Peter Lynch was the portfolio manager of Fidelity Magellan Fund from May 1977 to May 1990. Lynch’s fund returned a whopping 29% per year during those years. His investing philosophy was buying small growth stocks at a reasonable price and holding them for the long term to realize outsized returns. Though the book, One Up On Wall Street was written years ago (the first edition came out in 1989), the principles detailed in the book are still relevant today.
Book Summary – One Up On Wall Street
Advantages of dumb money
Don’t listen to professionals. The amateur investor has a number of advantages compared to the so-called experts. If the amateur investor can make use of these advantages, he can easily beat the professional money managers. As you go about your daily life, look out for stores that are expanding rapidly or products you start seeing everywhere. Find out if these companies are public and research them. You will find 10 and 20-baggers before any Wall Street firm.
Chapter 1: The Making of a Stockpicker
Your genes don’t determine whether you are a good stock picker. Almost all of Lynch’s relatives distrusted the stock market, partly due to growing up during the Great Depression. Lynch lost his father when he was seven, which forced his mother to go to work. Lynch also found a part-time job at 11 as a caddy. Since there were a lot of CEOs of big corporations playing golf at exclusive clubs, Lynch figured that the best way to learn the board room was through the locker rooms of these clubs. Stock tips were also frequently discussed during rounds of golf and Lynch paid close attention to them.
At Boston College, Lynch mostly avoid math, science, and accounting and focused on art subjects such as history, psychology, and political science. In retrospect, Lynch fees that studying history and philosophy prepared him to be a better stock investor because investing is an art, not a science.
He bought his first stock when he was a sophomore in college – Tiger Flying Airlines. In less than two years, the stock was a five-bagger and he sold some of it to pay for graduate school at Wharton. He applied for an internship at Fidelity at the suggestion of Mr. Sullivan, the President, who he met at the golf course. As an intern with no background in finance or accounting, he was put to work in researching companies and writing reports.
At Wharton, he met his wife Caroline. After graduating, he served in the Army in Korea and missed the stock market while he was there. He returned to Fidelity as a permanent employee and research analyst. In 1977, he took over the Fidelity Magellan fund when it had 20 million in assets and 40 stocks. He bought more stocks bring the total number of stocks to more than 150 and the asset value continued going up.
Chapter 2: The Wall Street Oxymorons
Professional investing is an oxymoron. Professionals can’t invest in stock until respected analysts put the stock on their buy list. A stock is not attractive until some institutions have bought the stock. There is a “Street Lag” when it comes to owning stocks. Professional investors also have spend hours justifying the investment to their bosses and their clients. Professional investors also have to own a lot of stocks and can’t go to 100% cash. But as an individual investor, you are not tied by the rules that professional money managers have to abide by.
Chapter 3: Is this Gambling, or What?
Stocks have returned more than bonds historically. When you own a stock, you are a partner in an expanding business. When you invest in bonds, you are just a source of cash to someone, and the most you can get is your money back with interest. Stocks are riskier than bonds but the risks can be mitigated by investing appropriately.
Chapter 4 – Passing the Mirror Test
A lot of people lose money in stocks. How many people do you know that lost money in the house? Far less. That’s because an investment in a house is rigged in the investor’s favor. You can borrow more than 80% of the money needed to buy a house. It’s a leveraged investment with little downside risk (but not zero). You don’t have to pay taxes on the gains until you sell the house. Invest in your home before you invest in stocks.
If you need the money in the next couple of years, don’t invest in the stock market. Even blue-chip stocks can go down in a two to three-year time frame. Invest in stocks only what you can afford to lose without it having any effect on your daily life.
A stock investor needs to have patience, self-reliance, common sense, tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, willingness to independent research, willingness to admit mistakes, and the ability to ignore general panic. That a LOT of qualities required to be an investor. An investor must be comfortable making decisions without perfect information. History shows that humans are terrible stock market timers. Long-term investors become short-term investors when the market falls and sell for huge losses.
Chapter 5: Is this a Good Market? Please Don’t Ask
People are always interested in whether the stock market is good at the moment. But that’s not an easy question to answer. Economists work hard to predict recession but they can’t seem to get it correct twice in a row. Experts studying stock charts, put-call ratios, Fed policy, and foreign investment can’t predict markets with any useful consistency.
Focus on businesses and ignore the general market. Your job is to pick the right stocks. If it is an overvalued market, you will not find a single company to invest in because none of the stocks will be reasonably priced.
Chapter 6: Stalking the Tenbagger
The best place to find a tenbagger is closer than you think – it is in your backyard, your shopping mall, or where you work. Being “in the business” gives the average stock picker a huge advantage to pick winners from small, fast-growing companies. compared to Wall Street, which always gets the news late.
Chapter 7: I’ve Got It, I’ve Got It – What is it?
The size of the company has a lot to do with what kind of returns you can get. Big companies are stable but they don’t make huge moves. On the other hand, smaller companies can make gigantic moves in a short amount of time. All else being equal, you will do better with smaller companies.
