We Study Billionaires - The Investor’s Podcast Network - TIP511: How to Pick Stocks like Peter Lynch

Starting point is 00:00:00 You're listening to TIP. Hey, everyone, welcome to the Investors podcast. I'm your host, Clay Fink, and on today's episode, I'm going to be reviewing one of Peter Lynch's books, One Up, on Wall Street. Peter Lynch is one of my very favorite investors to study because he is able to make investing in individual stocks much more approachable for the everyday person, and he's really good at removing a lot of the financial jargon you might read in other books or seeing the news. Lynch is famous for managing the Fidelity Magellan Fund for 13 years as he achieved an average

Starting point is 00:00:35 annual rate of return of 29.2% per year from 1977 through 1990. One Up on Wall Street was originally released back in 1989 and since then it sold over 1 million copies. Lynch is an investing legend when it comes to picking stocks, so I definitely learned a lot from reading his book. During this episode, I'll cover how everyday people can actually have an advantage investing in stocks over those on Wall Street, Lynch's investing philosophies, how he categorizes the stocks he invest in in, in order to manage expectations, what to look for when searching for a great

Starting point is 00:01:14 company to invest in, why you should avoid companies that fall prey to what he calls diversification, the most common mistakes novice investors make, and much, much more. Without further delay, I hope you enjoyed today's episode covering Investing legend Peter Lynch. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now, when it comes to thinking about the most well-known stock investors, Warren Buffett and Charlie Munger, of course, come to mind. But Peter Lynch is also in fact, incredibly well-known, so I figured I'd go through his book, One Up on Wall Street, and discuss some of my biggest takeaways from reading the book. Lynch says that despite living in a world of instant gratification, he invests the old-fashioned way by owning stocks where

Starting point is 00:02:17 the results depend on the company's ability to increase their earnings with the expectation that the share price will eventually follow. Generally, Lynch's investment thesis in a company tends to play out over a three-to-ten-year time frame, or sometimes even more. Lynch definitely comes across as someone who just has an immense passion for stock investing. When he discovers a company that is potentially worth investing in, he just dives in and wants to know everything about the company that he possibly can. He's reading their earnings reports, he's talking to analysts, he's talking to people that work at the company as well as even the company's competitors.

Starting point is 00:02:55 One thing that I thought that was different from reading Lynch's work is that it almost seems like he is talking about stock investing as something you can almost get rich relatively quick on. He will mention multiple stocks that have increased by 10x or 20x over a 5 or 10 year time period, which, you know, is really pretty rare. So it seems to me that Lynch really wants to make stock investing a subject that really gets people excited so they dive in and really want to learn all they can about it. Warren Buffett, on the other hand, is not the type of investor that would tell you you should go out and look for stocks that have the potential to go up by tenfold. Rather, Buffett's much more well-known for being the value investor type,

Starting point is 00:03:37 and being much more conservative and put a lot more emphasis on the potential downsides. Lynch's work, however, did catch the attention of Warren Buffett. In 1989, Buffett gave Lynch a call, letting him know that he loved one of the lines in his book, and it was related to holding on to your winners. The line in the book stated, when you sell your great companies and add to the losers, it's like watering the weeds and cutting the flowers. Another one of Lynch's very famous quotes is that more money has been lost in anticipating a downturn than in the downturn themselves. This especially rings true for investors after the great financial crisis as we went through one of the greatest bull markets the world has

Starting point is 00:04:19 ever seen for equities. Lynch said in an interview with Fox that he's confident that the market will be higher 10, 20, 30 years from now. He's also confident that there will be many drawdowns along the way. During the dot-com boom, people paid attention to the fact that stock prices were just soaring, and all their neighbors and friends were getting rich by buying tech stocks. While an investor like Lynch is looking at a company's earnings to help evaluate whether it's a buy or sell, during a stock boom, investors are only looking at the stock's recent performance, whereas Lynch is really looking at the underlying fundamentals like any other great investor. I think that Lynch's focus on a company's earnings,

Starting point is 00:04:58 and how the stock has performed relative to that earnings growth can really be a helpful reminder for us on what really drives a stock's long-term performance. Lynch is very well known for being someone who believes that an amateur investor can succeed by picking tomorrow's big winners and paying attention to the new developments in their environment, whether that be in the workplace, what people are purchasing online or in physical stores, or any sort of new enterprise that comes into fruition in their life. In fact, Lynch actually believes that any normal person can pick stocks just as well, if not better, than the average Wall Street expert. Here's a clip of Peter Lynch chatting about this idea with Charlie Rose during an interview in 2013.

Starting point is 00:05:42 You still believe in the investment mantra that you were often credited as your mantra, which is invest in what you know. Yeah, I'm amazed at somebody. Imagine you spent a long time in your field and my field. Imagine if you're in a mall all the last three years. Yes. You would have seen the gap. You would have seen Best Buy. You would have seen Circumcite. You would have seen these companies that are crowded doing something better. And they're buying biotechnology stocks or oil companies.

