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Read their lives, sharpen your own trading. Welcome to Trading Right, Trading Lives, Meeting the Masters. This is a series about the great traders. We look at their lives, their beliefs, and their methods, at their successes and their failures. And we ask one very practical question, how can we use their wisdom today?
This is the 11th episode, and we meet a living legend among fund managers, Peter Lynch. In 1977, he took over Fidelity's Magellan Fund. When he left 13 years later, the fund had grown from about $18 million to about $14 billion. His central idea is almost embarrassingly simple, buy what you know. But how much homework hides behind that sentence?
The mid-1950s, Brae Burn Golf Club in Newton, Massachusetts. A boy of about 11 shoulders a heavy bag along the fairway. His name is Peter Lynch, born in Newton in 1944. According to biographical accounts, his father died of illness when he was 10, and his mother raised the family on her own. A caddy's pay mattered to him.
A caddy's job is simple, watch where the ball lands, and hand over the right club. The members came from all walks of life. One of them was the president of Fidelity, D. George Sullivan. This story appears again and again in Lynch's own telling and in the press, as almost the start of his road into Fidelity.
What the two of them actually said, we cannot verify. What is certain is that a few years later the caddy was a Fidelity intern, and in 1969, he joined the firm for good. In 1977, aged 33, he took over a fund that was then small, Fidelity Magellan. 13 years later he left at 46 with a legendary record behind him.
But the most interesting question in this story is not how successful he was. It is, how did he actually pick stocks? The answer is surprisingly plain. Peter Lynch was born in 1944 in Newton, Massachusetts and grew up there. As we saw, he lost his father young and worked early to help at home. He went on to Boston College, then to the Wharton School at the University of Pennsylvania for an MBA.
While studying, he worked as an intern at Fidelity. That Boston firm would become the only employer of his whole career. In 1969, he joined Fidelity full-time, at first as a research analyst. An analyst's job is to study companies one by one, read the annual report, visit the site, talk to management.
It became a lifelong habit. According to reports, around 1974 he became Fidelity's director of research. In May 1977, aged 33, he took over the Magellan fund. At that time the fund held only about $18 million. The 1970s were hard for American stocks, high inflation, oil shocks, and the bear market of 1973 to 1974.
Around 1982, a long bull market began and it ran on well after he left. In May 1990, aged 46, he announced that he was stepping down as Magellan's manager. His stated reason was to spend more time with his family. He stayed connected with Fidelity afterwards, but no longer ran the fund day-to-day. After leaving, he gave more of his time to writing.
One Up On Wall Street in 1989, Beating the Street in 1993, and Learn to Earn in 1995. Lynch's philosophy can be boiled down to one sentence. Ordinary people have an edge. In One Up On Wall Street, his view is that at work, in the shops, buying things for your children, you often see a company changing before Wall Street's analysts do.
His best-known example is a pair of tights. By his own account in the book, his wife Carolyn brought home a brand of pantyhose called L'eggs from the supermarket, and that drew his attention to the company behind it, Hanes. His books also mentioned chains such as Dunkin' Donuts and Taco Bell. He came to like them in daily life first, and only then research the stocks.
Note the order. See it in life first, and only then study it. This is where he is most often misread. Buy what you know does not mean buy what you like. What you notice in daily life is a clue, not a reason to buy. Then comes the homework. Does the company make money? How much debt does it carry? Where will growth come from?
Is the price too high? He also took a stance. He did not forecast the market or interest rates. More than once he suggested, half joking, that time spent on macro forecasting is mostly wasted. His logic is that behind every stock is a real company. Prices jump about in the short run, but in the long run, what matters is how much the company earns.
He also admits frankly that he makes mistakes. His point, in substance, in this business, being right six times out of 10 is already remarkable. So, his philosophy is not to be right every time, but to let a few big winners grow large enough to pay for all the mistakes. Finally, a discipline that sounds small for every stock you own, you should be able to say in a few sentences why you own it.
In the next chapter, we see how he turned these ideas into a method. Lynch's method falls roughly into three steps: find, check, classify. Step one, find. Clues can come from your job, the shops you visit, a report, or a phone call to the company. As a fund manager, he leaned much more on research. By his own account and the presses, he visited hundreds of companies a year, and his team did homework, too.
Step two, check. He looked at earnings, debt, and cash, and whether the company was buying back its own shares. The measure he did most to popularize is the PEG ratio, the price-to-earnings ratio divided by the earnings growth rate. An illustration, a PE of 15 with earnings growing 30% a year gives a PEG of 1/2.
Another company, a PE of 30 with growth of only 10% gives a PEG of three. His rule of thumb in the book, in substance, a PE roughly equal to the growth rate is fair. Half of it is very attractive, double it, and be careful. But, he also warned that growth rates are forecasts, and forecasts are wrong.
PEG is a sieve, not an answer. Step three, classify. He sorted stocks into six categories: slow growers, stalwarts, fast growers, cyclicals, turnarounds, and asset plays. Each category brings different expectations. Of large stalwarts, he says in the book, you can generally hope for a gain of 30 to 50%.