Lynch prefers to put stocks in categories because it helps him develop a story. Then you can fill in the details to help you guess how the story will play out.
- Slow Growers – These companies are large and aging. Grow slightly faster than GDP, around 2% to 4% per year
- Stalwarts (medium growers) – These companies are faster than slow growers but only grow 10% to 12% per year
- Fast Growers – Grow 20% to 25% per year. These are the companies that are likely to grow 10-to 40-baggers
- Cyclicals – Companies whose profits rise and fall in a regular if not predictable fashion (eg. autos, steel companies, etc)
- Turnarounds – These are depressed companies that are on the verge of bankruptcy. These companies have no growth and people expect them to never come back up.
- Asset Plays – These companies have something valuable but Wall Street has overlooked them.
A company doesn’t stay in one category forever. In fact, fast growers burn out, slow down and become stalwarts. The reverse can also occur – a slow grower can find growth and surprise investors.
Chapter 8: The Perfect Stock, What a Deal
If you have to choose between a great company with excellent management in a competitive and complex industry or a so-so company with mediocre management in a simple industry with no competition, go for the latter.
Lynch’s favorite attributes of companies
- It sounds dull, or even better, ridiculous – companies with names such as Automatic Data Processing, Pep Boys – Manny, Moe, and Jack are boring but businesses and stocks are going up.
- It does something dull – Take the case of Crown, Cork and Seal, a company that makes bottle caps. Professional investors stay away from boring businesses until some big news comes out. Then these stocks become trendy and overpriced, and it is time to sell.
- It does something disagreeable – These companies are not just boring, they are disgusting. But they grow their earnings every quarter and their stock follows suit.
- It’s a spin-off- Companies don’t want spin-offs to get in trouble because that would bring bad publicity. Hence spin-offs have strong balance sheets and are primed to be successful as independent companies
- Institutions don’t own it and analysis don’t follow it – these stocks were not followed by analysts at or they were once popular but analysts have abandoned them
- The rumors abound: It’s involved with toxic waste and/or the mafia – Despite being in an industry that almost everyone despises, Waste Management is up to 100-fold. Lynch prefers these kinds of industries and companies.
- There is something depressing about it – Service Corporation International (SCI) is in the funerals business, again something people like to not think about or ignore. The company was ignored by institutional investors for years.
- It’s a no-growth industry – everyone wants to invest in high-growth industries. But there are great opportunities in no-growth industries where there is little competition
- It’s got a niche – There is a lot of value in exclusive franchises to a company. Once you have an exclusive franchise, you can raise prices and the stock prices tend to follow. Drug companies benefit from products that no one is allowed to make.
- People have to keep buying it – think drugs, soft drinks, razor blades, etc. People need to keep buying them and the companies that make them stick around for a long time
- It’s a user of technology – Companies like Automatic Data Processing that benefit from cheaper computing are able to increase profits.
- Insiders are buyers – Insiders have the best information. Anytime an insider buys a stock, it means that they think the stock is undervalued.
- Company is buying back shares – When a company buys back its shares, it reduces the share count and earnings per share goes up. This in turn causes the stock prices to go up.
Chapter 9: Stocks I’d Avoid
Avoid the hottest stock in the hottest industry. These stocks tend to go up fast. They get a lot of publicity but eventually fizzle out. Beware of companies that are touted as the next Intel or Disney.
Chapter 10: Earnings, Earnings, Earnings
Earnings are what makes a company valuable. A P/E ratio is a useful measure to check whether a stock is overpriced, fairly priced, or underpriced. There are five ways a company can increase its earnings: reduce costs, raise prices, expand into new markets, sell more of its products, sell money-losing operations. Analyzing how a company can improve its earnings will help you develop a story about the company.
Chapter 11: Two-minute Drill
Before you invest in any stock, give yourself a two-minute monologue about the “story” of the stock. It doesn’t matter which of the six categories the company falls in, develop a story to explain why you are investing in the company. If it is a fast-growing company, ask yourself “how can the company continue to grow?”.
Chapter 12: Getting the Facts
One area where professional investors have an advantage is being able to talk to the companies directly. Amateur investors can’t call a CEO and ask questions but they can use their broker to get information on the company. Many brokerages are happy to provide analyst reports if you ask. Read their annual filings, especially the balance sheet.
Chapter 13: Some Famous Numbers
If a company has a new exciting product, find out what percent of sales this product (and the product line) represents. The following metrics are important when analyzing a company.
- Percent of sales – if a company has an exciting product, check the percentage of sales for that product and product line
- Price/Earnings ratio- P/E ratio that is half the growth rate is positive, P/E ratio that is twice the growth rate is negative
- Cash – more cash on the balance sheet, the better
- debt – pay attention to the debt and the debt structure
- Book value – don’t just look at book value, understand what these values are. What a company counts as assets may not be worth much
- Cash flow – free cash flow is what’s leftover after normal capital spending. A company can have modest earnings but excellent free cash flow.
