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New York Society of Security Analysts Presents Strategies of Great Investors. Instructor: John M. Longo, Ph.D., CFA Finance Department, Rutgers Business School Chairman of Investment Committee, The MDE Group November 15, 2005.

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new york society of security analysts presents strategies of great investors

New York Society of Security AnalystsPresentsStrategies of Great Investors

Instructor: John M. Longo, Ph.D., CFA

Finance Department, Rutgers Business School

Chairman of Investment Committee, The MDE Group

November 15, 2005

slide2

Q: Why Can Using Public Information (on the Internet or elsewhere) Add Value Or Help Result In Superior Investment Performance?(* Let’s Have A Picture Reveal The Answer *)

slide3

Q: How

Would

You

Describe

The

Woman

In The

Picture?

the human element in stock prices
The Human Element In Stock Prices

Two people can look at the same exact picture (or company) and come to completely opposite conclusions.

Unlike the laws of physics (e.g. gravity, motion, etc.) there is no formula that can consistently forecast security prices – mainly due to the (irrational?) human element.

mosaic theory
Mosaic Theory

Mosaic Theory – Obtain bits and pieces of public information and weave them together into a new, unique picture that others do not clearly see.

program summary
Program Summary
  • No investment strategy works all the time. Studying the strategies of successful investors may help you discover the strategy that works best for you and may help you avoid costly mistakes. Find the strategy that best fits your skill set, resources, and personality type.
nature of investment strategies
Nature Of Investment Strategies
  • What is Your Advantage?
    • Superior Information
    • Receive market-moving material before others (difficult in the Internet Age and in the presence of Insider Trading laws.)
    • Use of relevant information sources with limited distribution (e.g. obscure website, bulletin board, newsgroup, newsletter, etc.)
nature of investment strategies cont d
Nature Of Investment Strategies (cont’d)
  • What is Your Advantage?
    • Superior Execution of Strategy (Very Important With High Turnover Strategies)
    • Low transaction costs.
    • Minimal market impact when executing trades.
    • Direct access vs. agency execution.
    • Market vs. Limit Orders.
nature of investment strategies cont d1
Nature Of Investment Strategies (cont’d)
  • What is Your Advantage?
    • Superior Interpretation of Public Information (Mosaic Theory)
    • Unique insight in interpreting publicly available information.
    • Use of superior technology to aggregate relevant, disparate information sources (e.g. multiple ECN and exchange data feeds).
    • Superior qualitative or quantitative proprietary models.
nature of investment strategies cont d2
Nature Of Investment Strategies (cont’d)
  • Length of Strategy Effectiveness (Fleeting vs. Eternal, Static vs. Dynamic)
  • Successful strategies often self-destruct.
  • Successful investors attract attention.
  • People reverse engineer successful strategies.
  • Too much money chasing too few investment opportunities reduces returns.
  • Make plans for a new strategy before your existing one begins to falter.
types of strategies
Types of Strategies
  • Strategy Type: Quantitative vs. Qualitative
    • Qualitative: Flexible in dealing with all scenarios, but difficult to back-test and stress test strategy.
    • Quantitative: Easy to back-test and stress test strategy, but may backfire when operating in a new, unseen market environment (e.g. trading post 9/11)
    • Combination: Quantitative model that can be overruled or enhanced by human qualitative judgment.
strategy complexity
Strategy Complexity
  • Strategy Complexity: Univariate vs. Multivariate
    • Occam’s Razor Principle: when choosing between two theories of similar explanatory power, the simpler method is preferred.
    • “You cannot earn excess returns unless you obtain information that is not already discounted in the market.” – Stephen Ross, renowned MIT Finance Professor.
strategy complexity cont d
Strategy Complexity (cont’d)

“The people who profit from the market are those people who are able to identify the anomalies not yet seen by the market.”

Sanford Grossman,

Renowned Wharton Finance Professor and successful hedge fund manager.

benjamin graham
Benjamin Graham

Q: Who is this person?

