Five Market Insights from Peter Lynch

Peter Lynch managed the Magellan mutual fund at Fidelity Investments between 1977 and 1990. He averaged a 29% annual return and managed to increase his fund’s assets under management from $18 million to $14 billion. Magellan started as a private investment arm for Fidelity’ founding Johnson family. The fund didn’t open to outside investors until 1981. Between 1981 and 1990, Lynch managed to return 22.5% per year vs 16.5% for the S&P 500. During that period, the average investor at Lynch’s fund made 7% a year. Why the big discrepancy? Well, many investors sold Magellan fund when it had a down year and bought it back when it had a good year.

The majority of Peter Lynch’s returns came when he was managing a relatively small amount of capital. He was also lucky to start at Magellan at the end of one of the biggest and longest bear markets in financial history, which brought many stocks to extremely low valuations.

Peter Lynch is also one of the most prolific writers, whose market thoughts continue to be widely quoted and applied to these days. Here are some of my favorite:

The two biggest mistakes that investors make

There are two ways investors can fake themselves out of the big returns that come from great growth companies.  The first is waiting to buy the stock when it looks cheap.  Throughout its 27-year rise from a split-adjusted 1.6 cents to $23, Walmart never looked cheap compared with the overall market.  Its price-to-earnings ratio rarely dropped below 20, but Walmart’s earnings were growing at 25 to 30 percent a year.  A key point to remember is that a p/e of 20 is not too much to pay for a company that’s growing at 25 percent.  Any business that an manage to keep up a 20 to 25 percent growth rate for 20 years will reward shareholders with a massive return even if the stock market overall is lower after 20 years.

The second mistake is underestimating how long a great growth company can keep up the pace.

Let Your Winners Run

It’s easy to make a mistake and do the opposite, pulling out the flowers and watering the weeds.  If you’re lucky enough to have one golden egg in your portfolio, it may not matter if you have a couple of rotten ones in there with it.  Let’s say you have a portfolio of six stocks.  Two of them are average, two of them are below average, and one is a real loser.  But you also have one stellar performer.  Your Coca-Cola, your Gillette.  A stock that reminds you why you invested in the first place.  In other words, you don’t have to be right all the time to do well in stocks.  If you find one great growth company and own it long enough to let the profits run, the gains should more than offset mediocre results from other stocks in your portfolio.

Look for situations, where perceptions are worse than reality

The big winners come from the so-called high-risk categories, but the risks have more to do with the investors than with the categories.

Embrace market corrections

It is not entirely clear what causes deep market corrections (a clear prove that markets are irrational), but without them many of the best performing long-term investors would have never achieved their spectacular returns.

The biggest winners are usually a pleasant surprise

The point is, there’s no arbitrary limit to how high a stock can go, and if the story is still good, the earnings continue to improve, and the fundamentals haven’t changed, “can’t go much higher” is a terrible reason to snub a stock. Shame on all those experts who advise clients to sell automatically after they double their money. You’ll never get a ten-bagger doing that.

Frankly, I’ve never been able to predict which stocks will go up tenfold, or which will go up fivefold. I try to stick with them as long as the story’s intact, hoping to be pleasantly surprised. The success of a company isn’t the surprise, but what the shares bring often is.

3 Major Takeaways from the Crash in 1987

October 19. 2016 marks 29 years since the so-called “Black Monday” when Dow Jones lost 22% in a single day. Coming into Black Monday, DJIA was already down 20% from its annual highs achieved in August and trading below its 200-day moving average. Paul Tudor Jones, who was one of the lucky guys to make a fortune in 1987 says that he used the 200-day MA as a sign get out and get short. He made 127% net of fees that year.

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Not everyone was as fortunate as PTJ in 1987.

Stanley Druckenmiller lost a lot of money during the crash by trying to pick a market bottom.The Friday before the 1987 crash, Druckenmiller goes from net short to 130% long. Here is his conversation with Jack Schwager in The New Market Wizards’ book:

– You’ve repeatedly indicated that you give a great deal of weight to technical input. With the market in a virtual free-fall at the time, didn’t the technical perspective make you apprehensive about the trade?

