0 to about 80.
Tanous:If you’d lost money, is there a chance we might not betalking today?
Lynch: Well, I guess if I'd lost money over and over again thenmaybe I would have gone into another field. How do you know whereyour life is going to go in the end? You have no choice who yourparents are; you have no choice where you grow up. I was luckyenough to have great public schools and go on to Boston College. Itwas only three or four miles away, so I could be a commuter. That’sa lot of good fortune.
Tanous:Peter, since you are arguably the most successful, as wellas the most famous, fund manager of all time, and given the focus ofthis book, I want to zero in on process and methodology, especiallyon areas that I think will fascinate readers of this book. My firstquestion relates to style. From my analysis, I’d say you have a growthbias, but you really can’t be pegged to one style, unlike so many ofthe others in this book. In fact, in Beating the Street, you said: “Inever had an overall strategy. My stockpicking was entirely empirical.”That was some stockpicking! Apart from hanging around at malls,could you tell us a little bit about the selection process?
Lynch: I guess I was always upset by the fact that they calledMagellan a growth fund. | think that is a mistake. If you pigeonholesomebody and all they can buy are the best available growth compan-ies, what happens if all the growth companies are overpriced? Youend up buying the least overpriced ones. If you can find growthcompanies at very low valuations and with great balance sheets andgreat futures, that’s where you invest. Only sometimes you find thatthese companies are terrific, but they are selling at 50 times earnings.
My premise has always been that there are good stocks everywhere.Some people say you can’t buy companies with unions, or you can’tbuy companies in dying industries; for instance, who would ever buya textile company? I mean, I didn’t buy it but a company called Unifi
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went up, I think, a hundred fold in the textile industry. I missed it.But look at all the money I made with Chrysler and with Boeing. Ialso lost money with a few airlines and I made money with airlines.But you hear this concept that you can’t make money if you ever buya company that has a union, because the union will kill it. These areprejudices and biases that prevent people from looking at a lot ofdifferent industries. I never had that. I think there are good and badstocks everywhere.
Tanous:But in zeroing in on the process, one of the things thatmystifies me is this: How much of your personal ability just can’t bedefined? I mean, how much of it is simply the keen, even instinctive,judgment that you have, and maybe that a lot of other people don’t?Or is there some methodology that you hang your hat on that you,and maybe our readers, can turn to for process?
Lynch: | think that if you take my great stocks, and you ask ahundred people to visit them and spend a reasonable amount of timeat it, 99 of them, assuming they had no prejudices and biases, wouldhave bought those same stocks. I disagree with a part of your question.I don’t think that with great stocks you need a Cray super-computeror an advanced Sun microstation to figure out the math.
Take this example of a company I missed: Wal-Mart. You couldhave bought Wal-Mart ten years after it went public. Let’s say you'rea very cautious person. You wait. Now ten years after it went public,it was a twenty-year-old company. This was not a startup. So it’s nowten years after the public offering. You could have bought Wal-Martand made 30 times your money. If you bought it the day it wentpublic you would have made 500 times your money. But you couldhave made 30 times your money ten years after it went public.
The reason you could have done that is that ten years after it wentpublic, it was only in 15% of the United States. And they hadn’t evensaturated that 15%. So you could say to yourself, now what kind ofintelligence does this take? You could say, this company has minimalcosts, they’re efficient, everybody who competes with them saysthey’re great, the products are terrific, the service is terrific, the bal-ance sheet is fine, and they’re self-funding. So you say to yourself,why can’t they go to 17% [saturation]? Why can't they go to 21%?Let’s take a huge leap of faith: why can’t they go to 23%? All theydid for the next two decades was roll it out. They didn’t change it. Ionly wish they had started out in Connecticut instead of in Arkansas.
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I bought Stop & Shop because I saw it here in New England. I alsobought Dunkin’ Donuts because they were a local company.
Tanous: You’re touching on what I call the Great Peter Lynch Invest-ment Theorem, which is to observe early business success as it occursaround you. I suppose it helps when the great companies happen tobe in your own backyard and you see them every day. Of course, you’vedone well with other companies, too.
