Beating the Street (4 page)

A group of us investment seers meets every January to participate in a panel discussion sponsored by
Barron's
magazine, which later publishes the transcript. If you had bought many of the stocks that we recommended, you would have made money, but if you paid attention to our expert opinions on the direction of the market and the economy you would have been too scared to own stocks for the last seven years.
Chapter 2
deals with the pitfalls of this “weekend worrying” and how to ignore it.

Chapter 3
, “A Tour of the Fund House,” is my attempt to devise a strategy for mutual fund investing. Although I remain a stockpicker at heart, my retirement gives me the opportunity to discuss a subject
I was reluctant to tackle as a fund manager. When you're still in the business, almost anything you say about it could be construed as either self-serving or a sneaky way to attract new customers—charges that I trust will not be leveled against me now.

Recently, I helped a not-for-profit organization in New England devise a new portfolio strategy. (This organization shall remain nameless because its identity isn't relevant to the exercise.) We first had to decide how much of the money to put into stocks and how much into bonds, and then how to invest each portion. These are the same decisions that every household CEO must make, which is why I've provided a detailed description of how we approached the problem.

Chapters 4, 5, and 6 are a three-part retrospective: how I managed Magellan during 13 years and 9 major corrections. This exercise gave me an excuse to go back and figure out exactly what factors contributed to whatever successes I had. Some of the conclusions have surprised even me, and I was there.

In this part of the book I've tried to concentrate on methodology and to downplay the idle reminiscence. Perhaps there's something to be learned from my occasional triumphs and my numerous mistakes.

In
Chapters 7
through 20, which account for more than half of these pages, I describe how I went about picking the 21 stocks I recommended to the readers of
Barron's
magazine in January 1992. I've talked before about theories of investing, but in making these selections I took notes as I went along. With these notes in hand, I've tried to analyze my stockpicking habits in as much detail as possible. This includes both how to identify promising situations and how to go about researching them.

The 21 stocks that I've used to illustrate this Lynch Method cover many of the important categories and industry groups (banks and S&Ls, cyclicals, retailers, utilities) in which people routinely invest. I've arranged the chapters so that each one deals with a specific kind of company.
Chapter 21
, “The Six-Month Checkup,” describes the regular process of reviewing the story of each company in a portfolio.

I have no pat formulas to offer. There are no bells that ring when you've bought the right stock, and no matter how much you know about a company you can never be certain that it will reward you for investing in it. But if you know the factors that make a retailer
or a bank or an automaker profitable or unprofitable, you can improve your odds. Many of these factors are laid out here.

The text is fortified with liberal doses of Peter's Principles, such as the two you've already had to tolerate. Many of these lessons I've learned from experience, which is always an expensive teacher, so you're getting them here at a discount.

(The stock prices of the 21 companies that I describe in the second half of this book were constantly changing in the course of my research. For example, Pier 1 was selling for $7.50 when I began looking into it and $8 when I finally recommended it in
Barron's.
On one page, I may refer to Pier 1 as a $7.50 stock, and on another as an $8 stock. Several such anomalies may appear in the text.)

Amateur stockpicking is a dying art, like pie-baking, which is losing out to the packaged goods. A vast army of mutual-fund managers is paid handsomely to do for portfolios what Sara Lee did for cakes. I'm sorry this is happening. It bothered me when I was a fund manager, and it bothers me even more now that I have joined the ranks of the nonprofessionals, investing in my spare time.

This decline of the amateur accelerated during the great bull market of the 1980s, after which fewer individuals owned stocks than at the beginning. I have tried to determine why this happened. One reason is that the financial press made us Wall Street types into celebrities, a notoriety that was largely undeserved. Stock stars were treated like rock stars, giving the amateur investor the false impression that he or she couldn't possibly hope to compete against so many geniuses with M.B.A. degrees, all wearing Burberry raincoats and armed with Quotrons.

Rather than fight these Burberried geniuses, large numbers of average investors decided to join them by putting their serious money into mutual funds. The fact that up to 75 percent of these mutual funds failed to perform even as well as the stock market averages proves that genius isn't foolproof.

But the main reason for the decline of the amateur stockpicker has to be losses. It's human nature to keep doing something as long as it's pleasurable and you can succeed at it, which is why the world
population continues to increase at a rapid rate. Likewise, people continue to collect baseball cards, antique furniture, old fishing lures, coins, and stamps, and they haven't stopped fixing up houses and reselling them, because all these activities can be profitable as well as enjoyable. So if they've gotten out of stocks, it's because they're tired of losing money.

It's usually the wealthier and more successful members of society who have money to put into stocks in the first place, and this group is used to getting A's in school and pats on the back at work. The stock market is the one place where the high achiever is routinely shown up. It's easy to get an F here. If you buy futures and options and attempt to time the market, it's easy to get all F's, which must be what's happened to a lot of people who have fled to the mutual funds.

This doesn't mean they stop buying stocks altogether. Somewhere down the road they get a tip from Uncle Harry, or they overhear a conversation on a bus, or they read something in a magazine and decide to take a flier on a dubious prospect, with their “play” money. This split between serious money invested in the funds and play money for individual stocks is a recent phenomenon, which encourages the stockpicker's caprice. He or she can make these frivolous side bets in a separate account with a discount broker, which the spouse doesn't have to know about.

