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Saturday, February 15, 2014

Stalking The Tenbagger: Peter Lynch Book Review

In this article, I am reviewing the concepts in the book "One Up On Wall Street" by Peter Lynch (one of the prominent equity mutual fund portfolio managers during the pre-2000 bull market).

The book is somewhat dated (the second edition was published in 2000; the end of that equity bull market), but I find it interesting as it presents a view of investing that is almost diametrically opposed to how I analyse markets. Peter Lynch advocates bottom-up, macro agnostic, growth investing. Meanwhile, I look at markets from a top down, macro-driven perspective.

Review Disclaimer...

I will first note that I borrowed the French translation of the book from my library. Since I do not wish to hazard a translation back into English, I will not be quoting from my copy.  I obviously cannot comment on his writing style, other than noting that I previously owned another one of his books, Beating the Street (affiliate link), and it was well-written. ("Beating the Street" was re-released in March 2013, so I assume it would have had some updates discussing the aftermath of the equity meltdowns of 2000 and 2008. My guess is that he did not add commentary from the Occupy movement, who might use the phrase "Beat the Street" with a slightly different implication.)

I would like to note the credit was given to the translator as "Traduit de l'américain par Anne Poniatowski". Yes, the French have shrewdly observed that Canada's neighbour to the South speaks American, not English. (Many of whom probably believe that I just wrote neighbour incorrectly.) Additionally, Mme. Poniatowski diplomatically renamed the chapter "50,000 Frenchman Can Be Wrong" to "Don't Do What Everyone Else Is Doing" (my translation).

Traquer Le 10-Bagger

One of the terms that Peter Lynch continuously refers to is the "tenbagger": a stock whose price goes up by a factor of 10. This is a concept that is foreign to vanilla analysis of developed market government bonds. The potential for a security to go up by a factor of 10 changes the strategies that are available to an investor.

To put this is in perspective, imagine that on a 5-year horizon:
  1. 10%  of your portfolio goes up by a factor of 10 (over the entire period); and 
  2. the other 90% grows at "only" 5% per year on a 5-year horizon (and you do not rebalance).
This will turn $100 into $214.87 over the 5 years, or an annualised return of 16.5%. Look at that return, which was driven by a very small weight of the overall portfolio, and then look up the 5-year Treasury Note yield.

If it is possible to find at least a couple stocks that can go parabolic like that, you can end up with very interesting portfolio returns. You will expect to buy a few dogs along with the winners. But the most you can lose is 100% of your investment (you're not using leverage, right?), so a loser cannot cancel out a winner that at least doubles in value. You do not need a very high percentage of "winning" stocks, so long as those winners are "home runs".

The obvious objection is: you can buy a lottery ticket, and you can possibly get an even more amazing return on your cash. But how realistic is it to plan on such winnings? The point of Peter Lynch's books is that individual investors should be able to spot such winners, and in fact, they have some advantages over professional equity managers in this quest.

Learn To Earn

Peter Lynch's books are predicated on the idea that you should be able to spot growing companies just by being a consumer in the United States (or probably other developed markets, but the book is U.S.-centric). If you see a product or service that you like, you need to put yourself in the habit of asking: is the company that produces this public? And if your job puts you in a position to gauge growth - i.e., you are in sales, and one of your customers keeping expanding orders, you should look into the situation.

However, this is not a painless exercise. In addition to providing a good product, the stock has to be at the right price, and the company has to be sensibly financed. It takes work to be able to judge this. You need to dig through the financial statements, read annual reports, and do things like phone the company and ask them questions. In other words, it's not enough to go through the stuff in your closet, and buy the companies that produced them. Also, you cannot wait until the company is globally renowned; you probably need to buy relatively early.

As a result, a good portion of the book is a discussion of how to analyse a company. I believe that this portion should be understandable, but it might take a little work if you are not familiar with finance. If you want to pursue this style of investing, you will need to roll up your sleeves and do the due diligence. One could argue that this is probably a much more sensible use of spare time than most other passive forms of entertainment. And the potential payoff could be immense. If you do manage to snare one or more tenbaggers, you could possibly shave years off of your time stuck in the cubicle tax farm.