Lynch: Yes, but I wish Home Depot had started here in Boston in-stead of in Atlanta. You could have bought Toys R Us after they had20 stores open and made a fortune on it the next fifteen years. Youhave to ask: why can’t this company go from 20 stores to 400 stores?
Tanous:There was something in one of your books that addressesyour legendary stockpicking that rang a bell. Fidelity started invitingvarious corporations in for lunch or breakfast so that you could heartheir stories firsthand. But then you contrasted those you invited withthe companies who wanted to invite themselves over. Those companieswere telling you the same story that they were telling everyone aroundthe Street. Peter, you talk a lot in your books about communications,meetings, information sharing, and so forth, and that starts to giveme a picture.
Lynch: Again, I’ve always said that if you look at ten companiesyou'll find one that’s interesting. If you look at 20, you'll find, two;if you look at 100, you'll find ten. The person that turns over the mostrocks wins the game. That’s the issue. If you look at ten companiesthat are doing poorly, you’ll probably find nine companies that thereis not much hope for. But maybe in one of them, one of their compet-itors has gone out of business, or the plant that caused them a lot ofproblems has been closed, or they got rid of the division that waslosing money. You'll find one out of ten where something concretehas happened and the stock hasn’t caught up with it. If you look at20, you'll find two. It’s about keeping an open mind and doing a lotof work. The more industries you look at, the more companies youlook at, the more opportunity you have of finding something that’smispriced.
The theory is that the market is perfect and that all companies arefairly priced. And that is true in a majority of cases. If you find acompany whose stock is on the new high list, generally they’re doingwell and they have a good future. You might also find companies
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where the stock is depressed and they’re doing poorly, and you'll alsofind out that the company is having problems.
But maybe you'll find a company where the stock’s gone from 40to 4, it has no debt, it has two dollars per share of cash, and theymight be losing money but, remember, they have no debt. It’s a realchallenge to go bankrupt if you have no debt. I find it interestingthat people will buy a bunch of companies that are losing money. Ifyou do, you might as well buy the company that has the good balancesheet and also has something going on that they can show - maybea new product that is working out well, or something else. Each storyis different.
Tanous:In fact, one of the people I interviewed, who is one of myfavorite managers, is a guy called Richard Driehaus in Chicago. Theway he put it is that a lot of people play the piano but how manybecome virtuosos? The point is to become a virtuoso you’ve got topractice a lot.
Lynch: And what I’m saying is that you could have bought Mi-crosoft three years after it went public and made 30 times your money.Now I didn’t buy it. I don’t own a computer. I can’t turn on a com-puter. My kids can do it, my wife can do it, but there are millions andmillions of people who know about software. Now maybe you don’tknow who’s going to win the hardware game. Is Compaq going towin? Is Acer going to win? Is it going to be Dell or IBM? There arelots of guys selling PCs. But somebody should have been able to figureout that Microsoft was the one that had the operating system thatwas going to win.
Well, people could have bought Microsoft but, instead, many peoplewere buying biotechnology companies, which are very hard to under-stand. That doesn’t make any sense to me. What I’m saying is thatthere’s a 100% correlation between what happens to the companyand what happens to the stock. The trick is that it doesn’t happenthat way over one week, or even over six or nine months, and that’sterrific. Sometimes the fundamentals are getting better and the stockis going down. That’s what you’re looking for. The stock market andthe stock price don’t always run in synch.
There are two basic things. First, there can be a mistake that appliesjust to this company. Or second, you'll have the occasional correctionswhere the whole market goes down. These great companies, whereeverything is fine, get back to a price where you get a chance to buy
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them again just because the market dropped sharply. So you caneither have a general market correction that gives you this opportun-ity, or you'll have ten companies that are depressed and you justmight find one of them where the market is wrong. So that’s whatyou're trying to find.
If you look at the electric utility industry, you might find two orthree that are mispriced. If you look at the insurance industry or theretailing industry, which is out of favor - I mean, it used to be reallyin favor three or four years ago, now it’s out of favor - but you don’twant to get pigheaded. Take banking. In the early nineties, that in-dustry was quickly going south. You had to wait till it got better. Idon’t buy things just because they’re depressed. I wait until the fun-damentals get better. That’s what happened in the banking system.You can’t wait until everything is dramatically improved. But youhave to wait for symptoms, signs, even some evidence that things aregetting better, and not just the hope that it’s getting better.
