Peter Lynch is a well-known investor with some of the highest annualised returns on record. As manager of the Magellan Fund, a 100% equity fund, he achieved an annualised return of 29% between 1977 and 1990, a period of notable volatility. However, perhaps the most telling detail about this episode is that, despite extremely high rates of return, surprisingly, more than half of the fund’s participants lost money.
When the fund experienced sharp gains, it saw an influx from investors who wanted in on the action. When markets corrected with equal intensity, those investors sold, often at a loss, unable to weather the fluctuations, only to re-enter at higher prices.
The performance of a fund is one thing, the behaviour of investors is quite another.
This episode deeply affected Lynch. As an author, he has successfully managed to portray the average behaviour of investors and strongly maintains that beating the markets does not require great sophistication. He detailed this experience in his now classic book, Beating the Street.
One of Lynch’s key messages for long-term investors is to focus financial portfolios on shares, by far the most profitable asset on any exchange, with the advantage, moreover, of being easier to understand and value than complex bonds. Based on experience, Lynch also recommends shying away from structured products and derivatives (short transactions), where assumed risk is rarely properly offset.
Aware of the breadth of equity markets, Lynch recommends always searching where no one else is looking, a sine qua non approach to finding attractive valuations (in addition to moments with Mr. Market panics and corrects for any reason). But an attractive valuation – not necessarily measured by P/E ratio – is not enough. It is also crucial to find good businesses.
Measuring business quality is an art form. It consists of using the limited information available to estimate the future free cash flows (FCF) of a company (a central element in the fundamental analysis of any share). In this respect, Lynch suggests analysing companies whose products and services we have used for some time as a good starting point to identify these types of businesses. As Lynch points out, if we like a product, we will probably like the business too.
Another key idea, common among other great investors like Warren Buffett, is an obsession with investing in businesses that are understandable. Lynch recommends investing only in those companies whose money-making process we can explain to a third party and refraining from investing in complex businesses that escape our comprehension.
The best risk management begins with knowing what we are investing in and why.
Lynch’s book also shares some warnings for investors regarding behaviours to avoid and indications that help detect securities that may not be good investments: companies that spend huge amounts of money on representation expenses or showy corporate headquarters, a lack of alignment between managers and shareholders (“skin in the game”), and complex accounting techniques, among others.
A good book of practical wisdom on financial markets for all audiences.