Beating the Street: In Praise of Amateur Stock Pickers
"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." -Peter Lynch
Famed mutual fund manager Peter Lynch began chapter one of "Beating the Street" with a lament about the way "geniuses" at mutual funds were replacing amateur stock pickers. What's more, those fund managers were delivering mediocre results. He wrote, "The fact that up to 75% of these mutual funds failed to perform even as well as the stock market averages proves that genius isn't foolproof."
However, he did find two sets of investors, and would-be investors, who were fighting the good fight for amateur stock picking. First, it was a group of seventh-grade students at St. Agnes School in Arlington, Massachusetts, and second, clubs of adult investors around the U.S.
As in his earlier and more famous book, "One Up on Wall Street", Lynch is writing for those he called "amateur" investors, non-professionals who research and buy and sell stocks in their spare time. When he talks about amateurs, note that Lynch is talking about investors who do a reasonable amount of fundamental research before making their decisions. As for those who buy stocks with no research at all, just hunches or a tip from someone's uncle, they should buy mutual funds.
The seventh-graders
At the St. Agnes School, the students were in a class taught by Joan Morrissey, who organized them into groups of four. Each group did research and chose one stock; with 14 groups, the portfolio for the year was made up of 14 stocks.
How did they do? Very well, according to Lynch:
"An investment in the model St. Agnes portfolio produced a 70% gain over a two-year period, outperforming the S&P 500 composite, which gained 26% in the same time frame, by a whopping margin. In the process, St. Agnes also outperformed 99% 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."
When the students sent their results to Lynch, they provided not only their picks, but also drew pictures of each company. Which prompted this statement: "This leads me to Peter's Principle #3: Never invest in any idea you can't illustrate with a crayon."
To research their picks, the students learned to read "Investor's Business Daily" and to check the earnings and relative strength of each company. Lynch cited Morrissey, their teacher, as saying:
"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."
In all picks, the students knew something about each stock before putting it on their short lists. For example, they considered the Gap (NYSE:GPS), where they bought their clothes; PepsiCo (NASDAQ:PEP), which fed them in several different ways; and Topps, which produced the baseball cards so many of them liked to buy. In every case, the students were starting with a list of companies they knew and then shortlisting with the fundamentals.
How has the portfolio done since Lynch's book was published? Very well. All the companies listed above have done very well, as did most of the other heavyweight names, including Walmart (NYSE:WMT), Nike (NYSE:NKE) and McDonald's (NYSE:MCD). Assuming this was a real portfolio and no changes had been made to it, between dividends and capital gains, it would have been quite profitable.
National Association of Investors Corp.
In his second case meant to prove that amateur investors can, and should, have confidence in themselves, Lynch turned again to the National Association of Investors Corp. When this book was written in the early 1990s, the association represented some 10,000 stock picking clubs and chapters. He said they provided evidence that adults, as well as children, could beat the market averages with a disciplined approach.
The majority of chapters had beaten the S&P 500 Index and three-quarters of all mutual funds in the decade of the 1980s. Lynch attributed their outperformance to their practice of investing on a regular schedule, thus removing the temptation to try to time the market. It also helped them avoid impulse buying and selling. He added that those who invest in stocks automatically will profit from their self-discipline.
The author had some research done on regular investing (like dollar-cost averaging) and found these results:
Had you invested $1,000 in the equivalent of an S&P 500 index fund on Jan. 31, 1940 and left it alone for 52 years (until 1992), your investment would be worth $333,793 (there were, of course, no index funds in 1940).
Suppose you added $1,000 every Jan. 31 from 1941 through 1992, your $52,000 investment would be worth $3,554,227.
And, if you added $1,000 each time the market fell 10% or more, your $83,000 investment would be worth $6,295,000.
Obviously, investing on a regular schedule is a profitable practice, and it is even more potent if you add shares when everyone else is rushing to the exits. The clubs did that during and after the big October 1987 correction.
Lynch wrote:
" In 40 years of experience, the NAIC has learned many of the same lessons I learned at Magellan, beginning with the fact that if you pick stocks in five different growth companies, you'll find that three will perform as expected, one will run into unforeseen trouble and will disappoint you, and the fifth will do better than you could have imagined and will surprise you with a phenomenal return. Since it's impossible to predict which companies will do better than expected and which will do worse, the organization advises that your portfolio should include no fewer than five stocks. The NAIC calls this the Rule of Five."
Conclusion
Lynch wanted amateur investors to know they could do as well as the professionals, provided they started with companies they knew and were willing to analyze the fundamentals. Not full-time research, but during the evenings and on weekends.
His evidence came in the form of two group projects: the seventh-graders at St. Agnes School and member clubs of the NAIC. Both outdid the indexes and most professional fund managers.
Finally, don't forget the new rule: "Peter's Principle #3: Never invest in any idea you can't illustrate with a crayon."
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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This article first appeared on GuruFocus.