Starting point is 00:06:04 It makes no sense. If you're in the steel industry, you see it go from awful to better. Why don't you buy a steel stock? But we expect mutual funds to know that stuff. No, obviously. Well, if you're managing. But they're ahead of us. You know, if you look at Magellan or you look at Black Rock,

Starting point is 00:06:17 you think they must have access to the best information in the world. But they don't have that information. They're not in the steel arms. They don't see things get. better, you know, the way, they don't see the camel in the industry turning as soon as the people in the chemical industry do. I mean, it could be in the plastics, fuels, a lithium, whatever it is. People in the business see it first. And that they see it first. Where are, in that's, go ahead. In a mall, imagine the companies you've seen the Dunkin' Donuts. It goes on and on. Walmart,

Starting point is 00:06:41 you know, stop and shop. These are all companies that really got better. See, I'm shopping there. I'm not saying people should, if they want to invest, I'll do the same kind of research they do when they buy a refrigerator. They should take your trip to Italy, do some homework. Do you know what the, do you know what is about this country that is, stunning to me. But the most part, we don't do that about medicine and our health. We don't do it. We are more interested in getting the best television than we are the best. No, I agree. I mean, the diagnostics, talk about it. The diagnosis today is so much better. All right. The other thing is what advice we give to young investors who almost certainly will

Starting point is 00:07:13 have more direct responsibility for their retirement savings than their predecessors, of which I'm going to talk about later. But I think the advantage of putting money into a retirement fund, Obviously, a Fidelity Fund I would prefer, but index fund, whatever it is. Put some money aside. It's going to compound tax-free. You start saving earlier. The numbers are amazing. Compound and we'll do one to the way you want.

Starting point is 00:07:34 But until you want to invest directly in individual stocks, start a paper portfolio, say, I'm going to buy these 10 companies and then write down in like five bills. Why? What's the reason I bought those? And then keep checking year-laid, what happened? Did they really keep growing or did a competitor come along? Do a paper portfolio. And you can do exactly what I did with a real portfolio.

Starting point is 00:07:53 portfolio and find out, what am I good at? What am I bad at? Am I really good at turnarounds? I good at small growth companies? Maybe I pay it too high for stocks. You can do this very, you can do this over four or five years and learn what's your skills and then specialize that. I had to own thousands of companies. You know, the average person, all you have need is a few in a lifetime. Yeah. Make a difference. Now, Lynch doesn't say that just because you and your friends really like going to Chipotle or you like shopping on Amazon means that you should go and buy these stocks. But he does believe that those are a good starting place to dig deeper because it's already a company that

Starting point is 00:08:28 you're at least somewhat familiar with. Said another way, liking a company's products is a good reason to research the company further, but it's not a good reason to own the underlying stock. Lynch also emphasizes that you don't have to be right on every single stock in your portfolio. In fact, not even Lynch himself or even someone like Buffett bats 100%. Lynch says that just batting 6 out of 10 puts you in a really good position because your losses in a company are limited to what you have invested while your gains over the years to come have unlimited potential upside. If you invested $1,000 in a bad company, the most you could lose is obviously $1,000. If you invest $1,000 in a great company, you could make $10,000, $20,000 or even more

Starting point is 00:09:15 over the years to come. If you're listening to this show, it's very likely you're aware that investing for the long run is where the really big money is made. Lynch says that nobody believes in long-term investing more passionately than him, and he points out that is much easier to preach long-term investing than to actually practice it. It's so easy nowadays to get swayed by the headlines in the newspapers or follow the Fed's actions with interest rate hikes or follow what's happening on Twitter. Most of this up-to-date news is pretty irrelevant to the long-term investor, so it can be really

Starting point is 00:09:49 difficult to keep that mindset and approach as we've read these things every single day that incentivize the opposite behavior of long-term investing. Bear markets are, of course, to be expected for stock investors, as a market correction of 10% or more can happen every couple of years on average. Corrections of 20% or more happen every six years, and severe bear markets or declines of 30% or more have occurred five times since the Great Depression since the time this book was written. So you can probably add three more occasions to his total being the tech crash, the great financial crisis, and then the COVID crash. It's foolish to assume that we've seen the last of the bare markets, and it's important to keep in mind that we should only invest

Starting point is 00:10:32 money that we know we won't need over the next couple of years, as we won't be forced to sell at a loss. Lynch recounts that in order to be a true long-term investor, you need to hold through all of these downturns, meaning that you don't try and time the market and constantly get in and get out of your positions, and then you incur capital gains taxes along the way. If someone had invested $100,000 in stocks in July of 1994 and stayed fully invested for five years, they would have ended up with $341,000. If you had happened to miss the 30 best days in the market with the biggest gains, your end sum would have only been $153,000. So by staying invested, you would have doubled your end result and made sure you stayed in on those

Starting point is 00:11:19 really good days. Those that are bearish on the market will state that the market's overpriced, which seems believable, especially nowadays in 2022. The problem is that nobody really knows when a bear market will occur. So the people that are bearish on the market may be right that the market is overvalued. For example, at the beginning of 2017, someone may have concluded that the market was far overvalued, and they were going to get out of stocks and buy back in at a cheaper price. The S&P 500 at the time traded at around $2,250. But 2017 was a great year for stocks, as the S&P 500 marched upward to nearly $2,900. Then it corrected down to around 2,400, which even with that correction, it's still a higher price than the start of the year.