A: Benjamin Graham is known as the father of Value Investing and pioneered a rigorous, quantitative approach to Security Analysis. Graham was a successful money manager and also taught at Columbia University, where he and fellow faculty member David Dodd wrote Security Analysis – the “Bible” of Value Investing, first published in 1934.

benjamin graham cont d
Benjamin Graham (Cont’d)

Q: Who is this person? (Cont’d)

A: Warren Buffett and John Templeton were among the many successful investors who took Graham’s course. Graham was also a founding member of an organization of professional security analysts.This organization is now known as the New York Society of Security Analysts.

benjamin graham cont d1
Benjamin Graham (Cont’d)

Q: What are the main concepts of his strategy?

A: Value approach with a “margin of safety.” Focused on quantitative measures of value and strongly preferred existing assets and current earnings over promises of future profits/returns.

benjamin graham cont d2
Benjamin Graham (Cont’d)

“To have a true investment, there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.” 

“Investment is most intelligent when it is most businesslike.”

benjamin graham cont d3
Benjamin Graham (Cont’d)

“Every corporate security may be best

viewed in the first instance as an ownership

in, or a claim against, a specific business

enterprise.”

Over the long-run performance of both

companies and share prices generally revert

to the mean.

benjamin graham cont d4
Benjamin Graham (Cont’d)

Order of preference in determining value:

1) Value of existing assets.

2) Value of current earnings power.

3) Value of potential growth – only in rare cases and if the growth is within the core competence or franchise of the firm and benefits from some sustainable competitive advantage.

benjamin graham cont d5
Benjamin Graham (Cont’d)
  • “Net-Net” approach was a favorite strategy
    • “Net-Net” stocks -> Market Cap < (Current Assets – Current Liabilities)
    • In other words, the stock is trading below net cash value.
  • These stocks are difficult to find in the present market, but were more abundant during the Great Depression when Graham and Dodd first published their seminal work.
benjamin graham cont d6
Benjamin Graham (Cont’d)
  • Recognizes the role of psychology in investing.
  • “The investor’s chief problem – even his worst enemy – is likely to be himself.”
  • Focuses on investment, not speculation
  • “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting the requirements are speculative.”
benjamin graham cont d7
Benjamin Graham (Cont’d)
  • Regards growth stocks as a whole as too uncertain and risky a vehicle for the defensive investor.
  • “Of course, wonders can be accomplished with the right individual selections … But the average investor can no more accomplish this than to find money growing on trees. In contrast, we think the group of large companies that are relatively unpopular, and therefore obtainable at reasonable earnings multipliers, offers a sound if unspectacular area of choice by the general public.”
benjamin graham cont d8
Benjamin Graham (Cont’d)
  • Seven quality and criteria suggested for the selection of common stock for the defensive investor:
    • Adequate size of the enterprise (Measured in sales, $100MM in 1971 dollars.)
    • A sufficiently strong financial condition (e.g. credit rating)
    • Earnings stability – positive earnings for 10+ consecutive years.
benjamin graham cont d9
Benjamin Graham (Cont’d)
  • Seven quality and criteria suggested for the selection of common stock for the defensive investor: (Cont’d)
    • Dividend record – 20+ years is preferred.
    • Earnings growth – min increase of at least 1/3 in EPS in past 10 years using 3 years averages at the beginning and end.
    • Moderate P/E ratio -> current price should not be more than 15x average earnings over the past 3 years.
    • Moderate ratio of price to Assets
      • < 1.5 Book value (unless P/E < 15) orP/E * Price / Book <22.5 (= <15 P/E *1.5 Book)
benjamin graham cont d10
Benjamin Graham (Cont’d)
  • “If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ.” (Ed. Note: Value investors are often contrarian, going against the crowd at large.)In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.”
  • “To achieve satisfactory investment results is easier than most people realize. To achieve superior results is harder than it looks.”
t rowe price jr
T. Rowe Price, Jr.

