Trading like a Seventh-Grader

Sometimes the best investment advice is the most obvious: invest in stocks that "make sense" to you – simply put your money in companies that you understand. That’s exactly what famed fund manager; Peter Lynch did…and look where he is now. Sala Kannan shows us how he got there…

The golf course has always been fertile ground for business talk, but for an 11-year-old caddy, it changed his life – and set him on the path to become one of the most celebrated legends of Wall Street. And the secrets that this boy picked up on the fairways during the 1950s could also help you build an incredible portfolio of small-cap winners.

Who was this club-toting wunderkind? Peter Lynch, of course, the storied fund manager of the Magellan Fund. As a boy, Lynch learned about investing in the 1950s, when he was a caddy at a posh golf club. He constantly heard corporate executives and financial bigwigs talk about stocks during their golf games. Lynch quietly noted down the names of stocks he heard about at the golf course. Then he looked up their prices and found that months later, these stocks were going up.

That process led Lynch, decades later, to the development of a stock-picking theory based on companies that "make sense." Because back then – before computers, before the quarter-to-quarter rat race, and before cutthroat global competition – the kinds of executives that Lynch caddied for invested in companies that produced the unglamorous staples of industry and daily life.

At age 33, Lynch became one of the youngest fund managers when he took over Magellan. By this time, he had had a stint in the Army and had a degree from the Wharton School of Business – giving him the kind of background that applied both practical and theoretical strategies for finding great companies that "make sense."

So for Lynch, to "make sense" meant putting the money of Magellan’s investors into businesses that were easy to understand. It meant investing in companies that made everyday products. And the payoffs were huge.

If you had put $10,000 into Magellan when Lynch took over in 1977, 13 years later, when he retired from the fund – your $10,000 would have grown into a whopping $288,000.

Peter Lynch: Keep It Simple

How did Lynch do it? His technique was to keep it simple. For example, he invested in retail stock because he understood the business – everybody needs to shop for clothes, and he observed consumer behavior through his family’s shopping sprees.

Lynch achieved great success by investing in companies he understood and by staying away from businesses that he could not understand. In fact, even Warren Buffett has often admitted that he stayed away from the tech mania of the late ’90s only because he did not understand technology and computers.

The simple policy of staying away from what you don’t understand can save you a lot of money. And investing in what you do understand can make you a ton if it.

Often, Lynch’s stock ideas came from everyday life and mundane observations. While running Magellan, Lynch was always open to any idea and ready to investigate or dig deeper, no matter where the investment idea stemmed from.

At one point, pantyhose maker, Hanes, was the fund’s largest holding, and the investment idea came from Lynch’s wife, Carolyn.

Carolyn came home one day from grocery shopping with her new find – Hanes pantyhose. She loved the product. And Lynch started investigating. He found that the average woman goes to grocery stores more often than department stores.

But the best pantyhose was sold only in department stores. Hanes, on the other hand, sold its hosiery in grocery stores as well. Lynch knew he was on to something.

He even went out and bought the products of competitor, Kaiser-Roth. He requested his employees try both products out and give him feedback. "Hanes is better," was the unanimous conclusion.

Lynch’s painstaking effort to understand Hanes and its product paid off handsomely. The stock experienced hyper-growth and yielded 500% gains for Magellan’s portfolio, and eventually got bought out by Sara Lee.

How many fund managers actually go the store, buy the product of a company they are researching and even try out its competitors’ products? This fundamental research at the grass-roots level is what distinguishes Lynch from other fund managers.

The typical mutual fund manager gets his stock picks from piles of annual reports, stock screens flickering on his computer and the mainstream media. He talks to colleagues on Wall Street for investment ideas – the people that read the same annual reports, run the same stock screens and read the same Wall Street Journal articles every day.

Peter Lynch: Where Does He Get His Inspiration?

Lynch, on the other hand, gets his investment inspiration from the mall, the streets, his daughters, his dining table and even from his barbershop.

He calls the story of how he found hair salon chain, Supercuts "My Close Shave at Supercuts." After a visit to this hair salon, and, later, some research on the company, Lynch decided he didn’t like the haircut, but loved the stock.

Lynch rationalizes his love for Supercuts like this: "The theory behind Supercuts is that hair care is a $15-40 billion industry dominated by independent barbers…Barbers are a vanishing breed. Hair grows half an inch a month. This was the perfect opportunity for a well-managed…franchise to come in and capture the market." It was that simple. Hair grows half an inch a month, and there weren’t enough people to cut it. Lynch recommended Supercuts for Barron’s that year. Regis Corp. eventually bought out the company.

What makes Lynch unique is the fact that his investment ideas come from all walks of life. Some of his best picks were introduced to him by his family.

