Treasure in the Backyard: The Colonial Group Mutual Funds

Book: Beating the Street by Peter Lynch with John Rothchild | ISBN: 978-0-671-75915-5

Peter Lynch ran the most famous mutual fund in America. And for years he completely forgot to invest in the companies that sell mutual funds.

Think about that. The guy who ran Magellan didn’t buy stock in the companies doing the exact same thing he was doing. It’s like a restaurant owner forgetting to invest in other restaurant chains. He was so deep in the forest he couldn’t see the trees.

The Pick-and-Shovel Play

Lynch makes a great comparison here. During the Gold Rush, the people who made the most money weren’t the prospectors digging for gold. It was the people who sold picks and shovels.

Same idea with mutual funds. During the late 1980s and early 1990s, billions of dollars were pouring into mutual funds. The fund companies themselves, the ones collecting management fees on all that cash, were printing money. Companies like Dreyfus, Franklin Resources, T. Rowe Price, Eaton Vance, and State Street Bank.

If you had divided your money equally among eight of these fund company stocks at the beginning of 1988 and held them for two years, you would have outperformed 99 percent of the actual funds those companies were selling. The companies running the funds beat the funds themselves.

The One He Missed. Twice.

Lynch admits he kept missing this opportunity. He missed it before 1987. He missed it again going into 1991. Each time, the stocks bounced back and delivered massive returns. Franklin gained 75 percent in 1991. T. Rowe Price gained 116 percent. State Street Bank gained 81 percent.

By 1992, Lynch was determined not to make the same mistake a third time. He took a hard look at the entire group. But most of them had gotten expensive after those huge 1991 gains. The one that hadn’t was Colonial Group.

The Colonial Group: Cheap for No Good Reason

Colonial Group was a small mutual fund company based in Boston. Lynch knew them from his neighborhood. And the stock was selling for $17 a share, the same price as its 1985 IPO.

But here’s the thing. The company was way stronger than it was in 1985. Back then, Colonial managed $5-6 billion in fund assets and earned $1 per share. By 1992, it managed $9 billion and earned $1.55 per share. It had accumulated $4 per share in cash. It had bought back 7 percent of its own stock. And it had zero debt.

So you could buy a much better company for the same price. And if you subtracted the $4 in cash, you were actually getting it for $4 less than the IPO price six years earlier.

T. Rowe Price was selling for 20 times earnings. Franklin was selling for 20 times earnings. Colonial Group? Just 10 times earnings. Half the price of its competitors.

Why Was It So Cheap?

Fair question. Earnings had stayed flat for four years, even though assets under management had nearly doubled. Colonial was not a household name. People knew Dreyfus and T. Rowe Price. Nobody talked about Colonial at dinner parties.

But Lynch couldn’t see why being unknown meant the company should trade at half the valuation of its peers. It was profitable. It kept raising its dividend. It kept buying back shares. The business was solid.

The State Street Connection

Lynch called Davey Scoon, Colonial’s treasurer, on January 3. Scoon said business was improving, especially in municipal bond funds. Colonial had several muni bond funds, which were getting more popular as people looked for ways to dodge higher taxes.

Then Scoon dropped an interesting piece of news. State Street Bank had just chosen Colonial Group to market some new funds that State Street was launching. State Street handled the back-office work for most of the mutual fund industry. It wanted to start its own funds but didn’t want to compete directly with its existing clients. So it hired Colonial to do the selling.

Lynch loves this kind of thing. He says if you make 10 phone calls to 10 different companies, at least one of them will tell you something unexpected. Unexpected developments are what move stock prices. And this State Street deal was going to add a nice chunk of new business to Colonial’s bottom line.

The Mother-in-Law Confession

This chapter also contains one of Lynch’s funniest stories. Years earlier, he had talked his mother-in-law into selling her State Street Bank shares. His reasoning was solid at the time: earnings might drop, and she had already doubled her money.

After she sold, State Street tripled again. But then State Street did a three-for-one stock split. When his mother-in-law looked at the stock price in the newspaper, it appeared to have gone nowhere since she sold. She kept congratulating Lynch on what a smart call it was. He never had the courage to tell her the truth.

Stock splits, Lynch says, have at least one advantage: they help stockpickers hide the mistake of selling too early. At least from friends and relatives who don’t follow the market closely.

The Lesson

Sometimes the best investment ideas are right in your backyard. Lynch literally worked in the mutual fund industry and kept forgetting to invest in mutual fund companies. Colonial Group was a Boston company. He could have driven there in 20 minutes.

The bigger lesson is about finding the cheapest stock in an attractive group. When an entire industry is doing well, don’t just buy the most popular name. Look for the one that’s been overlooked. The one nobody is talking about. The one trading at half the valuation of its peers for no particularly good reason.

Colonial Group gained 69.7 percent over the next 24 months. Not bad for a company that nobody on Wall Street had even mentioned in two years.

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