Tanous:You said that you don’t operate a computer. That thingbehind your desk looks like a fancy computer to me.
Lynch: All that gives is stock quotes. It’s a dumb terminal.
Tanous:It’s getting hard to function without knowing how to operatea computer, isn’t it?
Lynch: Warren Buffett uses his to get in on a bridge game. He’sdone pretty well the last ten years without a computer. I had dinnerwith him last week and he doesn’t have a computer in his office. Hejust uses one to play bridge. You can play bridge with somebody inWashington, or Arizona, or France.
Tanous:Speaking of banking, I interviewed Michael Price. His Chasestory is real interesting.
Lynch: Mine was Bank of America. I bought two percent of it. Ithink I started buying it at 16 and it went down to 8. But it was get-ting better and it wasn’t going to go bankrupt.
Tanous: You bought it at 16 and it went down to 8? And you stuckwith it?
Lynch: Yeah. Here’s the example of a case where Bank of Americawasn’t doing very well. But it was over 100% retail-funded. A lot ofbanks get their money by selling money to money market funds orcommercial paper to businesses. Bank of America’s loans were allbacked up by retail deposits. With some of the banks like Bank ofNew England or Continental Illinois, if you’re half wholesale-funded,
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and people hear you’ve got problems, not only will they probably notrenew your paper, but if they renew it, they want 200 basis pointsmore. So your cost of money goes up because you have problems,and now you've got more problems.
But Bank of America didn’t have to pay more for their depositsbecause all their deposits were FDIC insured. The public didn’t careabout the headlines that Bank of America wasn’t doing well. Therewasn’t going to be a run on this bank. They had more branches, Ithink, than there were post offices in California. They may even havehad more branches than McDonalds. So, if you looked at the companyand said this is not the same situation as some of those banks inTexas, or some of those banks in New England (where they are basic-ally wholesale-funded and the deposits are going to disappear, orthey’re going to have to pay 200 or 300 basis points more, and they’regoing to get squeezed), you would have realized that this bank didnot have that kind of problem.
Tanous:I’m on the board of a bank. Why didn’t I figure this out?
Lynch: That’s one of my arguments. People who’ve been in therestaurant industry should have seen Taco Bell, they should have seenPizza Hut, they should have seen Kentucky Fried Chicken, they shouldhave seen Chili’s, they should have seen Dunkin’ Donuts, they shouldhave seen McDonalds, Applebee’s and many more. And when thecompanies lose their edge, these same people will see the slippagemonths ahead of the professional investors. Fundamentals deteriorateand the people in the business could sell six months or a year aheadof the professionals. They see the industry; they have great informa-tion. But they throw it away.
Tanous:Peter, you really do make sense when you articulate thiscommonsense approach to investing. Now let’s go to the heart of theissue. In this book, I’m trying to engage the debate on something youalluded to earlier, the efficient market theory. This is where youropinion is so important, because you and Warren Buffett are the twopeople whose names always come up as examples of very successfulactive managers. Let me start my question by quoting from One Upon Wall Street. “It’s very hard to support the academic theory thatthe market is irrational when you know somebody who just made atwenty fold profit in Kentucky Fried Chicken and who explained inadvance why the stock was going to rise. My distrust of theorizersand prognosticators continues to the present day.”
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Now the academics say the market is efficient. Everything that isknown about a stock is in the price, and you just can’t predict whatstocks are going to go up except by chance. So, of course, people withopposing viewpoints say, what about Peter Lynch, what about WarrenBuffett, and a few other great names. The academics say, look, theseguys are the outliers on a normal distribution curve. Okay. To them,the Peter Lynches and Warren Buffetts are the outliers on the righttail of the distribution curve, the lucky orangutans that write Romeoand Juliet by pure luck. How do we answer that?
Lynch: Well, you could answer by saying that there are going tobe one million tennis matches this weekend. And there are going tobe 500,000 people who lose and 500,000 people who win. Therefore,should people not practice tennis, should they not practice their serve?Should they not practice their backhand? The question is; why notbe the winner rather than the loser? You could be a better investorif you looked at the balance sheet, if you knew what the companydid, if you use the information you have. You would simply do abetter job. Just like you would be a better tennis player if you workedon your weaknesses and improved your strengths. The concept is thatmaybe we should ban tennis, since half the people are going to loseso the other half can win.