Q: Who is this person?

A: T. Rowe Price, Jr. is one of the pioneers of Growth Investing. He was a successful fund manager and founded the large mutual fund company, T. Rowe Price. He is perhaps best known for his company life cycle approach to investing.

t rowe price jr cont d
T. Rowe Price, Jr. (Cont’d)

Q: What are the main concepts of his strategy?

A: Corporations have life cycles. Buy when earnings are increasing / accelerating to maximize return and reduce risk.

t rowe price jr cont d1
T. Rowe Price, Jr. (Cont’d)
  • Price’s Goal: “To maintain purchasing power of both income and principal with the minimum risk of loss of principal and reduction of income.” (Ed. Note: This goal is somewhat inconsistent with investing in Growth stocks since many “blow up” when projections are missed and/or the expected growth does not materialize.)
t rowe price jr cont d2
T. Rowe Price, Jr. (Cont’d)
  • “Corporations, like people, have life cycles. Risks increase when maturity is reached.”
  • Three phases of the corporate life cycle:
      • Growth (growing faster than economy)
      • Maturity (at or near maximum earnings)
      • Decadence (experience long-term secular decline in earnings)
t rowe price jr cont d3
T. Rowe Price, Jr. (Cont’d)
  • There are greater gain possibilities and less risk of loss while the earnings trend is growing.
  • “Because the economic or business cycle runs concurrently with a company’s life cycle, it is difficult to determine in advance when earnings power is on the decline. Research and an understanding of social, political, and economic trends should enable one to recognize the change in long-term earnings trend of business.”
t rowe price jr cont d4
T. Rowe Price, Jr. (Cont’d)
  • Price on measuring industrial life cycles:
  • The two best ways of measuring the life cycle of an industry are:

1) unit volume of sales and

2) net earnings.

t rowe price jr cont d5
T. Rowe Price, Jr. (Cont’d)
  • According to Price, there are two major types of growth stocks.

1) Cyclical Growth (tied to economy – e.g. Autos in the 1950’s)

2) Stable Growth (not tied to the economy – e.g. Healthcare, Beverages, etc.)

  • An emphasis on Stable Growth should be preferred when the market seems expensive (see below on metrics to assess market valuation) and visa versa.
phillip fisher
Phillip Fisher

Q: Who is this person?

A: Philip Fisher is one of the pioneers of Growth Investing. His work (along with Graham’s) has had a profound impact on Warren Buffett, arguably the greatest investor ever. Fisher was one of the first to do traditional fundamental analysis (beyond looking at a company’s financials) using his “scuttlebutt” method - talking to management, competitors, suppliers, former employees, etc. His son, Ken Fisher is a well-known investor and columnist for Forbes.

phillip fisher1
Phillip Fisher

Q: What are the main concepts of his strategy?

A: Identify Growth Stocks with rapidly growing sales and earnings. Enhance traditional fundamental analysis (i.e. analyze financial statements) with legwork or by uncovering “scuttlebutt” - talking to management, competitors, suppliers, former employees, etc.    

phillip fisher2
Phillip Fisher

Q: What are the main concepts of his strategy?

A: Identify Growth Stocks with rapidly growing sales and earnings. Enhance traditional fundamental analysis (i.e. analyze financial statements) with legwork or by uncovering “scuttlebutt” - talking to management, competitors, suppliers, former employees, etc.

phillip fisher3
Phillip Fisher
  • In Fisher’s seminal book on Growth Investing, Common Stocks and Uncommon Profits, he identifies 15 factors to look for when buying common stock: (emphasis added) 

1) Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?  

phillip fisher4
Phillip Fisher

2) Does management have a determination to continue to develop products or processes that will still further increase in total sales potential when the growth potential of currently attractive product lines have largely been exploited?

3) How effective are the company’s research and development efforts in reflection to its size?

4) Does the company have an above average sales organization?

phillip fisher5
Phillip Fisher

5) Does the company have a worthwhile profit margin?