As stockpicking disappears as a serious hobby, the techniques of how to evaluate a company, the earnings, the growth rate, etc., are being forgotten right along with the old family recipes. With fewer retail clients interested in such information, brokerage houses are less inclined to volunteer it. Analysts are too busy talking to the institutions to worry about educating the masses.

Meanwhile, the brokerage-house computers are busily collecting a wealth of useful information about companies that can be regurgitated in almost any form for any customer who asks. A year or so ago, Fidelity's director of research, Rick Spillane, interviewed several top-producing brokers about the data bases and so-called screens that are now available. A screen is a computer-generated list of companies that share basic characteristics—for example, those that have raised dividends for 20 years in a row. This is very useful to investors who want to specialize in that kind of company.

At Smith Barney, Albert Bernazati notes that his firm can provide
8–10 pages of financial information on most of the 2,800 companies in the Smith Barney universe. Merrill Lynch can do screens on ten different variables, the
Value Line Investment Survey
has a “value screen,” and Charles Schwab has an impressive data service called “the Equalizer.” Yet none of these services is in great demand. Tom Reilly at Merrill Lynch reports that less than 5 percent of his customers take advantage of the stock screens. Jonathan Smith at Lehman Brothers says that the average retail investor does not take advantage of 90 percent of what Lehman can offer.

In prior decades, when more people bought their own stocks, the stockbroker per se was a useful data base. Many old-fashioned brokers were students of a particular industry, or a particular handful of companies, and could help teach clients the ins and outs. Of course, one can go overboard in glorifying the old-fashioned broker as the Wall Street equivalent of the doctor who made house calls. This happy notion is contradicted by public opinion surveys that usually ranked the stockbroker slightly below the politican and the used-car salesman on the scale of popularity. Still, the bygone broker did more independent research than today's version, who is more likely to rely on information generated in house by his or her own firm.

Newfangled brokers have many things besides stocks to sell, including annuities, limited partnerships, tax shelters, insurance policies, CDs, bond funds, and stock funds. They must understand all of these “products” at least well enough to make the pitch. They have neither the time nor the inclination to track the utilities or the retailers or the auto sector, and since few clients are invested in individual stocks, there's little demand for their stockpicking advice. Anyway, the broker's biggest commissions are made elsewhere, on mutual funds, underwritings, and in the options game.

With fewer brokers offering personal guidance to fewer stockpickers, and with a climate that encourages capricious speculation with “fun” money and an exaggerated reverence for professional skills, it's no wonder that so many people conclude that picking their own stocks is hopeless. But don't tell that to the students at St. Agnes.

The fourteen stocks shown in
Table 1-1
were the top picks of an energetic band of seventh-grade portfolio managers who attended the St. Agnes School in Arlington, Massachusetts, a suburb of Boston, in 1990. Their teacher and CEO, Joan Morrissey, was inspired to test the theory that you don't need a Quotron or a Wharton M.B.A., or for that matter even a driver's license, to excel in equities.

You won't find these results listed in a Lipper report or in
Forbes
, but an investment in the model St. Agnes portfolio produced a 70 percent gain over a two-year period, outperforming the S&P 500 composite, which gained 26 percent in the same time frame, by a whopping margin. In the process, St. Agnes also outperformed 99 percent of all equity mutual funds, whose managers are paid considerable sums for their expert selections, whereas the youngsters are happy to settle for a free breakfast with the teacher and a movie.

Table 1-1. ST. AGNES PORTFOLIO

I was made aware of this fine performance via the large scrapbook sent to my office, in which the seventh graders not only listed their top-rated selections, but drew pictures of each one. This leads me to Peter's Principle #3:

Never invest in any idea you can't illustrate with a crayon.

This rule ought to be adopted by many adult money managers, amateur and professional, who have a habit of ignoring the understandably profitable enterprise in favor of the inexplicable venture that loses money. Surely it would have kept investors away from Dense-Pac Microsystems, a manufacturer of “memory modules,” the stock of which, alas, has fallen from $16 to 25 cents. Who could draw a picture of a Dense-Pac Microsystem?

In order to congratulate the entire St. Agnes fund department (which doubles as Ms. Morrissey's social studies class) and also to learn the secrets of its success, I invited the group to lunch at Fidelity's executive dining room, where, for the first time, pizza was served. There, Ms. Morrissey, who has taught at St. Agnes for 25 years, explained how her class is divided every year into teams of four students each, and how each team is funded with a theoretical $250,000 and then competes to see who can make the most of it.

Each of the various teams, which have adopted nicknames such as Rags to Riches, the Wizards of Wall Street, Wall Street Women, The Money Machine, Stocks R Us, and even the Lynch Mob, also picks a favorite stock to be included in the scrapbook, which is how the model portfolio is created.

The students learn to read the financial newspaper
Investor's Business Daily.
They come up with a list of potentially attractive companies and then research each one, checking the earnings and the relative strength. Then they sit down and review the data and decide which stocks to choose. This is a similar procedure to the one that is followed by many Wall Street fund managers, although they aren't necessarily as adept at it as the kids.

“I try to stress the idea that a portfolio should have at least ten companies, with one or two providing a fairly good dividend,” says Ms. Morrissey. “But before my students can put any stock in the portfolio, they have to explain exactly what the company does. If they can't tell the class the service it provides or the products it
makes, then they aren't allowed to buy. Buying what you know about is one of our themes.” Buying what you know about is a very sophisticated strategy that many professionals have neglected to put into practice.