where the tenbaggers come from, beyond the boundaries of accepted Wall Street cogitation.
When you invest, there’s no Flint around to criticize your quarterly results or your semiannual results, or to grill you as to why you bought Agency Rent-A-Car instead of IBM. Well, maybe there’s a spouse and perhaps a stockbroker with whom you are forced to converse, but a stockbroker will be quite sympathetic to your odd choices and certainly isn’t going to fire you for picking Seven Oaks—as long as you’re paying the commissions. And hasn’t the spouse (the Person Who Doesn’t Understand the Serious Business of Money) already proven a faith in your investment schemes by allowing you to continue to make mistakes?
(In the unlikely event that your mate is dismayed at your stock selections, you could always hide the monthly statements that arrive in the mail. I’m not endorsing this practice, only pointing out that it’s one more option available to the small investor that’s out of the question for the manager of an equity fund.)
You don’t have to spend a quarter of your waking hours explaining to a colleague why you are buying what you are buying. There’s no rule prohibiting you from buying a stock that begins with r, a stock that costs less than $6, or a stock in a company that’s connected to the Teamsters. There’s nobody to gripe, “I never heard of Wal-Mart” or “Dunkin’ Donuts sounds silly—John D. Rockefeller wouldn’t have invested in donuts.” There’s nobody to chide you for buying back a stock at $19 that you earlier sold at $11—which may be a perfectly sensible move. Professionals could never buy back a stock at $19 that they sold at $11. They’d have their Quotrons confiscated for doing that.
You’re not forced to own 1,400 different stocks, nor is anyone going to tell you to sprinkle your money on 100 issues. You’re free to own one stock, four stocks, or ten stocks. If no company seems attractive on the fundamentals, you can avoid stocks altogether and wait for a better opportunity. Equity fund managers do not have that luxury, either. We can’t sell everything, and when we try, it’s always all at once, and then there’s nobody buying at decent prices.
Most important, you can find terrific opportunities in the neighborhood or at the workplace, months or even years before the news has reached the analysts and the fund managers they advise.
Then again, maybe you shouldn’t have anything to do with the stock market, ever. That’s an issue worth discussing in some detail, because the stock market demands conviction as surely as it victimizes the unconvinced.
3
Is This Gambling, or What?
“Gentlemen prefer bonds.”
—Andrew Mellon
After major upsets such as the Hiccup of Last October, some investors have taken refuge in bonds. This issue of stocks versus bonds is worth resolving right up front, and in a calm and dignified manner, or else it will come up again at the most frantic moments, when the stock market is dropping and people rush to the banks to sign up for CDs. Lately, just such a rush has occurred.
Investing in bonds, money-markets, or CDs are all different forms of investing in debt—for which one is paid interest. There’s nothing wrong with getting paid interest, especially if it is compounded. Consider the Indians of Manhattan, who in 1626 sold all their real estate to a group of immigrants for $24 in trinkets and beads. For 362 years the Indians have been the subjects of cruel jokes because of it—but it turns out they may have made a better deal than the buyers who got the island.
At 8 percent interest on $24 (note: let’s suspend our disbelief and assume they converted the trinkets to cash) compounded over all those years, the Indians would have built up a net worth just short of $30 trillion, while the latest tax records from the Borough of Manhattan show the real estate to be worth only $28.1 billion. Give Manhattan the benefit of the doubt: that $28.1 billion is the assessed value, and for all anybody knows it may be worth twice that on the open market. So Manhattan’s worth $56.2 billion. Either way, the Indians could be ahead by $29 trillion and change.
Granted it’s unlikely that the Indians could have gotten 8 percent interest, even at the kneecracker rates of the day, if in fact there were kneecracker rates in 1626. The pioneer borrowers were used to paying much less, but assuming the Indians could have wangled a 6 percent deal, they would have made $34.7 billion by now, and without having to maintain any property or mow Central Park. What a difference a couple of percentage points can make, compounded over three centuries.
However you figure it, there’s something to be said for the supposed dupes in this transaction. Investing in debt isn’t bad.
Bonds have been especially attractive in the last twenty years. Not in the fifty years before that, but definitely in the last twenty. Historically, interest rates never strayed far from 4 percent, but in the last decade we’ve seen long-term rates rise to 16 percent then fall to 8 percent, creating remarkable opportunities. People who bought U.S. Treasury bonds with 20-year maturities in 1980 have seen the face value of their bonds nearly double, and meanwhile they’ve still been colle
cting the 16 percent interest on their original investment. If you were smart enough to have bought 20-year T-bonds then, you’ve beaten the stock market by a sizable margin, even in this latest bull phase. Moreover, you’ve done it without having to read a single research report or having to pay a single tribute to a stockbroker.
(Long-term T-bonds are the best way to play interest rates because they aren’t “callable”—or at least not until five years prior to maturity. As many disgruntled bond investors have discovered, many corporate and municipal bonds are callable much sooner, which means the debtors buy them back the minute it’s advantageous to do so. Bondholders have no more choice in the matter than property owners who face a condemnation. As soon as interest rates begin to fall, causing bond investors to realize they’ve struck a shrewd bargain, the deal is canceled and they get their money back in the mail. On the other hand, if interest rates go in a direction that works against the bondholders, the bondholders are stuck with the bonds.
Since there’s very little in the corporate bond business that isn’t callable, you’re advised to buy Treasuries if you hope to profit from a fall in interest rates.)
LIBERATING THE PASSBOOKS
Traditionally bonds were sold in large denominations—too large for the small investor, who could only invest in debt via the savings account, or the boring U.S. savings bonds. Then the bond funds were invented, and regular people could invest in debt right along with tycoons. After that, the money-market fund liberated millions of former passbook savers from the captivity of banks, once and for all. There ought to be a monument to Bruce Bent and Harry Browne, who dreamed up the money-market account and dared to lead the great exodus out of the Scroogian thrifts. They started it with the Reserve Fund in 1971.
My own boss, Ned Johnson, took the idea a thought further and added the check-writing feature. Prior to that, the money-market was most useful as a place where small corporations could park their weekly payroll funds. The check-writing feature gave the money-market fund universal appeal as a savings account and a checking account.