6)  What is the company doing to maintain or improve profit margins?

7) Does the company have outstanding labor and personal relations?

8) Does the company have outstanding executive relations?

9)  Does the company have depth to its management?

10) How good are the company’s cost analysis and accounting controls.

phillip fisher6
Phillip Fisher

11) Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?

12) Does the company have a short-range or long-range outlook in regards to profits?

13) In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel?

phillip fisher7
Phillip Fisher

14) Does the management talk freely to investors about its affairs when things are going well, but “clam up” when troubles and disappointments occur?

15) Does the company have management of unquestionable integrity?

phillip fisher8
Phillip Fisher

Fisher also discussed three reasons to sell a stock: (emphasis added)

1) When a mistake has been made in the original purchase and it becomes increasingly clear that the factual background of the particular company, is by a significant margin, less favorable than originally believed.

phillip fisher9
Phillip Fisher

2) Sales should always be made of the stock of a company which, because of changes resulting from the passage of time no longer qualifies … to about the same degree it qualified at the time of purchase (e.g. determination of management, market has changed) (Ed. Note: Sell when stock does not meet many of the 15 hurdles discussed above.)

3) Opportunities for attractive investment are extremely hard to find. (Ed. Note: perhaps suggesting the market is overvalued)

phillip fisher10
Phillip Fisher
  • Fisher advocated a moderately sized portfolio since owning too many stocks made it impossible to “watch all the eggs in all the different baskets.”
  • He felt buying a company without a detailed understanding of the business may be more risky than having limited diversification.
warren buffett
Warren Buffett

Q: Who is this person?

A: Arguably the greatest investor ever. Buffett was a student of Graham’s at Columbia, worked for Graham, and later set up his own investment partnership. He eventually closed his investment partnership in 1969 because he felt the market was overvalued. Since that time, he has used Berkshire Hathaway as his primary investment vehicle. Buffett consistently ranks among the Top 5 on Forbes’ list of the richest people in the world.

warren buffett1
Warren Buffett

Q: What are the main concepts of his strategy?

A: Buffett describes himself as “15% Fisher and 85% Benjamin Graham.” He is predominantly known as a Value Investor who’s “favorite holding period is forever.”

warren buffett2
Warren Buffett
  • Buffett: Synthesis of Benjamin Graham and Philip Fisher.
    • “I’m 15% Fisher and 85% Benjamin Graham.”
    • (Ed. Note: Buffett’s long time partner, Charlie Munger, brought Fisher to his attention.)
  • Buffett: First student of Graham, then employee of Graham, then collaborator/ peer.
warren buffett3
Warren Buffett
  • Buffett’s approach – combine a qualitative understanding of the business and its management (learned from Fisher) with a quantitative understanding of price and values (learned from Graham).
  • Buffett called Graham’s “Net-Net” strategy the “cigar butt” approach (one or two puffs left, for a cheap price.)
  • According to Buffett, the last time it was easy to profit from Graham’s “Net-Net” strategy was 1973-74.
warren buffett4
Warren Buffett
  • Buffett:
    • Says he cannot predict short-term market movements and does not believe that anyone else can.
    • Does not commit any resources to judging economic cycles (or politics).
    • Says there is no difference between buying a business and shares in a business. (concurs with Graham)
    • Looks for companies selling at attractive valuations.
warren buffett5
Warren Buffett
  • Buffett (cont’d):
    • Looks for companies he understands with favorable long-term prospects,
    • Looks for companies that are operated by honest and competent people.
warren buffett6
Warren Buffett
  • In his book, The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor, Robert Hagstrom distilled Buffett’s approach to investing into a number of tenets or principles. (Ed. Note: Hagstrom did have access to and conversations with Buffett before publishing the book. Warren Buffett has never published a book on his investment philosophy, but writes a detailed letter to shareholders annually.)   
warren buffett7
Warren Buffett

Buffett’s Tenets, According To Robert Hagstrom

  • Business Tenets - Three basic characteristics of the business itself.
    • Management Tenets – Three important qualities that senior management must display.
    • Financial Tenets – Four critical financial decisions that the company must maintain.
    • Market Tenets – Two interrelated cost guidelines.
warren buffett8
Warren Buffett

Business Tenets

1) Is the business simple and understandable?