Ten baggers are likelier among small fast growers. Why classify? Because the questions to ask, how long to hold, and when to sell all differ by category. Then there is a famous habit, the two-minute drill. His idea is that you should be able to tell someone in two minutes why you own the stock. What would make it rise, and what would break the story?
As for selling, he cared less about a fixed stop line than about whether the original reason for buying still held. He also made popular a word, diworsification, a company blindly acquiring and turning a good business into a mess. From May 1977 to May 1990, 13 years. First, the figures most often quoted.
When he took over, Magellan held about $18 million. When he left, about 14 billion. Over those 13 years, the fund's average annual return is often cited as about 29%. Part of the growth in size came from performance, and part from the new money pouring in. By a widely cited account, in most of the years under his management, Magellan beat the S&P 500.
So, where did the performance come from? Start with what he loved most, ten baggers. He called a stock that rises tenfold a ten bagger. Tenfold sounds frightening, but do the sums. Ten times in ten years is about 26% a year. In 20 years, only about 12. So, a ten bagger comes mostly from time plus steady growth.
Patience is almost the whole secret. Another source was turnarounds. Chrysler, which he wrote about in his book, is one example. Put it together. Heavy research, clear classification, a portfolio that lets big winners grow, and a strong bull market at his back. Now we must look honestly at the other side.
First, the era. 1977 to 1990 was exactly when American stocks climbed out of a trough into a great bull market. Many funds rode that wind. Second, the intensity. By his own account and the presses, he visited hundreds of companies a year and had a team doing homework, too. That workload is almost impossible to copy for an individual with only spare time.
Third, after he left, Magellan grew enormous, and its later record no longer had the old halo. Some commentators argue that size itself drags on returns. With so much money, there are not enough good ideas. Fourth, buy what you know is often misread. A good product is not a good stock, and a crowded shop does not make its shares cheap.
His own books are full of admissions of mistakes. A lovely story, but numbers that did not back it up. Fifth, survivorship. We remember Lynch, but we seldom hear of the managers who were just as hard-working and just as devoted to stock picking, yet never became famous. Sixth, the investor's experience.
Research suggests that, for funds as a whole, investors tend to buy after rises and sell after falls. So, what they actually earned is often less than the fund's published return. How much Magellan's own investors actually earned? We have no reliable figure for, and we should not assume it. In the crash of October 1987, his fund was not spared.
Even the best stock picker cannot avoid a systemic fall. This is not a story of failure, but it reminds us that a fine record is usually a mix of era, effort, and a little luck. What Peter Lynch leaves behind is not a record, but a way of working. The first lesson, an idea is not a reason. Homework is.
What you see in a shop or notice at work is only a clue. After the clue, you must read the financials, check the debt, and ask where growth will come from. The second lesson, whether you can explain it in 2 minutes is a very good test. If you cannot explain why you are buying the stock, most likely you have not thought it through.
The third lesson, know first which type it is, and know in advance when you will exit. A fast grower and a cyclical are measured with different rulers. Your plan should also say when the story is no longer true. Just as important are a few things not to copy. Don't copy the numbers. 1977 to 1990 was a great bull era, and Magellan was still a modest fund.
Don't copy the intensity. He had a team, data, and hundreds of company visits a year behind him. That cannot be done in spare time. And don't read by what you know as by what you like, and don't expect 10-baggers to come often. Knowing without homework is only a feeling, and feelings are what the market loves to charge for.
Now, let's bring Lynch's method back to your own trading desk. A reminder first. Trading right will not pick stocks for you, and cannot guarantee a profit. What it can do is help you follow your own homework and your own rules. One, turn the 2-minute drill into the order confirmation checklist. Write a few questions into it.
What type is this? Why am I buying? And can I explain it in 2 minutes? What would prove me wrong? Answer them one by one before every order. If you can't answer, don't place the order yet. Two, use risk control to size every trade. Set the risk per trade as a fixed percentage of your account and work out the position size from it.
However sure you are of an idea, don't let one trade decide your account. Three, turn story breaks into a specific price. Lynch himself cared more about whether the reason had changed than about a mechanical stop. But for most people, writing the exit down at the moment of the order with the default stop-loss and take-profit is still a useful discipline.
Four, use trading rules to stop your portfolio turning into a heap of things you can't explain. For example, set a maximum position size for any single instrument and show a warning after a few losses in a row. That is a defense against diversification in a personal account. Five, use price alerts instead of watching the screen.
Set an alert at the level you researched. Until it arrives, keep doing the homework. Six, use Trading Rights trade review. Import your broker's trade records once a month and in your own trading journal write that 2-minute reason next to every trade. At month's end, check for the trades that made money.
Was the reasoning right or was it luck? For the ones that lost, was the homework missing or did the story really change? Let's return to that fairway. A boy carrying a golf bag watches one successful person after another walk by. He would become the best known of them. Yet, he left no secret formula.
What he left is a nearly plain demand. Know what you own and know why you own it. Perhaps what Lynch leaves to traders is this. Do the homework first, then let time do its work. In the next episode, we meet a very different master, George Soros. His idea of reflexivity and the famous battle for the pound.
This film is for education and biography only and is not investment advice. Learn from the masters. You cannot copy them. Thank you for watching Trading Right, Trading Lives, Meeting the Masters.
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