What the academics are saying is that people have done a bad jobinvesting, therefore they shouldn’t invest. As a result, people becomeconvinced by the academics and the media that the large investorsall have the edge with their large computers and their MBA degrees,and that the small investor - I don’t know what that means exceptmaybe all the people under five foot two - the small investor doesn’thave a chance. But what happens is the small investor buys this billof goods that they don’t have a chance. He or she goes in and maybebuys an option on the stock. Or they do one minute of research, orno research, and buy a piece of junk. Or they buy a company withno sales or no earnings and they lose more. And when they losemoney, do you know who they blame? They blame the institutionsbecause of program trading, or some other excuse.
When they shop for a car, and they buy a clunker, they don’t blameinstitutions. No! They say, my God, I should have done some research.When they buy a refrigerator, they ask their neighbors, what’s a goodrefrigerator? They get Consumer Reports. In all phases of their life, ifthey make a mistake and they buy a stupid house at the wrong price,
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they’re not going to blame institutions. But when it comes to investing,they’re looking for a scapegoat and all this stuff is feeding on itself.These people are being told they don’t have a chance, its a big casino,and they act accordingly. Then they get bad results. It’s sort of a self-fulfilling prophecy. You convince the public that the odds are againstthem so they behave like they’re in a casino. They go in there andbuy options - which is like betting on number twenty-six. It’s likeplaying poker without looking at your cards.
Tanous: You once said a share of stock is not a lottery ticket.
Lynch: True. But a better example is that people play cards, bridge,or poker. Now suppose they don’t look at their cards. What kind ofresults will they get? That’s like investing without doing research. Idon’t mean just reading the annual reports or the quarterly reports.I'm saying if you own Chrysler, you ought to find out if somebodyis coming up with a better Jeep, or somebody is coming up with abetter minivan. You don’t get that from reading stuff, you get thatby driving the new vehicle that’s coming out.
Tanous:I guess the appropriate expression here would be “kickingthe tires.”
Lynch: Literally ten years after Chrysler came out with the minivan,they still have a 60% share of the minivan market. This is a stockthat in 1982 you could have bought and made ten times or twentytimes your money. You could have bought it in 1990 and made sixtimes your money. In 1990, they were upgrading Jeep which no onehad done much with over the years. They bought AMC to get Jeep.They’ve been turning Jeep around ever since. If you were a car dealerin 1982 and 1983, or in 1990 and 1991, you should have said, wow,this company has got a lot going for it.
Chrysler wasn’t the only one. When Ford introduced Taurus/Sable,which was an enormous hit, I think Ford went up five times. So youcould have made money in Ford. There may be only a few times adecade when you make a lot of money. How many times in yourlifetime are you going to make five times on your money? I’m notsaying these stocks are available every week. | think that’s what peopleare missing. I’m not saying that you can wake up today and lookaround and the average person is going to find a good stock. Maybeonce every year, or once every two years, or maybe once every sixmonths you want to be able to find one of these. The average personought to be able to follow five or six companies. Remember, there
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are 15,000 public companies. So follow five or six companies, andknow these companies very well. But if none of them is attractive,don’t own any of them.
Tanous:Wouldn’t you agree that for most people mutual funds arethe way to go? And, if we use that as a premise, it still leads to an-other mystery in the selection process. That mystery, of course, is thegreat active versus passive debate. You recognized this in one of yourbooks. In Beating the Street, you stated that 75% of all mutual fundsdon’t beat the market.
Lynch: That was true in the eighties. I didn’t say that was goingto last for the next 25 years. I said in the ’80s, 75% of funds didn’tbeat the market.
Tanous: You don’t think we’re stuck with that number forever?
Lynch: No.
Tanous:My question is, whether it’s 75% or some other percentage,what sort of criteria would you recommend we use to pick funds?Most of us only have past performance to look at. In your book, youcite a lot of the dangers of only using past performance.
