Published July 16, 2007

A living legend named Lynch

LIN ZHAOWEI focuses on Fidelity's Peter Lynch in today's instalment of an ongoing series on the world's great investors

WHEN Peter Lynch took over Fidelity's Magellan Fund in 1977, the mutual fund had assets of US$20 million. Six years later, this had grown to US$1 billion, and by the time he retired 13 years later, it had swelled to over US$14 billion, gaining him legendary status. In between, he also found time to write a few books on his investment skills, such as One Up On Wall Street (1989) and Beating The Street (1993).

Mr Lynch first got interested in the stock market during his teens when he started caddying on the golf course at the age of 11. He often overheard the corporate executives talking about stocks and how they made money, as the market was very strong in the 1950s. So when he was in college, he started studying the freight industry, and found a winner in a company called Flying Tiger, the first stock he bought.

'I remember I thought air cargo was going to be a thing of the future - it got really lucky because it went up for another reason,' he recounted in an interview with the Public Broadcasting Service (PBS) in 1996. 'The Vietnam War started and they basically hauled a lot of troops to Vietnam in airplanes and the stock went up, I think, nine or ten-fold.' The money he made from it helped pay for his graduate studies.

He was chosen as a summer student at Fidelity in the 1960s, partly because he had been caddying for the company's president for eight years. After graduation, he spent two years in the army and another two in graduate school before joining Fidelity as an analyst at the age of 25.

He was later promoted to director of research and took over the Magellan fund in 1977. He loved his job, often working six or even seven days a week and was also an active participant in a variety of philanthropic endeavours.

INVESTMENT PHILOSOPHY

Mr Lynch's stock selection is based on well-grounded expectations concerning a firm's growth prospects. He says that the more familiar one is with a company, the better the chances of finding a good buy. According to Mr Lynch, our greatest stock research tools are our eyes, ears and common sense. He was particularly proud of the fact that many of his great stock ideas were discovered while walking through the grocery store or chatting casually with friends and family.

The bottom-up approach he uses means that all prospective stocks must be picked one by one. Instead of trying to predict growth rates, he suggests examining the company's plans - how it intends to increase earnings and how it is performing based on these intentions. The more familiar one is with the industry, the better one's ability to evaluate those plans and identify potential pitfalls.

Mr Lynch evaluates firms using year-by-year earnings, earnings growth, price-earnings ratio relative to historical average and industrial average, debt-to-equity ratio, net cash per share, dividends and payout ratios and inventories. These numbers can help determine the stability and strength of the company, he says.

In addition, there are certain characteristics he finds especially favourable when evaluating companies. He likes 'ugly duckling' type firms - boring names, products or services in a boring area, with a disagreeable or depressing nature of business - because their share prices tend to be lower, offering the prospect of finding good bargains. Service Corporation International, a funeral home operator, and Waste Management, a toxic waste clean-up firm, are two such companies he invested in.

Others included fast-growing companies in a low-growth industry (growth industries attract too much investor interest, driving up prices), companies selling non-cyclical products such as drugs, soft drinks and razor blades, and companies with ongoing share buy-backs. He avoids hot stocks in hot industries, profitable companies undergoing diversification acquisitions and those which rely too heavily on one big customer.

LONG-TERM INVESTING

As the portfolio manager of Magellan, Mr Lynch held as many as 1,400 stocks at one time. However, he points out that that there are difficulties in managing such a large number of shares - such as the problem of over-diversification. He argues that there is no point diversifying one's stock picks just for the sake of it, especially when it means less familiarity with firms.

Mr Lynch does not believe in market timing - one should invest for the long run. He says that an investor should have the stomach for temporary market declines. To him, it is also futile to predict how the economy will turn. He was often quoted as saying: 'If you spend 13 minutes a year on economics (by this he means forecasting the future), you've wasted 10 minutes.'

Instead, he believes the smart investor deals in facts. If one owns aluminium companies, one should be interested in how the inventories of aluminium changed. If one holds hotel stocks, one should be interested in how many people are building new hotels.

Although he invests for the long term, Mr Lynch does not advocate holding on to a stock forever. Instead, one should review holdings regularly and if there is a firm with better prospects, one may consider selling the old stock for the new one.

'If you have a lot of stocks, some will do mediocre, some will do okay; and if one or two of them go up big time, you produce a fabulous result,' he said in the PBS interview. 'In this business if you're good, you're right six times out of 10. You're never going to be right nine times out of 10.'