Library / Investment Classics

Date of review: February 2019
Book author: Peter Lynch
Вook published: 1989

One Up on Wall Street by Peter Lynch (1989)

This is the first book written by the legendary portfolio manager at Fidelity, Peter Lynch, whose Magellan Fund generated 29% annual returns during 1977-1990 period. The latest edition has an introduction written at the peak of the Dotcom bubble which allowed Lynch to share his perspective on the tech stocks. I view this book as a must-read investment classic even for those who have spent a few years in the markets.

Behind every stock there is a business

The core of Lynch's investment philosophy which is discussed in the book is that 'behind every stock there is a business' and, thus, performance of a stock would ultimately reflect performance of the business, namely earnings dynamics. Lynch reiterates a few times that understanding business prospects through first hand knowledge of a particular product (that you may be consuming every day) is the key to success. Trying to time the market or spend time thinking about future market direction is a waste of time, according to the investment guru.

The book focused on three main ideas: 1) Personal circumstances before you start investing, 2) How to find best investment ideas, and 3) Portfolio management. The main investment tool introduced by Lynch is the six categories of investment cases for various companies which help to decide on key issues to focus in each case as well as make decisions on when to buy and sell such companies. It also helps in portfolio management deciding on specific weights for each stock. The book also has a few useful check-lists for best companies and typical mistakes in investing. Finally, another very useful analytical tool introduced by Lynch is the share price vs earnings chart where two lines for each indicator are put together (when share price significantly deviates from the earnings line it is normally a signal to buy or sell the shares).

The first part highlights that you should allocate that part of your savings that you don't need to spend for the next few years and could even afford to lose and it is better to own a property where you live before you start allocating significant part of your capital on stock investments. Lynch also emphasises that a person has to have certain qualities to be a successful investor including making decisions with incomplete information. Other key qualities include patience, common sense, self-reliance, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, willingness to admit mistakes, ability to ignore general panic.

An amateur has a few advantages over professional investors, according to Lynch, not only because he / she is not constrained by formal rules, policies and can be more flexible with the weights for individual stocks, but most importantly because an amateur can focus on real products around him that either he enjoys and are popular with his friends and act quickly (after doing his own research first). As long as valuation is reasonable and balance sheet is not stretched, companies with great products would likely end up generating strong earnings growth pushing prices for their stock along the way.

This section of the book has also a short summary of key behavioural challenges as every investor passes in and out of three emotional states: concern, complacency, and capitulation. He's concerned after the market has dropped or the economy seemed to falter, which keeps him from buying good companies at bargain prices. Then after he buys at higher prices, he gets complacent because his stocks are going up. This is precisely the time he ought to be concerned enough to check the fundamentals, but he isn't. Then finally, when his stocks fall on hard times and the prices fall to below what he paid, he capitulates and sells in a snit.

Lynch also notes that there is always some uncertainty and no one should expect to be right with his stocks all the time. It is important to be prepared to take occasional losses. Lynch compares investing to a poker game where you win over time following the right method as opposed to winning in each round. Related to idea to this thesis on uncertainty is Lynch's advice against trying to time the market and his preference for always staying in the market. He refers to the last five years before the second edition of the book saying that if you missed the best 30 days since 1994, your returns would be half of what you could have earned staying fully invested throughout the period.

One final idea discussed in the first part of the book is that stocks offer best long-term returns compared to other asset classes. I have a post on this point in my Notes on investing where I highlight that while stock market index may outperform all other asset classes, more than half of individual stocks actually lose money, so it is an important warning against simply buying 5 stocks and expecting to achieve great investment results.

Two other sections of the book are, perhaps, the most interesting for a practising investor. To find a multibagger (a stock that delivers multiple times returns), you should try to find fast growing companies and of relatively small size. Looking around you in shopping malls (Internet, these days) can be the starting point. Your job, hobbies or hobbies of your children can be of great help to identify companies who products or services are just becoming popular as long as the market has not discovered this yet.

There are 6 main categories for stocks

Lynch introduces a very useful concept of how to categorise stocks based on key characteristics which helps to understand factors to look for in each stock as well as to allocate capital between different categories.