2) Does the business have a consistent operating history?

3) Does the business have favorable long-term prospects?

warren buffett9
Warren Buffett

Management Tenets

1) Is the management rational?

2) Is management candid with the shareholders?

3) Does management resist the institutional imperative? (The tendency of corporate management to imitate the behavior of other managers)

warren buffett10
Warren Buffett

Financial Tenets

1) Focus on return on equity, not earnings per share.

2) Calculate “owner earnings (approx. = net income + non cash charges – capital expenditures and any additional working capital that might be needed) to get a true reflection of value.

3) Look for companies with high profit margins.

4) For every dollar retained, make sure the company has created at least one dollar of market value.

warren buffett11
Warren Buffett

Market Tenets

1) What is the value of the business?

2) Can the business be purchased at a significant discount to its value?

warren buffett12
Warren Buffett

Hagstrom creates a 4-Step summary of

Buffett’s strategy (The Warren Buffett

Way)

  • Step 1: Turn off the stock market.
  • Step 2: Don’t worry about the economy.
  • Step 3: Buy a business not a stock.
  • Step 4: Manage a portfolio of businesses.
john templeton
John Templeton

Q: Who is this person?

A: John Templeton was a student of Graham’s and one of the pioneers of International Investing. He founded Templeton funds (now Franklin Templeton).

john templeton1
John Templeton

Q: What are the main concepts of his strategy?

A: Value investor who said, “If you search worldwide, you will find more bargains and better bargains than by studying only one nation.”

john templeton2
John Templeton

Templeton prefers to invest in countries that exhibit the following characteristics:

  • Less government ownership.
  • Less government regulation.
  • Less quarrelsome unions.
  • Lower taxes.
  • Higher research budgets.
  • People who are honest and reliable.
  • People who are farsighted, rather than short sighted.
  • Higher rate of savings.
john templeton3
John Templeton

In his book, The Templeton Touch, William

Procter listed twenty-two guiding

principles (or maxims) that Templeton said

have been instrumental in his success. I list

those that are most interesting in my

opinion. For the full list of maxims, please

consult Procter’s book.

john templeton4
John Templeton

1. For all long-term investors, there is only one objective. Maximize total return after taxes.

3. It is impossible to produce a superior performance unless you do something different from the majority.

4. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

john templeton5
John Templeton

8. If a particular industry or type of security becomes popular with investors, that popularity will always prove temporary and when lost, wont’ return for many years.

9. In the long-run, the stock market indexes fluctuate around the long-term upward trend of earnings per share.

john templeton6
John Templeton

15. If you search worldwide, you will find more bargains and better bargains than by studying only one nation (and provided increased diversification.)

17. The time to sell an asset is when you have found a much better bargain to replace it.

18. When any method for selecting stocks becomes popular, then switch to unpopular methods.

john templeton7
John Templeton

19. Never adopt permanently any type of asset or any selection method. Try to stay flexible, open-minded, and skeptical.

20.The best performance is produced by a person, not a committee.

john neff
John Neff

Q: Who is this person?

A: John Neff is one of the most celebrated mutual fund managers in history. He managed Vanguard’s Windsor Fund for more than 31 years. When Windsor closed its doors to new investors in 1985, it was the largest mutual fund in America. During Neff’s 31-year tenure as the portfolio manager of Windsor, the Fund increased in value 5,546% vs. a 2,299% gain for the S&P 500.

john neff cont d
John Neff (Cont’d)

Q: What are the main concepts of his strategy?