Starting point is 00:12:08 The next correction would occur in March 2020, and it would trade down from 3,400 down to 2,300. So timing the markets is really difficult because you just don't know when those bear markets are going to occur, and you don't know how low the price is going to go during the bear market. Remember that the stock market over the long run tends to trend up and to the right. Lynch says that markets at times do become overvalued, of course, but there is no point in worrying about it. A lot of the time, stocks climb a wall of worry, and the worries never cease. At the end of the intro to his book, he states that, quote, The basic story remains simple and never-ending. Stocks aren't lottery tickets. There's a company

Starting point is 00:12:51 attached to every share. Companies do better or they do worse. If a company does worse than before, its stock will fall. If a company does better, its stock will rise. If you own a good company that continues to increase their earnings, you'll do really well. Corporate profits are up 50-fold since World War II, and the stock market is up 60-fold. Four wars, nine recessions, eight presidents, and one impeachment didn't change that, end quote. Now, like I mentioned earlier, Lynch believes that amateur investors can do just fine in the markets because they can get a sense of what products are really good and what is going on in their environment. Five or ten years ago, I'd imagine that it was pretty easy to see that many people were addicted to their Starbucks coffee

Starting point is 00:13:35 and you could see the line of cars at Starbucks were going out of the parking lot when you drove by on your way to work. That's probably a good indication that it's a stock worth taking a look at. Or you might notice that Starbucks tastes a lot better than Dunkin' Donuts or vice versa. It makes a lot more sense to invest in a company you can actually understand and have experience with that company than invest in a company just because it's hot and you might not not really understand the underlying business, which is probably the case for a lot of tech companies today. I just don't understand many of these businesses. Lynch breaks up his book into three sections. Part one includes chapters 1 through 5, which covers preparing to invests. Part 2 covers

Starting point is 00:14:19 chapter 6 through 15, which covers picking winners. And part 3 is titled The Long-Term View for Chapter 16 through 20. In chapter 1 titled The Making of a Stock Picker, Lynch describes how he first got introduced to the world of the stock market at the age of 11 because he was a caddy and got to be on a golf course with presidents and CEOs of major companies. Lynch went to graduate school at Wharton and was thrilled to get an internship at Fidelity and right off the bat, he felt that what he learned at Fidelity was incredibly useful in learning how to pick stocks and much of what he learned in school was really setting him up to fail,

Starting point is 00:14:56 if anything. Lynch stated that it's hard to support the theory that the market is full. fully efficient when he knows somebody that has made a 20-fold profit on Kentucky Fried Chicken Stock and furthermore, in advance, they explained to him why the stock was going to rise as it eventually did. He stated his distrust of theorizers and prognosticators continues to this present day. After doing a two-year stint with the ROTC in Texas and Seoul South Korea, Lynch joined Fidelity again full-time in 1969, and in 1977, he famously took over the ROTC in Texas and in

Starting point is 00:15:30 the Fidelity Magellan Fund. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, In 20206, the Oslo Freedom Forum is entering its 18th year bringing together activists, technologists, journalists, investors, and builders from all over the world, many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to

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Starting point is 00:19:03 a beautiful online store with hundreds of ready-to-use templates, and Shopify is packed with helpful AI tools that write product descriptions, and even enhance your product photography. Plus, if you ever get stuck, they've got award-winning 24-7 customer support. Start your business today with the industry's best business partner, Shopify, and start hearing, sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. In Chapter 2, Lynch described a phenomenon in the investment world he calls street lag. Street lag described the tendency of many Wall Street firms to exclude a number of stocks from

Starting point is 00:19:54 their investments, largely because other firms don't follow it and don't own it. This leads many companies essentially flying under the radar because many firms simply won't find a company attractive until a large number of other institutions have recognized its suitability and respected Wall Street analysts have put it on their recommended list. He uses an example of a company called The Limited, which is a close. clothing retailer who went public in 1969. The Limited wasn't owned by any institution until 1975 and only had a couple of analysts following it as it only had 100 stores. A second institution took ownership in 1979 and the company had gotten up to 400 stores in 1981. By 1983,

Starting point is 00:20:39 the stock had risen by 18-fold from 1979. By the mid-1980s, many analysts started to pile in and put the company on their buy list in sort of a domino effect of more analysts making it appear that the stock was more worthy of attention. He lists example after example of companies that weren't closely followed that ended up being really big winners. This brought Lynch to his other point that you'll never lose your job by losing your client's money in IBM. Many fund managers likely have a bias towards not looking bad rather than stepping outside the box and purchasing companies that nobody else is buying. If you buy IBM and it goes bad, your boss will probably say something like, man, what is going on with IBM? If you buy a small, no-name company and it goes bad,

Starting point is 00:21:28 your boss might say, what the heck is wrong with you? Because I really enjoy playing poker from time to time with friends, I love how Lynch compares the stock market to playing poker. To him, an investment is simply a gamble in which you've managed to tilt the odds in your favor. Learning how to play poker well can provide a very consistent long-term return to people who know how to manage their cards. We're given limited information, and the winners raise their bets when their position strengthens and get out when the odds are against them. Losing poker players consistently hang on to the bitter end of every expensive pot,

Starting point is 00:22:05 hoping for miracles and enjoying the thrill of defeat. In poker and on Wall Street, miracles happen just often enough to keep the losers' lose. losing and keep them at the table. Also, similar to poker, even when investors make favorable bets, occasional losses are to be expected, such as when one bet's big with the top straight or top flush, only to be beat by a full house. Great investors accept their fate and know that the right investing strategy will inevitably reward them over time. They've realized that the stock market is not pure science where the superior position always wins. Lynch says that the stock market is a gamble worth taking as long as you know how to play the game. Remember that six out of 10