- Inventories – check the balance sheet to check if inventories are piling up. It may be a red flag.
- Pension plan – a company must pay its obligation even if it goes bankrupt
- Dividends – cushions the company from falling too much
- Growth rate – Companies with a 20% plus growth rate tend to be multibaggers
- Bottom Line – For long-term holdings, the stock must have a high profit margin.
Chapter 14: Rechecking the Story
After you have identified a stock, it is important to re-visit the story to confirm that it’s still valid. You can read quarterly reports and research on the company to check whether earnings are holding up as expected. A company goes through three phases – start-up phase, rapid expansion phase, and the mature phase. Each phase may last several years and the rapid expansion phase is where the most money is made. In the mature phase, the company runs into limitations.
Chapter 15: The Final Checklist
For stocks in general
- P/E ratio – is it high or low relative to its peers in the industry
- Percentage of institutional ownership
- Insider buying is positive
- Earnings growth
- Cash position
- Are dividends safe? What percentage of earnings are paid as dividends?
- Check the long-term growth rate of the company.
- How did the company navigate the previous recession
- Watch out for inventory levels, and the supply-demand relationship
- Anticipate a shrinking P/E as companies as business recovers and investors look forward to the next cycle
- 20-25% earnings growth is preferable
- Is the company able to replicate success in more than one city or area?
- Does the company still have room t grow?
- Is the stock’s P/E ratio at or near its growth rate? (good sign)
- If only a few institutions hold it, it’s a good sign because the stock is likely to go up in the future
- What is the company’s debt position? Can the company survive or will debt holders take over the company?
- Are costs being cut?
- Can the business come back?
- What is the value of the assets?
- Is the debt manageable?
- Is a corporate raider or activist investor involved to help shareholders benefit from an increase in share prices?
Chapter 16: Designing a Portfolio
An average investor can design a portfolio to generate a 12%-15% return. A small portfolio can own between three and 10 stocks. Spread your money between the different categories of stocks to minimize risk. Younger investors have more years to make mistakes and find great stocks. Portfolio design changes as you get older.
Chapter 17: Best Time To Buy and Sell
The best time to buy a stock is around the end of the year. Tax-loss selling and institutions cleaning up their portfolio (selling losers) drives stock prices down and allows patient investors to pick up bargains.
Here are some general sell signs
- Company announces massive share issuance
- Sales of business units bring in less cash than expected
- Reduction in corporate taxes considerably reduces a company’s tax loss carryforwards
- Institutional ownership has grown and reaches 60%
- Company has lost market share for two consecutive years
- No new products
- Acquires unrelated businesses and overpays for them
- P/E is too high
- New products have mixed results
- No insider buying
- Major division is vulnerable
- Growth rate is slowing down
- Sell at end of the cycle (if you can predict it)
- Costs rising and plants operating at full capacity
- Competition is heating up (especially from foreign companies)
- Demand is slowing down
- End of the expansion phase
- Top executives join rival firm
- High P/E, decreasing growth rate
- After a successful turnaround
- Debt has declined
- Inventories are rising
- P/E is inflated relative to expected earnings
- Is there a corporate raider in the wings?
- Institutional ownership hits 60%
Chapter 18: The Twelve Silliest (and most dangerous) Things People Say About Stock Prices
Here are 12 statements for which investors intuitively know the answer but struggle to execute.
- If it’s gone down this much already, it can’ go down further
- You can always tell if a stock hits a bottom
- If it’s gone this high already, how can it possibly go higher?
- It’s only $3 a share. What can I lose?
- Eventually, they always come back
- It is always darkest before dawn
- When it rebounds to $10, I will see
- What me worry? Conservative stocks don’t fluctuate much
- It’s taking too long for anything to ever happen?
- Look at all the money I have lost: I didn’t buy it
- I missed that one, I will catch the next one
- The stock has gone up, I must be right OR the stock has gone down, I must be wrong
Chapter 19: Options, Futures, And Shorts
Don’t waste your time trading options and futures. You will most likely lose your shirt. Warren Buffet thinks futures and options must be outlawed and Lynch agrees with the Oracle of Omaha.
Shorting a stock can be dangerous to your portfolio. You need high conviction, courage, and resources (money) to hold the stock if it does up after you buy.
Chapter 20: 50,000 Frenchmen Can Be Wrong
You hear financial news constantly that discusses the upcoming market declines, America’s debt, and savings rates, tax policies, etc. There is always something to worry about. But Lynch remains optimistic about America, Americans, and investing in general. He has faith in human nature, capitalism, and the country’s future prosperity. Ignore the noise and always look for new investing ideas. You will not find every tenbgagger but you will find a lot of them.
One Up On Wall Street is an easy read and many principles covered in the book are still relevant today. Take the time to do your own research on stocks and hold for the long-term to achieve extraordinary returns.
More Peter Lynch
Here’s an excellent interview Peter Lynch gave during the depths of the dot com recession in 2002.