The Misunderstanding of Peter Lynch's Investment Style

"I've never said, 'If you go to a mall, see a Starbucks and say it's good coffee, you should call Fidelity brokerage and buy the stock.'" - Peter Lynch

I saw an article in Monday's Wall Street Journal on Peter Lynch. Basically, it was a very brief piece where Lynch basically says that people are misinterpreting his advice to "buy what you know".

I like Peter Lynch. I think he had a genuine desire to help the individual small investor. That this objective also benefited his personal career does not diminish Lynch's sincerity in my view. He wanted to grow Magellan, but he also wanted to help teach people some simple concepts that he thought would be helpful.

His common sense investment philosophy is often oversimplified, but the main pillars still resonated with me (as they did with so many others as well). I particularly gravitated toward the idea of compounders (or as Lynch called them, 10-baggers--stocks that were growing and could go up 10-fold or more in value). The concept of finding a great business that can do the heavy lifting for you while you passively let value compound is about as good as it gets. These are very rare birds, but it became interesting to me to study these businesses and begin to focus on identifying some common denominators.

I've talked in numerous posts about the value of finding a business that can retain and reinvest capital at high rates of return. The key ingredients to Lynch's 10-baggers are attributes such as high returns on capital, ample reinvestment opportunities, and a long runway through either unit growth or price increases. A durable competitive position along with shareholder friendly management often provide tailwinds to these 10-baggers as well.

This concept stuck with me. I place a premium on the quality of a business and its ability to produce attractive returns on capital.  However, I've always thought that the most people misinterpreted Lynch's advice in a way that became a desired short-cut of sorts to achieve investing success. Maybe Lynch was a bit too simplistic and didn't properly set expectations. But I think part (most) of the onus should be on the reader. There is no free lunch and beating the market is not easy. Investors should know and expect this if they decide to pick their own stocks.

Lynch's Early Magellan Years

Lynch compounded capital at 29% annually during his incredible 13-year run at Fidelity, but his best years of outperformance were early. And they were achieved not by latching onto 10-baggers and holding them for years, but rather by owning stocks for an average of just 3 months! Lynch estimates his turnover ratio was a very high 300% early on. Here are the results of Lynch (as mentioned in Beating the Street) when he was just getting the snowball rolling:

• 1978: 20.0%

• 1979: 69.9%

• 1980: 94.7%

• 1981: 16.5%

I wrote a post earlier this year referencing Lynch and how he was able to achieve these results. He was a very active investor, constantly moving in and out of stocks. I prefer more concentration and less activity in my own investing. That said, turnover is neither good nor bad in and of itself. The benefits/drawbacks are misunderstood. Portfolio turnover (like asset turnover when evaluating a business's efficiency) is just one part of the equation that determines returns on investment. Some businesses achieve high returns through high profit margins and low asset turns. Other companies can achieve attractive returns despite very low margins by turning over their inventory very rapidly. The same is true for a portfolio of securities... some achieve great returns by owning relatively few stocks that return huge profits over multiple years, others are more active traders who make many different investments and have shorter holding periods and smaller average profits per investment.

Despite being famous for 10-baggers, in the early years Lynch was like a productive grocery store-he got very high returns by achieving relatively small margins on many different items (stocks) but turning over his capital multiple times per year. His turnover exceeded 300% per year during the early years of Magellan. He frantically would buy stocks that were dirt cheap, sell them as they appreciated, and then rotate his funds into other stocks that were cheaper.

I think Lynch benefited enormously from an informational edge that has been mitigated mostly by technology, and also due to new Regulation FD (full disclosure) rules that eventually made it illegal for companies to share information with portfolio managers unless they shared it publicly at the same time.

Lynch's approach would likely be different today, just as Warren Buffett's approach would be different today if he were just starting. The edge that they both had in the 1980's and 1950's when they were starting is much different than the edge that investors have in the 2010's.

So I think there is a misunderstanding about both Lynch's strategy and also the reasons for his success. He remarked in Beating the Street: "I doubt that I was ever more than 50% invested in the growth stocks to which Magellan's success is so often attributed."

Lynch preferred the growth stocks. It's just that he wanted to buy them at a fair price. But he was always on the lookout for the potential 10-bagger. Some of the stocks that made the most returns for Magellan shareholders were these big winners that played out over multiple years. And Lynch is right in that 2 or 3 of these huge winners (the Walmarts, the Cracker Barrels, the Suburus, the Wells Fargos, etc...) can make a career. So for good reason, Lynch trumpets the merits of looking for these home runs.

I believe the edge today is much more about being able to look out further than most other investors, and most importantly, being extremely selective. The key is waiting for the fat pitch--i.e. the rare opportunity when a large gap between price and value appears. They are rare, but they appear often enough.

• Good book featuring interviews with great investors including Lynch

• Here are some posts I've written on the Importance of ROIC

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John Huber is the founder of Saber Capital Management, LLC. Saber is the general partner and manager of an investment fund modeled after the original Buffett partnerships. Saber’s strategy is to make very carefully selected investments in undervalued stocks of great businesses. 

John can be reached at john@sabercapitalmgt.com.