Starting point is 00:22:50 appropriately sized bets is all it takes to succeed as a stock investor. Lynch urges investors to consider three things prior to purchasing stocks. First, he urges them to consider their position on owning a house touting the benefits of home ownership when done right because real estate, tends to appreciate over time, and the bank allows you to use leverage in your purchase. Additionally, when people buy a house, they aren't tempted to trade in and out of it, and the interest expenses are tax deductible. Second, Lynch urges to only invest money that you won't need for the foreseeable future, as fluctuations in the prices of stocks might lead you to selling at a loss if you need

Starting point is 00:23:31 the money in the short term, say, within two or three years. The third and most important consideration is that if you have the personal qualities it takes to succeed as a stock investor, he lists traits such as patience, self-reliance, common sense, a tolerance for pain, open-mindedness, persistence, humility, a willingness to do independent research and admit to mistakes, understand human psychology, among others. One of the most important of these is likely psychology, as investors tend to be bullish and bearish at inopportune times due to recency bias. I touch more on the psychology of investing at the end of this episode. Volatility is definitely something investors should become more comfortable with.

Starting point is 00:24:16 Lynch's Magellan Fund declined between 10 and 25% on eight separate occasions in just 13 years. The really brilliant thing about the stock market is that you don't have to be a forecaster and be able to know and predict where the market is heading. If Peter Lynch, Warren Buffett, and Howard marks know they can't consistently predict where the market is heading in the short term, then why should you be able to as a less sophisticated investor? The good news is that buying and holding quality companies can still yield exceptional results when held for the long haul. Many professionals have a lot to say about the stock market in general, but remember that when you are buying stocks, you are buying ownership in a real company producing real goods and real services. If a company is able

Starting point is 00:25:00 to continue to increase their earnings per share year after year, then over the long run, odds are that you'll have a favorable outcome. That concludes my summary of part one of the book, moving along to part two, which covers picking winners, which covers a lot of different topics, including how to exploit an edge, the characteristics of a great company, the questions to ask and researching a stock, how to monitor a company's progress, among other things. As I mentioned earlier, Lynch believes that the best place to begin looking for winning stocks is looking at your own backyard and what is popular in your daily life. Just thinking about companies I interact with today that potentially are good stocks to buy,

Starting point is 00:25:42 Airbnb is an app I use when I travel, Apple has multiple products I use every single day, Amazon is a site I purchase from every week or two, I use Google Search and Gmail all the time. These are just simple examples of companies that provide a lot of values, to me and don't have a lot of competition when just looking at first glance, so it's worth taking a look at their stocks. Another great place to look is looking at the industry you work in. For example, I used to have an eye on the health insurance industry as that was my line of work, and I noticed that United Healthcare was one of the leaders in selling senior health

Starting point is 00:26:18 products, which is really hot with the baby boomers hitting their retirement years. Sure enough, the company is one of the extremely good performers over the past 10 years. or so, investing in an industry you are more familiar with than most other people is a really simple way to get an edge and be more comfortable with the companies you're buying and holding. For Peter Lynch, he saw firsthand the massive boom that was occurring in the mutual fund industry. Although Fidelity wasn't publicly traded, he could have just as easily purchased a stock in a company like Dreyfus, which went up a hundredfold from 1977 to 1986. Many other mutual fund companies did exceptionally well as investors flooded in toward mutual fund investments.

Starting point is 00:27:02 Lynch categorizes stocks into six categories, slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds. Slow growers are companies that are much more mature that have low to mid-single-digit growth rates in their top line revenue. Most industries and companies begin as fast growers and eventually transition to being a strong. slow grower. Another sign of a slow grower is a generous and steady dividend since they don't have the opportunities to reinvest back in the company at high rates of return. Lynch states that you won't find slow growers in his portfolio because slow growers often equate to slow growing stocks. Stallworts are the next step up from slow growers. They're still mature companies,

Starting point is 00:27:46 but they're growing their top line revenue a bit faster, maybe in the high single digits or lower double digits. Some companies today that I would categorize as a stalwart would be Coca-Cola, Berkshire Hathaway, Dollar General, and Walmart. There's a bit more upside potential and growth opportunities in stalwarts. Lynch says that at times he'll be able to identify a stalwart trading at a discount that he buys and waits for it to increase 30 to 50 percent more towards its fair value before selling it and allocating the money elsewhere. He likes stalwarts because they will perform better during a recession than the other higher growth companies. Then there are the fast growers that Lynch just loves, and these grow at around 20 to 25% per year.

Starting point is 00:28:30 Lynch says that if you invest wisely here, this is where you'll find the land of 10 to 40 baggers, or even more. This may be a bit optimistic relative to when Lynch was investing, but getting a 10 or 40 bagger in today's market is likely much more difficult than when Lynch was investing, and Lynch actually prefers that these fast-growing companies are in a slow-growing industry, such as the way Walmart grew in retail and Marriott grew in the hotel industry. The problem with fast growers is that when their growth slows down, they tend to get punished by the market, as we've definitely seen in 2022.