Lynch: Particularly the last quarter or last six month’s performance.If you buy the hottest fund of the last three months, I don’t thinkthat’s a good formula.
Tanous: There are different studies on this.
Lynch: Before you get to that step, you’ve got to understand whatkind of funds you have. If you buy ten emerging growth funds andall these companies have small sales and are very volatile companies,buying ten of those is not diversification.
Tanous:Of course not. You’re not diversified by style.
Lynch: What I’m saying is people have to say: What do I want?Do I want to have five funds, with one fund in international marketsbecause | think over the next ten to twenty years those markets aregoing to grow faster than the United States? Maybe in the near futuregold is going to be the place to be. Inflation is going to heat up. Theyhave to decide what they want, and then put together a portfolio theyare happy with. And that’s what some firms will do for them, evenover the telephone. They'll explain this like a waiter. They'll say inour fund group this fund is a very conservative fund. It’s a third inbonds, it’s two thirds in stocks that pay dividends, very large maturecompanies. But, in addition, we have this other fund that just buysvery rapidly growing, high octane small companies. Then we have
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one that just buys quality blue chip growth stocks. Then we haveanother one that buys emerging market stocks. It buys in 40 emergingmarkets that are growing at twice the rate of the ten largest countriesin the world. The point is: this is a more important question than whothe hot fund manager is over the next year.
Tanous:That’s absolutely right. But that is exactly the point theacademics are making. They'll say you’re absolutely right. The wayto diversify and do this intelligently is to pick style and size. In fact,Gene Fama’s three factor model [page 171] is based on these compon-ents of risk and returns. But the academics will also quickly add:Decide how much you want in small-cap. Decide how much you wantin value stocks. Decide how much you want in growth or internationalstocks. And then go out and pick the corresponding index funds. Stopworrying about which manager is better or worse than the other guy.Does that make sense to you?
Lynch: I think if people aren’t willing to do homework and they’renot willing to do research, maybe they should buy an index fund ofthe Russell 2000 or the Wilshire 5000, and buy an S&P 500 indexfund. Those people should just say, I think over time historicallysmall-cap stocks do better than big-cap stocks and I'll put half mymoney in big stocks, half my money in small stocks and so forth.
Tanous:Okay. But I say, that’s not good enough for me. I appreciatethat advice. It’s very nice. It sounds sort of safe. But I want to dobetter. Pl tell you what I want: I want to find another Peter Lynch!Can you help me do that?
Lynch: There’s no such thing as a hereditary talent for pickingstocks. What helped me the most is logic, because it taught me toidentify the inherent illogic of Wall Street. I believe I mentioned inmy book that Wall Street thinks like some of the ancient Greeks did.They’d sit around for days and debate how many teeth a horse had.The right answer is to go check a horse.
In picking funds, just using past performance doesn’t seem to work.Here’s an approach I used: several colleagues and I undertook an as-signment to pick money managers for a nonprofit organization. Wefigured that in a changing market, different styles of investing go inand out of favor. If you own only one fund, you might wind up witha manager who lost his touch or your fund’s style may be out of favor.A value fund, for example, can do well for three years and relativelypoorly for the next couple of years. So the first idea is to diversify
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by style and pick funds in the basic categories. One is capital appreci-ation. Magellan is one of these. Value funds are another. There arequality growth funds, emerging growth funds, special situation fundsand also international funds. But you have to stay with them for thelong term. If value funds are out of favor and growth is in favor,Mario Gabelli and Michael Price can’t be expected to perform as wellas a growth fund.
In deciding which managers to pick, it helps to look for a consistentand steady performer. Look at the fund’s performance in differentmarkets. Some funds lose more than others in a bear market but gainmore on the rebound. The ones to avoid are the funds that lose moreand gain less. In our search, we picked one value manager, twoquality growth managers, two special situation funds, three capitalappreciation funds, a fund that invests in companies that consistentlyraise their dividends, three convertible securities funds, and oneemerging growth fund. Out of this group, our hope is to produce adifferent star performer who beats the market every year. If we haveenough all-stars to counteract the poor performers, we hope to beatthe dreaded market averages.
Tanous: What is your opinion of technical analysis?
