Managing Magellan: How Peter Lynch Started the Greatest Fund Run
Book: Beating the Street by Peter Lynch with John Rothchild | ISBN: 978-0-671-75915-5
Peter Lynch didn’t start Magellan. He inherited it. And what he inherited in 1977 was kind of a mess.
The Magellan Fund started in 1963 as the Fidelity International Fund. A tax on foreign investments forced it to become a domestic fund. It merged, shrunk, and by 1976 had dwindled from $20 million down to $6 million. Nobody wanted stock funds. The salesmen who used to sell funds door-to-door had gone back to selling vacuum cleaners. Fidelity merged Magellan with the $12 million Essex Fund, mostly to take advantage of Essex’s $50 million in tax losses.
So when Lynch took over, here’s what he had: $18 million in assets, a shrinking customer base, constant redemptions, and the fund was closed to new investors. He couldn’t even attract new money if he wanted to.
It turned out to be a blessing.
Learning in Obscurity
Lynch spent those first four years operating in the dark. No spotlight. No pressure from a huge audience. He could make mistakes and learn from them without the financial media breathing down his neck.
And he needed that room. Before Magellan, Lynch had been an analyst covering textiles, metals, and chemicals. That’s maybe 25% of the market. Now he could buy anything. Capital appreciation funds have no restrictions. Domestic stocks, foreign stocks, even bonds. Lynch had total freedom and very little experience with most industries.
He started visiting companies obsessively. His diary from October 12, 1977 shows he visited General Cinema, selling for less than $1 a share. He passed. It eventually hit $30. A 30-bagger missed right off the bat. But Lynch says the market is merciful. It always gives you a second chance.
The Bloodhound Approach
Lynch never had an overall strategy. He says this bluntly. His stockpicking was “entirely empirical.” He went sniffing from one company to another like a bloodhound following a scent.
He cared more about individual company stories than whether his fund was overweight or underweight in any sector. One broadcaster would tell him business was improving. That broadcaster would mention a competitor. Lynch would check out the competitor, like the story, and buy that stock too.
His early picks had nothing in common: Congoleum (vinyl flooring and battle frigates), Taco Bell (tasty tacos in only 10% of the country), Hanes (his wife loved L’eggs), Fannie Mae, Kaiser Steel, La Quinta Motor Inns. A mystifying assortment.
And that was the point. Flexibility was the key. He put 15% of the fund into utilities at one point. He owned Boeing alongside Service Corporation International, the McDonald’s of funeral homes. He doubts he was ever more than 50% in the growth stocks that Magellan’s success gets credited to.
Peter’s Principle #7: “The extravagance of any corporate office is directly proportional to management’s reluctance to reward the shareholders.” Taco Bell’s headquarters looked like a neighborhood garage. Good sign.
Taking Companies to Lunch
One of Lynch’s best moves was convincing Fidelity to bring companies in for meals. Lunches turned into breakfasts and dinners. Soon you could eat your way through the S&P 500 in Fidelity’s dining rooms. There was a weekly menu, not of food, but of guests. Monday: AT&T or Home Depot. Tuesday: Aetna, Wells Fargo, or Schlumberger.
Lynch attended meals with companies he wasn’t invested in, just to see what he was missing. About 2 out of 10 random encounters turned up something important. He always ended with one question: “Which of your competitors do you respect the most?” He often ended up buying the competitor’s stock.
The Ones That Got Away
Lynch visited Home Depot early on, when the stock was at 25 cents (adjusted for splits). He loved it. Bought it. Then lost interest and sold a year later. Home Depot went to $65. A 260-bagger.
He did the same with Toys “R” Us, Albertson’s (a 300-bagger), and Federal Express (bought at $5, sold at $10, watched it hit $70). He calls this “pulling out the flowers and watering the weeds.” Warren Buffett called to ask permission to use that phrase in his annual report.
Crushed at the Start, Brilliant at the Results
In his first year, the fund was up 20% while the Dow lost 17.6% and the S&P 500 lost 9.4%. In 1979, Magellan was up 51% while the S&P rose 18%. In 1980, shareholders enjoyed a 69.9% gain against the S&P’s 32%.
But here’s the weird part. Even with these incredible returns, the number of shareholders kept declining. One third of shares were redeemed during this period. People who got into Magellan through the Essex merger waited until they recovered their losses and then cashed out. It’s possible to lose money even in a successful fund if your emotions make the buy and sell decisions.
Magellan wasn’t reopened to the public until 1981. The popular theory was that Fidelity cleverly incubated the fund. The truth was less flattering. Nobody was interested in buying stock funds. The brokerage houses had disbanded their sales departments. There was nobody left to sell shares to.
When Magellan finally crossed $100 million after the Salem Fund merger in 1981, the stock market promptly fell apart. Just when people felt safe returning to stocks, stocks suffered a correction. But Magellan still posted a 16.5% gain.
Lynch’s top 10 stocks in 1978 had P/E ratios between 4 and 6. In 1979, between 3 and 5. When good companies sell at 3 to 6 times earnings, he says, the stockpicker can hardly lose.
Small is not only beautiful. It can also be very profitable.
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