Starting point is 00:29:06 A good place to start when investing in fast growers is to ensure that the company has a strong moat and competitive advantage, as well as a strong balance sheet and positive earnings in free cash flow. Cyclicals are companies that have rising and falling profits in a fairly unpredictable manner. Auto, airlines, oil, steel, and chemical companies are all examples of cyclicals. Cyclicals can get more novice investors in trouble because they might assume it's a stalwart that will steadily grow when in reality it can quickly correct 50% if they buy in the wrong part of the cycle. Turnarounds are companies that are close to extinct whose investors are betting on the company's ability to pull themselves out of their troubles. Successful turnarounds aren't

Starting point is 00:29:49 very common, but when investors identify the right ones, they can pay off handsomely. Some companies are in need of restructuring due to what Lynch calls diversification, which is when a company makes a poor acquisition to try and expand its competitive position. An asset play is any company that is sending on something valuable that you recognize, but the overall market and Wall Street is overlooking. This is similar to Benjamin Graham's Cigarbet approach of buying something whose market value was trading below what the company's underlying assets were valued at minus any debt. These definitely aren't as common nowadays, with markets being much more efficient and information flowing much more freely catching these easy mispricings. Asset plays can also exist in something that's

Starting point is 00:30:33 more intangible. For example, what should the value of a Netflix subscriber be when compared to traditional cable and is the market undervaluing a Netflix subscriber and by how much? This is something that Tony Conierrez from Oakmark discussed with me on our Millennial Investing Show earlier this year with regards to Netflix. That is episode MI 153 on the Millennial Investing Show. Once you find a stock, you want to be able to categorize it in roughly one of these six categories. You also want to be aware that it might switch categories in the future. Eventually, a fast Grower transitions to a stalwart, or competition floods in and it turns into a slow grower. Lynch is most interested in companies that are underfollowed, which is oftentimes a business

Starting point is 00:31:17 that has a boring name and a boring business. Companies like Texas Roadhouse, Monster Beverage, and Domino's Pizza come to mind, as these are companies that many investors probably aren't too interested in as they're in the food and beverage industry, but these were some of the best performers over the last 10 to 20 years. Other hunting grounds are companies with little to know analysts that follow it, as well as little to know institutional ownership. Lynch also talks about industries that are shunned, or they're somewhat of a depressing sentiment around it. Lynch uses the example of funeral homes and the company MCI. I think that today this reminds me of a company like meta. There's just so much negative sentiment around it and people say that the Facebook app is

Starting point is 00:32:00 being disrupted and such. The strong negative sentiment has led to many value investors even adding it to their portfolios. Other things Lynch likes to find is companies that have their own niche that they are really good at doing. This falls in line with Buffett's idea of a moat. If a newspaper company is the only newspaper in town and you see the business is improving year after year, then that's a great business to own because they aren't getting disrupted until, of course, the internet comes along and forces them to pivot. The final two items, he lists to look for in a company is that the insiders are buying the stock or they own at least a sizable position in the company themselves. So the interests are aligned between the two as

Starting point is 00:32:40 the shareholder and those running the company. Also, he wants the company to be buying back their own shares. Like Buffett always says, share buybacks are one of the easiest ways for a company to return capital back to the shareholders in a tax-efficient way. Share buybacks show that the company has the shareholders in mind, assuming that they don't have better opportunities. to invest in within the company. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up,

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Starting point is 00:36:13 risks, charges, and expenses. This and other information can be found in the income fund's prospectus at fundrise.com slash income. This is a paid advertisement. All right, back to the show. Lynch isn't afraid to let us know what stocks he would avoid as well. The first of which would be the hottest stocks in the hottest industry. These stocks are always in the news and on the front pages of newspapers and it's what everyone is talking about. Hot stocks can go up a lot really quickly, but the only thing holding them up is hope and thin air to support them, giving them the chance to fall just as quickly. Lynch says that, quote, if you had to live off the profits from investing in the hottest stocks in each successive hot industry, you'd be on welfare. The reason he avoids

Starting point is 00:36:59 these industries is because high growth in hot industries attract a very smart crowd that want to get into that business. As soon as Peloton is growing at 100% per year for a number of years, eventually money flows in to try and steal their market share with a very similar product at a more attractive price. Oftentimes, the hot industries are led by a company that is touted as the next Amazon or the next Apple-like opportunity. I believe people would call a Peloton the next Apple, claiming that the bikes were their way to lock customers into their subscription model.

Starting point is 00:37:32 Oftentimes, when a stock is claimed as the next Amazon or the next Apple, it has hit the end of its days of prosperity. Lynch is pretty well known for the idea of what he calls diversification, which I mentioned earlier, this is really just a different way of saying diversification, but it's the bad kind of diversification. Diversification essentially means that there's always the corporations who don't have any ways to grow their own business, so they go out continuing to acquire other businesses that end up not being the best use of their capital. You'll oftentimes see this in companies that have matured and are no longer innovating, so they're trying to acquire their way to growth

Starting point is 00:38:10 to compensate for their lack of innovation or creativity. Acquisitions are tricky to get right and oftentimes controversial, as the prices paid tend to be fairly high, especially for companies that are trying to buy smaller competitors that are growing quite fast. One recent example of this is Adobe acquiring Figma, which is a much smaller company that is growing their top line very rapidly. They paid around $20 billion for Figma, and it was expected to add $200 million in annual of recurring revenue for Adobe. The key to successful acquisitions is to add synergies and allow

Starting point is 00:38:47 the sum of the parts to be greater than if the companies were separate. For example, Adobe might have synergies to allow Figma to have accelerated growth or vice versa for Adobe's core business. Ideally, the best acquisitions are in related businesses. In Chapter 10, Lynch dives into the importance of the company's earnings and assets. Assuming the company doesn't get liquidated in sold off, earnings are the most important aspect of valuing of business. In the long run, the stock is going to be very highly correlated to its underlying earnings. As most of our listeners are aware, the PE ratio is a good indicator of how the market views a stock. A company with a PE of 10 or less is likely predicted to have little to no earnings growth in the future.