Lynch: The problem with technical analysis is that somebody couldlove the stock at 12 and hate it at 6. In pure technical analysis, thestock itself will show what’s going on. You just have to watch themovement of the stock price. But to be fair, it doesn’t apply to all thestocks. Technical analysts will look at maybe ten formations [stockprice graphs] and one will tell them something. So they might likesomething at 12 and hate it at 6 because the formation has changed.That bothers me.
But, with that as the background, I have traditionally liked a certainformation. It’s what I call the electrocardiogram of a rock. The stockgoes from, say, 50 to 8. It has an incredible crater. Then it goes side-ways for a few years between 8 and 11. That’s why I call it the EKGof a rock. It’s never changing. Now you know if something goes rightwith this company, the stock is going north. In reality, it’s probablyjust going to go sideways forever. So if you’re right it goes north andif you’re wrong it goes sideways. These stocks make for a nice researchlist. You look at stocks that have bottomed out.
It’s like trying to catch a falling knife. When it’s going from 50 to8, it looks cheap at 15; it looks cheap at 12. So you want the knife
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to stick in the wood. When it stops vibrating, then you can pick itup. That’s how I see it on a purely technical basis. If you look at thefundamentals, you say, wow, at 15 it’s selling at 3 times earningpower. It’s got 12 dollars a share in cash. You can show fundamentalreasons why you should jump in at 15. But if you were a technician,you wouldn’t see it that way. From a technical standpoint, this is theonly formation that would show me something.
Tanous:But the problem with that formation is that that flat EKGcould go on forever. What makes it go up?
Lynch: That’s why the stock is on your research list, not on yourbuy list. You investigate and you find that of these ten stories, thisone has something going on. They’re getting rid of a losing division,one of their competitors is going under, or something else.
Tanous:So we’re back to fundamental analysis.
Lynch: The process cuts 15,000 public companies down to 20.
Tanous:An interesting screening technique.
Lynch: Yes.
Tanous:!’m interviewing one quant, David Shaw, who has a repu-tation for being mysterious and secretive. Do you have any experiencewith or opinion about quants and the use of super computers to findinefficiencies in the market?
Lynch: Yes. 20th Century Growth has had a good record. BradLewis at Fidelity went to Annapolis, then Wharton, and was a basicfundamental analyst and loved quantitative things. Now he’s runningDisciplined Equity and Stock Selector using artificial intelligence withan incredible amount of variables. He’s really in the forefront ofquantitative methods. He runs a high speed computer to chew outhundreds and hundreds of variables.
Tanous: What do you think of it?
Lynch: It works. I’ve seen the results. This is a very objectivebusiness. That’s not true in everything. For example, people mightsay, I’m dealing with the top urologist or the top cardiovascular sur-geon. But who’s in the bottom quartile of cardiovascular surgeons?Did you ever hear anybody say I’m going to a bottom quartile ortho-pedic surgeon? I mean, everybody thinks they’re dealing with the topneurosurgeon. Have you ever heard anybody say, I’m going to seethis person and he or she is at the bottom? But our business is object-ive. We measure everybody. So I’m saying that this guy, Brad Lewis,has done a terrific job.
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Your question was what’s my opinion of quants? When I see aquant who has done a good job over a period of time, I say theremust be a method to this. There’s been a long enough period to proveit. But it has to make sense. I mean, if they sit in the park with 23varieties of trees and the method involves observing which leavescome off and that worked, I still wouldn’t put my money in it. Butthe quantitative method has made sense, dealing with profit margins,inventory turnover, balance sheet changes and hundreds of variablesthat you can’t possibly balance in your head. They might say, rightnow the market is pricing earnings momentum, so they give moreweight to that. They might say that at certain moments in time, certainfactors are more important than others, and that makes sense to me.There are a certain number of variables that are impossible for a hu-man being to deal with and process all together.
I do it both ways. If the results are positive, I ask if it makes sense.If the answer is yes, then I would invest on it.
Tanous:I want to share with you an excerpt from an interview Idid with Bill Sharpe, who won the Nobel Prize in Economics. Likemost academics, he’s a believer in passive management. At a lectureat University of Virginia’s Darden School in 1990, he specificallycited your great performance and your outstanding selection ability.When I discussed this with him, he also said