  1. Slow growers (single digit earnings growth). Useful to own for dividends as defensive stocks to protect your portfolio in a downturn and have funds to buy cheaper / better stocks in a correction.
  2. Stalwarts (10-12 percent earnings growth). Do not expect huge returns, if your stalwart is up 50% within a year, consider taking profits.
  3. Fast growers (20-25% earnings growth, ideally young companies in stable industries). Best category to find multibaggers.
  4. Cyclicals (most commodity companies as well autos, airlines). Great to buy at the end of recession. Important to distinguish from Stalwarts as both are often large companies with good earnings growth in the past few years, but this growth can quickly reverse for a cyclical company. Timing is key for successful investing into cyclicals.
  5. Turnarounds.
  6. Asset plays.

Earnings growth potential is more important than the actual PE level

The process Lynch suggests investors follow would start from looking around for best products and then doing research on the company looking at its financials, understanding more background on the business and the industry. One key factor to consider at the second step is the price (PE multiple) which should not be too high.

Lynch emphasises that earnings growth potential is more important than the actual PE level. A very important point that he makes in the book is that a 15x PE stock whose earnings are growing at 15% annual rate offers better returns than a 10x PE stock with 10% growth. The formula he suggests to decide if a stock is attractive is to take the sum of dividend yield and growth rate and divide that sum by PE ratio. Anything at 2x or higher is potentially a bargain, while stocks with 1x ratio offer poor investment prospects. I think the level of interest rates would also impact such ratios and in the current environment of record low rates one may have to lower his target ratios by 0.5x points (so an ideal company could have 1.5x ratio instead of 2x recommended by Lynch).

13 key characteristics of a 'perfect stock' (chapter 8):

  1. It sounds dull
  2. It does something dull
  3. It does something disagreeable
  4. It's a spinoff
  5. The institutions don't own it, and the analysts don't follow it
  6. The rumours abound: it's involved with toxic waste/or mafia
  7. There's something depressing about it
  8. It's a no-growth industry
  9. It's got a niche
  10. People have to keep buying it
  11. It's a user of technology
  12. The insiders are buyers
  13. The company is buying back shares.

Lynch lists key points in stocks he would avoid which would be the most widely discussed stocks in the hottest sector with great expectations.

 The book discusses key financial and valuation ratios too. One interesting point I think is worth highlighting is that you should look for high-margin companies within fast growers (as you plan to hold them over the long-term so that they can withstand good and bad periods), while if you a buy a turnaround case, you would better off with a low margin business as its absolute earnings would see much bigger growth in a recovery phase.

I highly recommend reading Chapter 15 of this book as it outlines the checklist for making investment decisions which I find very useful. Having a checklist is generally very helpful as it removes emotions from decision making process and makes it more objective and, hopefully, leads to better results.

In the final part of the book Lynch discusses practical aspects of managing a stock portfolio. The author suggests that instead of targeting a fixed number of stocks (10-20-30) an investor should buy only those where a) he has an edge, and b) the company has great prospects after the necessary research has been completed. It could be just one stock or it could be a dozen. Another advice is to hold couple of stalwarts to reduce risks of fast growers / turnaround cases. Interestingly, Lynch makes a point against using stop losses as with high market volatility you could be forced to sell a good stock with good prospects. 'When you put in a stop, you're admitting that you're going to sell the stock for less than it's worth today'.

Lynch suggests that best time to buy would be in Oct-Dec period when people tend to sell to capture losses for tax purposes or during a correction (it is important to have a wish list of great companies to buy at lower prices). Chapter 17 has a few useful suggestions on when to sell a stock depending on its category (stalwart, turnaround, fast grower etc). I highly recommend it. I would also strongly encourage to read Chapter 18 as it explains common misconception about investing such as 'If it has gone this high already, how can it possibly go higher?' or 'If it has gone down this much already, it cannot possibly go down much more'.

Key notes:

  • Although it's easy to forget sometimes, a share of stock is not a lottery ticket. It's part of ownership of a business
  • Stay by your stocks as long as the fundamental story of the company has not changed.
  • The true contrarian is not the investor who takes the opposite side of a popular hot issue (i.e., shorting a stock that everyone else is buying). The true contrarian waits for things to cool down and buys stocks that nobody cares about.
  • The market ought to be irrelevant. If I could convince you of this one thing, I'd feel this book had done its job. And if you don't believe me, believe Warren Buffett. "As far as I'm concerned," Buffett has written, "the stock market doesn't exist. It is there only as a reference to see if anybody is offering to do anything foolish".
  • Wonderful companies become risky investments when people overpay for them. Buy the right stocks at the wrong price at the wrong time and you'll suffer great losses.
  • Stocks are most likely to be accepted as prudent at the moment they are not.

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