A: Buy low P/E stocks, watch the fundamentals, and use common sense.

john neff cont d1
John Neff (Cont’d)

Further Details on Neff’s Strategy

  • Assigns great weight to a judgment about the durability of earnings power under adverse circumstances.
  • Tried to create an impact by taking outsized positions where he saw promising returns.
  • Conducted exhaustive fundamental analysis (i.e., legwork, scuttlebutt, financial statement analysis, etc).
john neff cont d2
John Neff (Cont’d)

Introduces concept of “Measured Participation”

  • Measure degree of participation in one stock against the relative risks and rewards one would expect to find in other market sectors. (Ed Note: This sounds like an analysis of benchmark risk + valuation)
  • Assess firms on the basis of quality, marketability, growth, and economic characteristics.
john neff cont d3
John Neff (Cont’d)
  • Followed a durable investment style whether the market was up, down, or indifferent:
    • Low P/E ratio.
    • Fundamental growth in excess of 7%
    • Yield protection (and enhancement in most cases).
    • Superior relationship of total return to P/E (see Neff Formula For Value below)
    • No cyclical exposure without compensating P/E multiple.
    • Solid companies in growing fields.
    • Strong fundamental case.
john neff cont d4
John Neff (Cont’d)
  • Neff Formula For Value:(Projected Earnings Growth + Dividend Yield) / (P/E)

The higher the more undervalued.  

No solitary measure or pair of measures should govern a decision to buy a stock.

john neff cont d5
John Neff (Cont’d)

Neff on investing in cyclical (e.g. Autos, Steel,

Paper, etc.) stocks:

  • Buy after one cycle has decimated its stock price, but before earnings improvement becomes apparent to everyone.
  • A low P/E strategy typically makes maximum money 6-9 months before cyclical companies report better earnings.
john neff cont d6
John Neff (Cont’d)

Neff on Investing in Growth stocks:

  • Projectable growth rates of 12-20%
  • Single digit earnings multiples of 6-9x Earnings (Ed. Note: rare to find in today’s market)
  • Dominance or major participation in definable growth rates.
  • Easy industries to understand.
john neff cont d7
John Neff (Cont’d)

Neff on Investing in Growth stocks (cont’d):

  • Unblemished record of double-digit historical earnings growth.
  • Outstanding ROE, therein signifying management accomplishment and capacity to finance growth.
  • Significant Market Capitalizations and Net Income totals thereby qualifying companies for institutional consideration.
  • Prefers (but not essential) some Wall Street coverage, so “those that needs their hand held will have a wet nurse.”
  • 2-3.5% Dividend Yield in most cases.
john neff cont d8
John Neff (Cont’d)

Neff suggests investors watch three areas

of the economy for signs of excess.

1) Capital expenditures

2) Inventories

3) Consumer credit

john neff cont d9
John Neff (Cont’d)

Reasons To Sell:

1) Fundamentals have deteriorated.

2) Price approaches expectations.

david dreman
David Dreman

Q: Who is this person?

A:David Dreman is a successful money manager and one of the pioneers of examining the relationship between psychology and the financial markets. This field of study is now known as Behavioral Finance. Dreman is also a columnist for Forbes magazine.

david dreman1
David Dreman

Q: What are the main concepts of his strategy?

A: Contrarian, Value investor who favors low P/E stocks. He is also keenly aware of investor and market psychology.

Further Details on Dreman’s Strategy:In his book, Contrarian Investment Strategies: The Next Generation, Dreman lists over 40 Rules that wise investors should heed. I list those that are most interesting in my opinion. For the full list of rules, please consult Dreman’s book.