– A number of technical indicators suggested that the market was oversold at that juncture. Moreover, I thought that the huge price base near the 2,200 level would provide extremely strong support— at least temporarily. I figured that even if I were dead wrong, the market would not go below the 2,200 level on Monday morning. My plan was to give the long position a half-hour on Monday morning and to get out if the market failed to bounce.

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Another important lesson to be drawn from this interview is that if you make a mistake, respond immediately! Druckenmiller made the incredible error of shifting from short to 130 percent long on the very day before the massive October 19, 1987, stock crash, yet he finished the month with a net gain. How? When he realized he was dead wrong, he liquidated his entire long position during the first hour of trading on October 19 and actually went short. Had he been less open-minded, defending his original position when confronted with contrary evidence, or had he procrastinated to see if the market would recover, he would have suffered a tremendous loss. Instead, he actually made a small profit. The ability to accept unpleasant truths (i.e., market action or events counter to one’s position) and respond decisively and without hesitation is the mark of a great trader.

The infamous day trader, Marty Schwartz had a tough day on October 19, 1987, but he managed to cut his losses quickly:

I came in long. I have thought about it, and I would do the same thing again. Why? Because on October 16, the market fell 108 points, which, at the time, was the biggest one-day point decline in the history of the stock exchange. It looked climatic to me, and I thought that was a buying opportunity. The only problem was that it was a Friday. Usually a down Friday is followed by a down Monday.

The high in the S&P on Monday was 269. I liquidated my long position at 267.5. I was real proud of that because it is very hard to pull the trigger on a loser. I just dumped everything. I think I was long 40 contracts coming into that day, and I lost $315,000.

One of the most suicidal things you can do in trading is to keep adding to a losing position. Had I done that, I could have lost $5 million that day. It was painful, and I was bleeding, but I honored my risk points and bit the bullet.

I thought about going short, but I said to myself, “Now is not the time to worry about making money; it is the time to worry about keeping what you have made.” Whenever there is a really tough period, I try to play defense, defense, defense. I believe in protecting what you have.

Looking at the charts above, I have a few main takeaways from 1987.

1.  Crashes in stock indexes rarely happen when they are near their 52-week highs. They happen below 200-day moving averages.

2) The tape gave plenty of warning signs to decrease substantially your equity exposure. SPX made lower low below its 50dma a week before the event. People had plenty of time to raise cash or hedge their long-term long positions.

3) Any quick pullbacks of 20% or more in the general stock market are usually a good buying opportunity for long-term investors. The market took its sweet time to recover from that flash crash and I am sure that buying the right stocks made a big difference in returns.

How is the Boom in Passive Investing Changing Financial Markets

WSJ is out with a post calling stock picking a “dying business” and declaring passive investing the winner.  And the facts about money flows are on the Journal’s side, but as usual, they are greatly exaggerating things by posting data out of context.

Over the three years ended Aug. 31, investors added nearly $1.3 trillion to passive mutual funds and their brethren—passive exchange-traded funds—while draining more than a quarter trillion from active funds

As Howard Lindzon would say “there’s no such thing as pure passive investing, just fifty shades of active investing”. What’s more interesting to me are the potential consequences of this rising passive investing tsunami:

1.The more money flows to passive investing, the faster markets are likely to become. This will lead higher correlations among stocks and more volatility, which means bigger and quicker corrections; it also means bigger and quicker recoveries. Take a look at the bear market of 2000-2002. As harsh as it was, there were plenty of stocks the kept making new all-time highs during that period and delivered some real alpha. Then, compare it to the correction in 2008, 2011, even early 2016. We saw a lot higher correlations during the most recent corrections. Most stocks went down together; then, they recovered together. Is it a big surprise then if leveraged ETFs are becoming the weapon of choice of more and more active traders?

2. More opportunities for savvy stock pickers. A rising wave (bull market) will lift all boats, including the crappy ones, creating multiple great short targets. A swift correction will bring down strong businesses to super-attractive valuations.

3. A decrease in hedge funds’ fees. 1 & 10 might become the new 2 & 20. If you find a great money manager, 2 & 20 is a small price to pay, but the majority of investors are likely to demand and try to negotiate lower fees. Finding a great money manager is like finding the next Amazon before it happened. The trouble is that in most cases, people won’t stick long enough to see a big difference.