Art, Science, and Legwork: Peter Lynch's Stock Research Method
Book: Beating the Street by Peter Lynch with John Rothchild | ISBN: 978-0-671-75915-5
This chapter is where the Magellan retrospective ends and the practical stockpicking begins. Lynch is about to walk us through the 21 stocks he recommended at the 1992 Barron’s Roundtable. But first, he explains his method. And it starts with a warning about both extremes.
Too Much Science, Too Much Art, Both Dangerous
A person obsessed with measurement, head stuck in balance sheets, won’t succeed. If spreadsheets predicted the future, accountants would be the richest people alive. Lynch traces this back to Thales, the Greek philosopher so busy counting stars he kept falling into potholes.
On the other end, people who think stockpicking is pure intuition skip research and “play” the market. They lose money, which reinforces their belief they lack the magic touch.
Lynch’s actual method combines art, science, and legwork. Professional investors scramble to buy Bloomberg and Reuters to find out what other professionals are doing. Lynch says they should spend more time at the mall. All the software in the world isn’t worth anything without basic homework. Warren Buffett doesn’t use any of it.
The Barron’s History
Lynch has a history of going overboard at the Barron’s Roundtable. In 1986 he recommended 100+ stocks. In 1987, he topped himself with 226. Alan Abelson commented: “Maybe we should have asked you what you don’t like.” In 1988, he showed restraint with only 122. “You are an equal-opportunity buyer,” Abelson quipped.
After leaving Magellan, Lynch cut to 21 picks. He was a part-time stockpicker now. But that was fine. A part-time investor doesn’t need 100 winners. Lynch’s Rule of Five: limit your portfolio to five stocks. If just one is a 10-bagger and the other four go nowhere, you’ve tripled your money.
The Overpriced Market Problem
By January 1992, stocks in the Dow had risen to a year-end high of 3200. Everyone was optimistic. Lynch was the most depressed person on the panel.
Here’s why. He’s always more worried about an overpriced market than a beaten-down one. Recessions end. In a cheap market, bargains are everywhere. But in an expensive market, it’s hard to find anything worth buying.
Many large growth stocks had strayed far above their earnings lines. Philip Morris, Abbott, Wal-Mart, Bristol-Myers. Lynch checked the chart books and saw the warning signs. When a stock’s price climbs way above its earnings line, it has a habit of going sideways or falling until valuations come back to reason. He told the panel these growth darlings of 1991 would likely do nothing in 1992.
Lynch’s quick valuation check: look at a chart book comparing stock price to earnings. Buy when the stock price is at or below the earnings line. Don’t buy when the price diverges into the danger zone above it. Simple. Available at any library or broker’s office.
Go Small, Go Neglected
While large stocks were pricey, many smaller ones were not. Every November and December, tax-loss selling pushes small stock prices to pathetic lows. The “January effect” is especially strong for small companies, which historically rise 6.86% in January, compared to 1.6% for stocks overall. Small stocks were where Lynch expected bargains in 1992.
Don’t Chase New Stocks. Revisit Old Ones.
Before looking for new ideas, Lynch reviewed his 21 picks from 1991. Don’t keep jumping to new companies just to have a different quote to check. You’ll end up with too many stocks and no idea why you bought any of them.
Once you’ve bought a stock, you know the industry, how it behaves in recessions, what drives earnings. When the next downturn makes your old favorites cheap again, add to your position. Lynch carries a large notebook recording details from quarterly reports plus his reasons for buying or selling. He thumbs through these the way other people thumb through love letters found in the attic.
Cedar Fair had risen from $12 to $18, reducing its yield from 11% to 8.5%. No earnings improvement in sight. Dropped. EQK Green Acres mentioned it might not raise its dividend. When a company publicly debates skipping a dividend increase to save $100,000, that’s desperation. Dropped. (They later cut the dividend drastically.)
Coca-Cola Enterprises fell in price but its outlook was gloomier. Cheaper doesn’t automatically mean “buy.” Fannie Mae went up but prospects were excellent. More expensive doesn’t automatically mean “sell.” Lynch put Fannie Mae back on his list for the seventh year running.
Check the numbers. Check the story. Visit the stores. Use common sense. Do the legwork.
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