david dreman2
David Dreman
  • Rule 1: Do not use market timing or technical analysis. These techniques can only cost you money.
  • Rule 2: Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth profits.
  • Rule 5: There are no highly predictable industries in which you can count on analysts’ forecasts. Relying on these estimates will lead to trouble.
david dreman3
David Dreman
  • Rule 6: Analysts’ forecasts are usually optimistic. Make appropriate downward adjustments.
  • Rule 10: Take advantage of the high rate of analyst forecast error by simply investing in out of favor stocks.
  • Rule 13: Favored stocks underperform the market while out of favor companies outperform the market, but the reappraisal often happens slowly, even glacially.
david dreman4
David Dreman
  • Rule 14: Buy solid companies currently out of market favor, as measured by their low Price / Earnings, Price / Cash Flow, or Price / Book value ratios and their high Dividend Yields.
  • Rule 18: Invest equally in 20 to 30 stocks, diversified among 15 or more industries.
  • Rule 21: Sell a stock when its P/E Ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable prospects may appear. Replace it with another contrarian stock.
david dreman5
David Dreman
  • Rule 29: Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don’t sell.
  • Rule 41: A given in markets is that perceptions change rapidly.
peter lynch
Peter Lynch

Q: Who is this person?

A: Peter Lynch is arguably the most successful mutual fund investor ever. During the thirteen years that Lynch managed the Fidelity Magellan Fund (1977-1990) a $1,000 investment in the Fund would have grew to $28,000. At the time of Lynch’s retirement from active management in 1990, the Magellan Fund was the largest mutual fund in the world (subsequently passed by Vanguard’s S&P 500 Index Fund.)

peter lynch1
Peter Lynch

Q: What are the main concepts of his strategy?

A: Lynch advocates investing in what you already know in order to make money in the market. He follows up this common sense with rigorous fundamental analysis. His investing philosophy would generally fall in the Value camp, but he also has had success investing in Small Cap and Growth stocks.

peter lynch2
Peter Lynch

Further Details on Lynch’s Strategy

Lynch’s Common Sense Approach:

  • “Take advantage of what you already know.”
  • Ex: Lynch bought Dunkin’ Donuts because he liked the coffee (and subsequent fundamental analysis confirmed it as a buy)
  • “The average person is exposed to interesting local companies and products years before professionals.”
peter lynch3
Peter Lynch
  • Don’t overestimate the skill and wisdom of professionals.
  • Suggests looking for opportunities that haven’t yet been discovered by Wall St. – companies that are “off the radar scope.”
peter lynch4
Peter Lynch

Lynch’s Philosophy is largely consistent with Graham & Buffett’s.

  • Invest in companies, not the stock market.
  • Ignore short-term fluctuations.
  • Predicting the economy is futile.
peter lynch5
Peter Lynch

Lynch’s Philosophy (Cont’d)

  • In the stock market, one in the hand is worth ten in the bush.
  • However, he appears to be less concerned with strict valuation measures.
  • “If the story is still good and earnings keep growing, then of course it can go higher.”
peter lynch6
Peter Lynch

Lynch’s Suggested Stock Hunting Grounds

He:

  • Prefers small companies that are already profitable and have proven that their concept can be replicated.
  • Is suspicious of companies with growth rates of 50% to 100% a year.
  • Generally avoids hot stocks in hot industries.
  • Prefers simple companies that appear dull, mundane, out of favor, and haven’t caught the fancy of Wall Street.
peter lynch7
Peter Lynch

Lynch’s Suggested Stock Hunting Grounds (Cont.)

  • Suggests moderately fast growers (20 – 25%) in non-growth industries are ideal investments.
  • Looks for companies with niches.
  • Looks for companies that consistently buy back their own shares
  • Looks for companies with little or no institutional ownership.
  • Views, insider buying as a positive sign, especially when several individuals are buying at once.
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Peter Lynch

Lynch on Fundamental Analysis

  • “Understand the nature of the companies you own and the specific reasons for holding the stock.”
  • Suggests carefully consideration of the P/E ratio as a valuation metric. “If the stock is grossly overpriced, even if everything goes right, you won’t make any money.”
  • Distrusts diversifications, which usually turns out to be what he terms “diworseifications.”
  • Steers away from long shots since they “almost never pay off.”
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Peter Lynch

“Companies that have no debt, cannot go bankrupt.”

