Lesson #11: How to Find Great Businesses, the Peter Lynch Way

Value Investing Masterclass - Safal NiveshakIf there is one legendary investor who not just beat the market but destroyed it, it is Peter Lynch.

Lynch ran Fidelity’s Magellan Fund in the US for 13 years, from 1977 to 1990. During this period, he beat the US stock market index S&P 500 in 11 years. His average annual return during this period stood at a mind-boggling 29%.

It means that every US$ 1 invested in his fund in 1977 grew to more than US$ 27 by 1990.

Fortunately for us, Lynch has laid down his secrets in two great books that every investor must own and read several times – One Up on Wall Street, and Beating the Street.

In fact One Up on Wall Street is one of the first books I ask new investors to read. The easy-going and simplistic stock-picking style discussed in this book brought Lynch great success in his profession as a fund manager.

Lynch wasn’t just a great investor, he had a wonderful way of getting across the secrets of his success in everyday language, exemplified by this warning of the perils of putting money into businesses that you don’t understand.peter_lynch

Another of his catchphrases was to “invest in what you know” and he believed everyone could use this advice to spot successful companies.

In fact, he got many of his best ideas at home or when wandering around shopping malls, rather than by poring over company accounts.

“I stumble on to the big winners in extracurricular situations,” he said. “Apple computers – my kids had one at home and then the systems manager bought several for the office. Dunkin’ Donuts – I loved the coffee.”

Now, he didn’t just go straight out and buy shares in the companies he spotted this way. Instead, he used these insights as a basis for further research. As he’s mentioned in his book, he was looking for shares that offered “growth at a reasonable price”. The idea was to avoid two common investment mistakes –

  1. Either paying too much for fast-growing companies;
  2. Or buying seemingly cheap firms without realising that they have stopped growing.

Lynch summarised his approach in 25 investing principles outlined as Peter’s Principles in his book Beating the Street.

Now, one of the Peter’s principles is – “Never invest in any idea you can’t illustrate with a crayon.”

He wrote in Beating the Street –

A class of seventh graders at an American primary school did a social studies project on stocks, the kids had to do their own research and dig up stocks for a paper portfolio. They sent their picks to Lynch, who later invited them to a pizza dinner at the Fidelity executive dining room, illustrating their portfolio with little drawings representing each stock. Lynch just loved this because it illustrates the principle that you should only invest in what you understand, the kids portfolio consisted of toy manufacturers, makers of baseball swap cards, clothing manufacturers and outlets, Playboy Enterprises (a couple of boys chose that one), Coke, and other stocks of that ilk.

With a portfolio notably lacking in glamorous technology ventures and entrepreneurial risk taking they went for solid stocks with excellent profits, their portfolio returned 69.6% against a background of a 26.08% gain in the S&P500 in 1990/91.

Now, this is a great idea – Never invest in any idea you can’t illustrate with a crayon – if you are searching for some great businesses to invest in for the long run. Of course, you must buy such businesses only after you research the ideas well, and only when they are available at reasonable prices as compared to the growth they promise.

Anyways, borrowing this idea from Lynch, I’ve tried to illustrate (through my poor drawing skills ???? ) some great businesses you can find in your own living room, kitchen, and bathroom.

My list is in no way exhaustive, but it’s quite comprehensive as you can see in the two images below…

identifying_stocks_peter_lynch

identifying_stocks_peter_lynch_1

As you can see, most of us in India are connected to most of these businesses on a daily basis, and we also like the products/services of most of these companies.

So what stops you from researching them further if you are trying to search for those great investment ideas for your long-term portfolio?

Most of these are simple businesses, and have already created a lot of wealth in the past. But a lot of these businesses also have a great future potential, which you can identify only when you read about them, and understand them properly.

A lot of small, new investors complain that they have a very small circle of competence. I’m sure this chart will erase all those complaints.

Knowing and researching 70+ stocks is, in no way, having a small circle of competence.

Interestingly, people get incredibly valuable fundamental information from their jobs also that may not reach the institutional investors for months or even years.

Not many small investors appreciate this, but it is one of the best ways they can pick great stocks.

If I’m a banker, I know what makes up a bank’s balance sheet and I also know which banks are worth banking upon as investments.

Considering this, I would be a fool eyeing biotechnology or IT stocks, especially when I don’t understand the ABCs of these industries, but just go by what my broker or friend advises me.

Many of the future 10, 20, 30 or even 100 bagger stocks are perhaps lying in plain sight.

So go, find some great stock ideas by drawing things you understand (at your home, in your job, while shopping or roaming around etc.), and then research them deeper. You never know when you paint a beauty!

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