One Up on Wall Street is probably one of the most famous from investor and former portfolio manager of Fidelity Investment Management, Peter Lynch. Lynch is known for having championed the GARP method (Growth at Reasonable Price) in Equity Research. This book is a good read for beginners and retail investors. It might not be an exciting read for practitioners and/or people with graduate degrees in finance, but I think it can still be a good refresher for most, especially for the ones willing to explore a different point of view on basic rules for equity research. Another negative of this work is that it is quite outdated, being written in 1989 and has received a partial update in 2000. Nevertheless, it is still interesting to see how equity research has evolved over time and most importantly how a great investor like Lynch was thinking back then about stock picking.
The first chapters, at least until the eight, are really basic and contain only a handful of useful investment heuristics. The most useful heuristic from this part is probably the one that says that the layman will start talking about stocks at the exact moment in which the market becomes overvalued. This is a useful suggestion to keep in mind, giving that it stems from behavioral finance, which suggests that individuals tend to look for confirmation in other people about something they have heard and reinforce their beliefs in a feedback loop (confirmation bias).
Probably the most important tips come from chapter 8, where Lynch lays down his main investment philosophy in picking stocks. Some other heuristics are laid down in this section regarding stock picking. A stock should have the following characteristics to be considered:
It sounds dull (i.e. it does not change its name to Long Blockchain Corp from Long Island Iced Tea Corp., which really happened two years ago)
It does something dull: the rationale here is that investors often overlook boring businesses that have the potential to develop in a niche industry.
It does something disagreeable: this is actually the opposite of modern ESG investing (ESG concepts were non-existent before 2010). Lynch argues that some of the best deals are found in stocks associated with disagreeable businesses, like tobacco or funeral services, which might be overlooked by investors for moral reasons or just because they dislike the business itself.
It is a spinoff: still, a valid point to these days, Lynch, who was wary of the mergers frenzy of the sixties, saw spinoffs as a way to unleash hidden value in a corporation which could then specialized in their core business. Recently, Valuation guru Damodaran also argued against investing in companies dedicated to growth through acquisitions.
It is ignored by institutional investors and analysts: this characteristic might be very difficult to find in the overcrowded financial markets of our times, but again here Lynch suggests that the best deals are found away from the “hot stocks” of the moment.
It is a no-growth industry: the rationale here is that companies in no-growth industries are pushed to improve themselves through cost-cutting and process improvement, rather than being lifted by the overall performance of their industry. Moreover, it is likely that companies in no-growth industries face considerably less competition with respect to companies in popular industries.
It has a niche: a company focusing on a niche is more likely to have a “moat”, that is a competitive advantage that makes it difficult to be challenged by new entrants.
The customer needs to keep buying the products: here Lynch foresaw the appeal of subscription-based services on companies’ profitability and stability of earnings that we are witnessing in our times (i.e. Netflix, Amazon Prime, Gym memberships). Lynch argues that a company with steady cash flows coming from a loyal customer base which keeps buying the product over time (he makes the example of Philip Morris) is preferable over a company which may come up with a fancy product to boost sales that are not sustainable and stable over time.
It is a user of technology: Lynch, who at the time was beginning to see the rise of technology (and the bubble forming in internet stocks), suggests that economies of scale can be found in companies that gain from increased competition and declining prices in the technological sector. For example, Automatic Data Processing, a payroll processing company, was getting increasingly profitable while computers were getting cheaper. Fast forward 30 years and ADP is one of the top Fortune 500 companies. Where is Webvan now?
The insiders are buyers: this is quite a simple but important suggestion. When insiders are buyers (more than one insider), it usually means good news for the future prospects fo the company. On the other hand, when insiders are sellers, the investor should investigate with skepticism but should not consider the event as bad news per se: it might be that the insider seller is engaging in portfolio diversification.
The company is buying back shares: this is self-explanatory and indeed was the biggest driver of stock prices after the 2008 Financial Crisis (remember that Lynch wrote this book in 1989 and slightly updated it in 2000).
Financial metrics
On a slightly more technical side, Lynch suggests looking at the P/E ratio and on debt levels as the main criteria in stock screening. Moreover, he suggests that companies with a large amount of cash in relation to the size of the balance sheet are more attractive, provided that they do not spend it on harmful acquisitions. For P/E ratio, he suggests looking for P/E ratios of at least half of the company’s growth rate and below two times the growth rate (a sign of overheating). Another metric he uses is the growth rate plus dividend yield over the P/E ratio. This figure, a variant of the more famous PEG ratio, would signal a good investment if exceeding 1.5/2. Regarding debt, Lynch warns prospective investors to companies with a large amount of bank debt outstanding, since bank debt is often redeemable on call from the bank and thus could hinder a company’s operations if called unexpectedly. Thus, corporate debt is preferable over bank debt.
Behavioral Biases Lynch also describes some basic behavioral biases which routinely affect retail and even institutional investors. Lynch does not name these biases in an “academic” way but mentions them multiple times throughout the book. Among these biases, we find:
Loss Aversion: the tendency of investors to get increasingly uncomfortable with a losing position and thus holding losers for too long and selling winners too early.
Confirmation bias: as mentioned before, confirmation bias sways investors in considering only information confirming their previously held views and ignoring contrarian evidence (this bias goes together with cognitive dissonance).
Endowment effect: investors tend to be emotionally attached to stocks they picked after extensive research and tend to value a given stock more when owned.
Escalation of commitment: a variant of the endowment effect, this particular bias makes investors increase their position in a given stock even when facing overwhelming evidence that the investment was a mistake.
Fear of missing out: this is not properly a bias but it can nevertheless affect an investor's judgment. Fear of missing out arises when an investor looks at a successful stock and regret not having invested in it before it rose. This irrational behavior might also lead to increased risk-taking in the future, to mentally “make-up” for the lost opportunity. A related bias in the hindsight bias, by which an investor assumes that he or she would have able to spot the successful stock if not for a given set of events.
All in all, this book is a good addition to any beginner library and to anyone who is approaching stock investing for the first time. For the practitioner, the reading might seem redundant or too simplified. Even so, I suggest this reading to anybody interested in a helpful refresher from a very successful investor, always taking into account the historical context surrounding the book.
Written by: Edoardo Cicchella
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