Starting point is 00:39:33 A company with a PE of, say, 30 or more tells you that the market puts a premium on that company's earnings because they expect earnings to be higher in the years to come. To use two companies just as a general example, AT&T is a company with a P.E. ratio of seven, so for whatever reason, the market hasn't priced in much earnings growth for the company going forward. While Costco has a P.E. of 40, likely because the market has a lot of confidence, that they will be able to continually increase those earnings year after year, as they really have a strong moat and they're able to fend off their competitors from taking the share of their earnings. So looking at the PE ratio can give you a general idea of how the market

Starting point is 00:40:14 views a company. When a company has a relatively low PE, but you have a good understanding of the business and believe that the earnings will be higher in the years to come, then that may be an opportunity to buy a company at a really good price. Alphabet, for example, is a company that I don't expect to be disrupted anytime soon with how powerful their assets like Google Search and YouTube are. Yet they're only trading at a PE of around 20. However, it's also important to keep in mind that maybe the market is right and there is a good reason for the company to be trading at the PE ratio that it is. And we should be mindful of Buffett's idea of owner's earnings and make necessary adjustments

Starting point is 00:40:52 to those earnings that are reported by the company. We should also be hesitant to compare the PE ratio between companies that are in different industries. Just because AT&T has a PE ratio of 7 doesn't make the stock cheap, and just because Costco has a PE of 40 doesn't make the stock expensive. We have to look deeper into the company and understand the industry they operate in before we assess the company's valuation and if it's under or overvalued. Lynch lists five ways a company can increase its earnings. A company can reduce costs, raise prices, expand into new markets, sell more of its product in current markets, or revitalize

Starting point is 00:41:32 clothes or dispose of a losing part of their business. These are things to consider as you devise develop an understanding of a business. When Lynch is analyzing a business, he wants to develop a story around it. Why would he want to own it and what has to happen for the company to increase its earnings in the future in order for the stock to increase as well? He uses Coca-Cola as an example of a potential stalwart. The story might be Coca-Cola is selling at a low end of its historical PE range, but its earnings growth has accelerated over recent years. The company has improved in several ways. It's sold off half its interest in Columbia pictures to the public. Diet drinks have sped up the growth rate dramatically. Last year,

Starting point is 00:42:13 the Japanese drank 36% more Cokes than they did the year before, and the Spanish up to their consumption by 26%. And because of these factors and others, Coca-Cola may do better than people think. And this is an old example from the book just to give you an idea of how Lynch develops a story. You'll want to learn as much as you can about the company in order to develop a story, and the more you know about them, the better you can understand the company's competitive position, which is really critical to a company's continued growth. Le Quinta was another company that Lynch went on to explain the story of. This was a stock he purchased that ended up increasing by 11x over a 10-year period.

Starting point is 00:42:52 In his research, he discovered that La Quinta was making a lot of progress in the hotel industry. They were a middle-of-the-road-type hotel that offered a lower price than holiday ends, but a higher quality than the low-budget hotels one could stay. Le Quinto was very strict on minimizing costs so they could offer a similar hotel experience to Holiday Inn, but at a price that was 30% cheaper. They eliminated the wedding area, conference rooms, kitchen area, restaurant, none of which contributed to bottom-line profits. They also kept costs low by building 120-room ends instead of 250 rooms.

Starting point is 00:43:28 They got really savvy in minimizing their costs without giving up a price. too much in revenue. The company at the time was growing at 50% per year in only trading at an earnings multiple of 10, which made it an incredible bargain. When analyzing a stock, it's also really important to remember that turnarounds often don't come into fruition. So rather than guessing whether a company will turn the corner and improve, it's better to stick with business models that are proven and able to stand the test of time. As far as digging into the numbers of a company, Lynch keeps it pretty simple in his book. In Chapter 13, he touches on which business segments the company's sales come from, the PE ratio, the cash and debt on the company's

Starting point is 00:44:09 balance sheet, the debt to equity ratio, the dividends, the company's book value, which isn't as important now as it was back then, and then the company's hidden assets that aren't included in the book value. Today, this would include things like intangible assets for technology companies. Then he looks at the cash flow in the company's capital requirements. As I mentioned during my episode covering Apple, episode number TIP 489, Buffett points out that Apple requires very little capital investment relative to a company with a lot of tangible assets like Berkshire Hathaway, which makes Apple a very great business to own. Finally, he looks into the expected growth rate of the company and analyzes if the company has sufficient pricing power. As I read through the book,

Starting point is 00:44:54 I noticed a lot of similarities in what Lynch is looking for in a company to Buffett and Munger, as he mentioned, that is better to purchase a stock with a multiple of 20 that's growing at 20% per year, than a stock with a multiple of 10 that's growing at 10% a year, which gets at the Buffett quote of, it's better to buy a wonderful company at a fair price than a fair company at a wonderful price. The compounding effect of a fast grower that is able to continually grow fast really adds up, and when it's held for long enough, whether you paid $40 or $60 per share really didn't matter because great companies do so well and grow into and beyond their original valuation.

