This the second part of our Book Review of One Up on Wall Street by Peter Lynch. This book is probably the most known work of 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.
We will continue here with the list of favorable characteristics a company should have in Lynch’s opinion for stock picking.
- It is a user of technology: Lynch, who at the time was just starting 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.
- The insiders are buyers: this is a simple but important suggestion. When insiders are buyers (better if more than one insider), it usually means good news for the future prospects of the company. On the other hand, when insiders are sellers, investors should investigate the reasons behind the fact with skepticism but should not consider the event as being “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 the increase in stock prices after the 2008 Financial Crisis (remember that Lynch wrote this book in 1989 and he slightly updated it in 2000).
Financial Metrics
On a slightly more technical side, Lynch suggests looking at the P/E ratio and 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.
Regarding the 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 variation of the more famous PEG ratio, would signal a good investment if exceeding 1.5 - 2.
Looking at debt, Lynch warns prospective investors of 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 with an “academic” jargon 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 variation of the endowment effect, this particular bias pushes investors to 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 earlier on.
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 been able to spot the successful stock if not for a given set of events. For instance, investors looking at the price of Tesla at the end of 2020 might feel a sense of regret not having invested in it at the beginning of the year, even though those returns were far from guaranteed.
All in all, this book is a good addition to any beginner financial education library and it is an advised read to anyone approaching stock investing for the first time. For the practitioner, the reading might seem redundant at times or too simplified in some chapters.
Even so, I suggest this reading to anybody interested in a helpful refresher from a very successful investor (Peter Lynch), always taking into account the historical context surrounding the book.
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