In the book, he gives a lot of examples to illustrate his points. All of the examples are dated now, but most were even at the time of first publication. What matters are the principles, not the specific companies. However, it may be that if you are unfamiliar with the companies he mentions (for example, if you are young and/or live outside of North America), it may be some of the references will be hard to follow.

The Cynical Macro Investor Response

For myself, I sort-of followed Peter Lynch's dictum of using what I already know when investing. My day job was working as a fixed income analyst, and so I had to follow macro trends. (Technically, I was supposed to be analysing interest rate relative value, but doing that without at least understanding the macro environment is suicidal.)  However, this situation is relatively rare, and so I do not think my "investing style" is easily generalised.

However, starting at about 2000, I started doing some individual stock picking (possibly as a result of reading Peter Lynch). I was moderately successful in absolute terms, and great in relative terms (the stock markets cratered over the period). However, when I looked at my performance later, I realised that my success was just the result of the fact that I bought a bunch of small cap value stocks when all the equity portfolio managers were putting their investors' money into large cap growth stocks (particularly technology; remember the "Gorrilla" investment thesis?). My "stock picks" were really just a bet on a sector within the stock market.

Since I was already following top down macro, working in some sector positions via exchange-traded funds (ETF's) was straightforward (e.g., I could buy an energy ETF if I liked energy). Trying to research individual companies was not the best use of my time.

However,  it is clear that I am unlikely to get a tenbagger with ETF's, unless I went far afield into emerging markets. A large number of holdings weighted towards larger companies will dampen out the volatility of individual holdings. All I hope to achieve is to enhance the returns on my portfolio by buying cheap assets while attempting to avoid meltdowns. And since not all investors can outperform averages by definition, it does raise the issue whether investors should ignore analysis and just invest passively (i.e., pick a stock/bond allocation, and just hold index funds to meet that target allocation). Instead, spend your time on factors that you can control: enhancing income via education or developing marketable "hobbies"; or reducing spending.

Additionally, there is an interesting question whether the equity quantitative analysts have rained on the parade of stock pickers. These analysts can run extremely effective "screens" on market and fundamental data, doing things like applying sophisticated transformations to accounting data to put all companies' financial results into a comparable form. (High frequency trading is running rampant all over the equity market, but this should not matter to stock pickers.)

In the book, he discusses how various companies (he mentions the names of lots of companies throughout the book) "flew under the radar screen", and were not covered by street analysts until their stocks had already quadrupled (or more). Does analyst coverage matter any more? I avoided sticking my nose into the equity analysts' business, and so I have no good idea of how much the environment has changed. My guess is that retail stock pickers will need to lean heavier on the qualitative aspects of fundamental corporate analysis, and not attempt to rely purely on numeric screens.

It's A Question Of Style

Deciding to spend time doing analysis to enhance your personal portfolio returns is very much a question of attitude and circumstances. (But if you are a professional portfolio manager or analyst, I would suggest that you spend at least a few minutes a day thinking about how to enhance your portfolio's returns.) The upside potential for success means that equity fundamental analysis could be an interesting use of time. However, if you do follow that route, you still need to remain disciplined, and compare your results to index returns periodically. Making 7% a year for a decade when the equity index ETF returned 10% would be a waste of time and money.

Additionally, it may be dangerous to invest in areas you know well, if that knowledge comes as being an employee in that industry. Throwing your personal portfolio into technology stocks when you were already an employee in the technology sector was an unmitigated disaster for many in the early 2000's; the stocks crashed and they lost their jobs.

Returning to the book, it does cover some of these larger issues. The first section discusses at which point you can start doing stock picking - when you have enough of a cash buffer so that you can afford to lose on your investments. The last section discusses various issues involved in portfolio design. It is very stock-focussed, and so it is not an introduction to personal finance for all situations. But he does discuss quite a few rules of thumb and investing situations, such as when to sell a stock.

My advice for a beginner would be to read a more general introduction first, and then follow up with this or a similar book if the idea of fundamental equity analysis sounds appealing.

The book is available at Amazon at: One Up On Wall Street: How To Use What You Already Know To Make Money In The Market (affiliate link).

(c) Brian Romanchuk 2014


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