Starting point is 00:45:33 If you started with $1 per share in earnings, and that amount grew by 20% per year for 10 years, you'd have $6.19 in earnings at the end of your 10, whereas if earnings only grew by 10% per year, the earnings per share would be $2.59. In his book, Lynch recommends, then's checking in on a company's story every few months to ensure that it's playing out at least as well as you expected it to. He breaks companies down into three stages in terms of where they're at in their growth cycle. During the startup phase, the company is still working out the kinks and the basics of the business. The rapid expansion phase is when a company has its business figured out and they're expanding into new markets. Then the saturation phase is when

Starting point is 00:46:17 the growth slows down and there aren't very many new opportunities to expand the. business. The first phase is the riskiest because the success of the business isn't yet established. The second phase is much safer in where a lot of the money is made assuming you pay the right price. The third phase is problematic for investors that want to be in a company with future growth potential rather than a more stable company with steady cash flows and a safe dividend. Assuming you're invested in a company in the second phase, you'll always want to be mindful of where you expect the future growth to come from, and see if the company is continuing to execute on that growth. Zoom out and look at the company's earnings reports from a few years ago. Where did they

Starting point is 00:47:00 expect future growth to come from? How much did they expect to grow? Then compare that to what actually happened. Did they grow faster than expected? And did the growth come from where they anticipated it would? Most people probably don't do this, but you should also learn to divorce the stock price from the actual fundamentals. If you tuned into my episode discussing Jeff Bezos and Amazon, you know that while Amazon's stock dropped 90% during the tech crash, the company's fundamentals were getting better and better with nothing but growth forecasted into the future. Just because the stock is going up doesn't mean the company's fundamentals are improving, and just because the stock is going down doesn't mean the fundamentals are declining.

Starting point is 00:47:42 Be sure to verify the fundamentals yourself and not create a story based on. purely on what the stock price is doing. In Chapter 15, Lynch included a final checklist that we can go through for each of the type of stocks he listed. In this chapter, seems to summarize much of what was covered in the chapters leading up to it. For each stock in general, he wants to understand the PE ratio the company is trading at, the institutional ownership to give him an idea of how well known and followed the company is, the insider ownership and stock repurchase activity, the company's recorded Ernie's growth to date, what the balance sheet looks like, and if the company is financially strong, as well as their cash position.

Starting point is 00:48:24 Some additional rules of thumb to keep in mind include understanding the companies you're investing in and developing a story around the company. Small companies have the potential to make big moves, while bigger companies don't have as much of that opportunity. Look for small companies that are already profitable and have a proven concept that can be replicated, be suspicious and skeptical of hot stocks in hot industries, as well as companies growing at over 50% per year, long shots almost never pay off, invest in simple companies that are dull, mundane, and out of favor, put a strong emphasis on the multiple you're paying for

Starting point is 00:49:00 the company, look for managers in which the management team owns a lot of the stock, and be sure to do your own research prior to investing in any company. Lynch doesn't provide a hard rule to how many stocks an investor should hold, but he does suggest to consider purchasing any stock in which you have an edge and you've uncovered an exciting prospect that passes all the tests of research. This could lead to a portfolio of five stocks for you or a hundred stocks. It just depends on how much time and effort you're willing to commit to the process. Linch owned a lot of stocks, partly because of his size, but also because the more stocks he owned, the better chance he would own some of the big winners that went up 10-fold or more. Lynch isn't one to hold cash to try and time

Starting point is 00:49:46 the market because he is just full of ideas and opportunities to invest in. So he's always fully invested into the market. It was in Chapter 16 in which Lynch mentioned the quote that Buffett called him about, that some people automatically sell the winners, stocks that go up, and hold on to losers, stocks that go down, which is about as sensible as pulling out the flowers and watering the weeds. Others automatically sell their losers and hold onto winners, which doesn't work out much better. Now, what he's really getting at here is that to sell your winners when they go up ignores what is actually happening within the company. If a company's stock price goes up because the fundamentals have improved, then it's silly to want to sell it for that same reason. If the

Starting point is 00:50:31 fundamentals have gotten worse and the future prospects for the company don't look as bright, then you may want to consider selling your position. So you're going to be more. So you're going to You want to look at the underlying fundamentals of the company and if the story has changed. The stock price doesn't really tell us anything about the fundamentals of the company, and sometimes the fundamentals and the stock price move in the opposite direction. He also dedicated a chapter to when you should buy and sell stocks. Of course, the best time to buy stocks is during a panic and a market crash because that's your opportunity to buy great companies at a discount.

Starting point is 00:51:05 It can be really difficult to buy during these times because you're stumbling. and your gut will be telling you to sell. And many people you know will likely be selling as well. Many times throughout the book, Lynch mentions the stock market crash in 1987, which is referred to as Black Monday. On that one single day, the Dow Jones fell by over 22%, and central banks around the world needed to step in and provide liquidity to prevent defaults among financial institutions. This then left to a swift recovery in the markets, making this crash, like all of the other crashes historically, great buying opportunities for long-term investors. Because of all the noise in the markets with regards to inflation, the war, the Federal Reserve,

Starting point is 00:51:50 interest rates, and so on, it can be really easy to get swayed by others bullish opinions and continually get in and get out of the market. But Lynch takes the approach that for the most part, you shouldn't consider extra-executive, external economic conditions when buying and selling. For stalwarts in particular, which are the more mature companies, Lynch tends to try and purchase these when they are at the lower end of the PE range and sell them when they're at the higher end. This generally falls outside of Buffett's approach of buying a stock and holding it forever,