Bases his purchases on the company’s prospects, “not on the president’s resume or speaking ability.”

Views market declines as an opportunity to buy stocks in companies he likes.

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Peter Lynch

“Just because a company is doing poorly, doesn’t mean it can’t do worse.”

“Buying a company with mediocre prospects just because the stock is cheap is a losing technique.”

“You won’t improve results by pulling out the flowers and watering the weeds.” (e.g. Cutting Winners and holding Losers)

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William O’Neil

Q: Who is this person?

A: William O’Neil is the publisher of Investors Business Daily – viewed by some as an investor focused complement to The Wall Street Journal.

His book, How To Make Money In Stocks is a bestseller and introduced his Growth strategy, C-A-N-S-L-I-M.

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William O’Neil

Q: What are the main concepts of his strategy?

A: His main strategy is the C-A-N-S-L-I-M method, which falls under the Growth approach. It is also considered by some to be a trading strategy vs. a long-term buy and hold strategy.

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William O’Neil (Cont’d)

Further Details on O’Neil’s Strategy 

  • Some critics claim O’Neil is advocating momentum investing. O’Neil retorts:
  • “We’re buying companies with strong fundamentals, large sales and earnings increases resulting from unique new products or services and trying to time the purchases at a correct point as the company emerges from the consolidation period and before the stock runs up dramatically in price.”
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William O’Neil (Cont’d)

C-A-N-S-L-I-M Method For Stock

Selection:

C = Current Quarterly Earnings Per Share

They must be up at least 18%.

A = Annual Earnings Per Share

They should show meaningful growth for at least

the last 5 years.

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William O’Neil (Cont’d)

N = New

Buy companies with new products, new management, or

significant new changes in their industry conditions. Most

importantly, buy stocks as they make new highs in price. 

S = Supply and Demand

There should be a small or reasonable number of shares

outstanding, not large capitalization, older companies. And

look for volume increases when a stock starts to move up.

L = Leaders

Buy market leaders, not laggards.

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William O’Neil (Cont’d)

I = Institutional Sponsorship

Buy stocks with at least a few institutional

sponsors with better than average recent

performance records.

M = The General Market

It will determine whether you win or lose, so learn

to interpret the daily general market indexes (price

and volume changes and action of the individual

leaders) to determine the overall market’s current

direction.

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William O’Neil (Cont’d)
  • Suggests Setting Stop-Loss Orders:
    • Limit your losses to 7% - 8% (Ed Note: Thisstrategy implies a very high turnover.)
  • Trading strategy: Take 20% profits when you have them (except with the most powerful of all stocks) and cut losses at 8%.
suggestions for further reading
Suggestions for Further Reading
  • I. Textbook

Z. Bodie, A. Kane, and A. Marcus, Investments. Publisher: McGraw-Hill/Irwin; 5th edition (July, 2001).

This is the most popular Investments textbook used by MBA programs.

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Further Reading Cont’d
  • II. Journal Articles / Investor’s Anthology

J. Vertin and C. Ellis (Editors), Classics: An Investor's Anthology. Publisher: Richard d Irwin; (November 1989).

This anthology provides a nice overview of investing articles published in academia and on Wall Street.

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Further Reading Cont’d
  • III. Investor Psychology / Behavioral Finance

H. Shefrin, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. Publisher: Oxford University Press; (January 2000).

This is a very readable and informative book on the topic of Investor Psychology / Behavioral Finance.

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Further Reading Cont’d
  • IV. Strategies of Professional Investors

P. Lynch, with J. Rothchild, One Up on Wall Street: How to Use What You Already Know to Make Money in the Market. Publisher: Fireside; (April 2000).

Peter Lynch, one of the world’s most successful investors, shares some of his investing secrets.

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Further Reading Cont’d
  • Benjamin Graham, The Intelligent Investor. Publisher: Collins Business Essentials; Updated, revised edition (2005).

This is a good book (originally) written by the greatest investment advisor of the twentieth century.