Starting point is 00:52:22 but Lynch seems to be the jack of all trades and be exposed to different types of companies and not just go for the fast growers. He may also sell a stalwart if their growth rate has slowed and doesn't see it picking back up anytime soon. For fast growers, the last thing he wants to do is sell a 10-bagger too early, but if the valuation gets so ridiculous, then he may consider taking some chips off the table in order to allocate to better opportunities. Other signs to potentially sell a fast grower are slowing growth and maturity, key executives leaving to join a rival, or there is a lot of hype around the stock on Wall Street. Lynch, for the most part, likes to hold on to fast growers,

Starting point is 00:53:01 even if they appear to be slightly overvalued. Lynch, like many other great investors, is very aware of human psychology and the natural mistakes people make with regards to the stock market. In Chapter 18, he lists what he calls the 12 silliest and most dangerous things people say about stock prices. So I'll briefly touch on some of these that I thought were pretty noteworthy. The first saying some people might bring up is, it's gone down this much, it can't go much lower. A company that is being disrupted and seeing declining sales year after year is a company

Starting point is 00:53:35 whose business model is in jeopardy. Polaroid is the example Lynch brings up in his book. It's a stock that just continue to drop and drop, and those who believed in the company would have believed that eventually the stock price would turn. But it's important to remember that there is no limit to how far a stock can fall. I think this is especially important for a company that isn't free cash flow positive, because if credit conditions are tight and the company can't make money through their business operations, then eventually they may have to file for bankruptcy. Great companies are able to control their costs, have a strong balance sheet, and be free cash flow positive so they can weather through these tougher economic conditions just fine.

Starting point is 00:54:16 But still, even the great companies can have their stock prices fall a lot further than you might think. So that's why you have to understand the fundamentals as well. The second line Lynch mentions is you can always tell when a stock hits a bottom. Bottom fishing is a popular investor pastime, but it's usually the fisherman who gets hooked. Trying to time the bottom and a falling stock is pretty close to impossible. Lynch says that it is normally a good idea to wait until the falling knife hits the ground and sticks for a while before you try and grab it. Nobody is ever going to be able to consistently time the bottoms and the stocks decline. The third one is,

Starting point is 00:54:53 If it's gone this high already, how can it possibly go higher? There is no arbitrary limit to how a stock can go. So if a great company has already gone up tenfold, that doesn't necessarily mean the stock is expensive. Amazon is a great example of this. You could have recognized that Amazon was a great company with great fundamentals 20 years after it had gone public in 1997, and you'd still have benefited from owning the stock, even though you were relatively late to the game. The fourth one is, it's only $3 a share. What can I lose? This is the psychological mistake investors make of thinking that just because the share price is low means that the stock is a bargain, which is anything but the truth. It doesn't matter whether a stock costs $50 a share or $1 a share.

Starting point is 00:55:40 If it goes to zero, you lose everything either way. The fifth saying is, eventually they always come back, which is very similar to the first mistake of assuming that a stock can't go any lower. He also touches on anchoring where the mistake is, when it rebounds to a certain price, then I will sell. Investors oftentimes assume that just because a stock like Tesla was just over $300 a few short months ago, then it should rebound to that price point in the near future. This psychological bias of anchoring leads many investors to holding losing stocks just because they don't want to actually click the sell button and incur the loss, even though they may realize that the investment thesis has been broken. which I'm not applying to Tesla stock in either way. I'm just using it as an example since it's

Starting point is 00:56:26 pretty volatile. The market does not care whether you own a stock or not, and it certainly doesn't care how much you paid for a stock in the past. Another common mistake is investors becoming too impatient and wanting something exciting to happen. Merck was a company that deeply tested investors' patience. From 1972 to 1981, the company grew their earnings at an average rate of return of 14% per year. Yet the stock went nowhere. Then the market started to reflect the reality of improved fundamentals of the business as the stock shot up by fourfold in the next five years. Remember that in the long run, stock prices tend to follow earnings. To round out the chapter, Lynch explains that the single greatest fallacy of investing is believing that when a stock's

Starting point is 00:57:15 price goes up, you've made a good investment. This may lead someone to purchase more of the stocks that went up and selling the stocks that went down, therefore being more influenced by the moves in the stock prices rather than the changes and the fundamentals of the company. For the most part, short-term price fluctuations should be disregarded by long-term investors. Now, after reading this book or listening to this podcast episode, many may believe it's time to go out and start investing in individual stocks. However, beating the market overall can be really difficult. And without a good understanding of individual, stock investing in the proper amount of research, it's probably best to just buy an index fund

Starting point is 00:57:56 that tracks something like the S&P 500 and really save you the extra work if you're not interested in picking individual stocks. So it's important to be mindful of just how difficult it can be to beat the market. However, Lynch's book One Up on Wall Street is a great book to pick up if you are interested in learning more about individual stock investing and building long-term wealth. That wraps up my biggest takeaways for reading One Up on Wall Street by Investing Legend, Peter Lynch. If you'd like to pick up the book yourself, I'll be sure to link that in the show notes. Thank you so much for tuning into today's episode. I really appreciate everyone's support of the podcast as of late.

Starting point is 00:58:33 With that, I'll see you again next week. Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

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