Lynch hung out with his three teenage daughters at the mall in order to get stock ideas. On a Christmas shopping trip to the mall more than 13 years ago, Lynch’s daughters dragged him to The Body Shop – a skin and hair care products maker and retailer. While the girls delighted in kiwi lip balm, beeswax mascara and honey-oatmeal facemasks, Lynch was uncovering a fabulous investment opportunity. "The Body Shop was one of the most crowded stores in the entire mall," Lynch notes.

The Body Shop started in British housewife Anita Roddick’s garage and "from its modest beginning…was soon transformed into an international network of franchises devoted to applying fruits and salads to the skin. In spite of two big bobbles in six years, the 5 pence issue had turned into 362 pence," observes Lynch in his excellent book, Beating the Street.

Lynch was impressed by the fact that the company reported increased same-store sales in 1991, despite the recession. He also found that The Body Shop had a "price niche" — its products were costlier than those at discount stores, but cheaper than department store products.

Lynch jokes in his book that his daughters often initiate coverage on companies he buys. And their coverage on The Body Shop was profitable, indeed. Magellan’s 1989 purchase of the stock fetches roughly135% gains today.

Peter Lynch: The Individual Investor

His strategy is so simple that it suits the individual investor perfectly. In fact, the small-cap investor can make a killing a la Peter Lynch – many of Lynch’s picks started out as small caps.

Lynch himself has often said that the small scale, individual investor has an advantage over the large mutual funds – individual investors are not governed by the kinds of rules institutions have to follow. This means retail investors can invest in stocks that institutions can’t.

Also, individuals are not under pressure, like the investment banks, to tout the stocks they have taken public. Lynch was a fan of a certain group of small-scale investors: seventh-grade students at St. Agnes School, Massachusetts.

This group of students built a model portfolio of companies whose products they used and understood, like Walt Disney, Gap, Nike and Wal-Mart. The seventh-graders bought what they knew. Which is why they bought Pentech Intl. — a maker of colored pens.

This model portfolio gained 70% from 1990-92, while the S&P 500 gained 26% for the same period. And this buy-what-you-know portfolio beat 99% of all equity mutual funds during that period!

A bunch of New England seventh-graders had beaten Wall Street at its own game. And they did it simply by picking companies whose products they came across every day. The seventh-graders’ success proves Lynch’s point further – buy stocks that make sense to you.

Best regards,

Sala Kannan
for The Daily Reckoning

June 22, 2005

P.S. Just look closer to home, and you are likely to find some very well run, financially sound small caps.

Editor’s Note: From India and a graduate of the University of Cambridge, Sala Kannan boasts connections with economists and industry insiders worldwide. An expert on global economic trends, she’s especially well versed in developing nations, such as India, Brazil, Argentina and China. Sala’s passion for small-cap stocks employs time-tested research methods that bring the best international analysis anywhere. Sala Kannan is one of the talented small-cap stock analysts behind Penny Stock Fortunes’ CXS Money-Multipler System.

"Unbuilt homes selling like crazy," says a headline in USA Today.

"Like crazy" is how you’d expect to sell something that didn’t exist. Unbuilt houses are a bit like those dotcoms in the late ’90s that had not yet developed a product or a business model to exploit it. That people still paid a lot for their shares was evidence of both the level of craziness in the market and the approach of its end.

Everything comes to an end. Ordinary things come to an ordinary end. The craziest things tend to come to an end sooner – and in a more madcap way.

As we mentioned yesterday, we are watching a group of epic reversals to the mean. Throughout the broad sweep of human history, a person in China earned about as much as a person in North America or in Europe. The Industrial Revolution knocked the world out of balance. GDP per capita rose much faster in the West than in the East. But now it is in the East that wages rise – a trend likely to continue for generations as the extraordinarily high wages of the West regress to the mean.

Another major regression to the mean we are watching is the U.S. dollar. The prestige of the greenback rose with the empire behind it. Our guess is that the two will fall together. Both seem doomed by their own absurdities. Congress passed the latest Pentagon bill yesterday – a budget of $408 billion. It costs a lot of money to maintain America’s protective umbrella over the world, even when there seems little to protect against.

At the risk of boring long time Daily Reckoning sufferers and annoying new ones, we offer a two-sentence explanation of the world economy, circa 2005, under the reign of George W. Bush and Alan Greeenspan:

Asians make things and sell them to Americans, who borrow money from their suppliers (on the inflated value of their houses) in order to continue living beyond their means. Asians take their profits and either relend them to Americans…or use them to buy more productive capacity, in America and elsewhere.

(We didn’t say the sentences would be short.)

For those who wonder where this trend will lead, we offer a guess: The average American will be left with a shoeshine kit and instructions on how to say "please" and "thank you" in Chinese.

More news, from our team at The Rude Awakening:

————–

Steve Sjuggerud, reporting from Florida…

"The put call ratio is telling us that many more people are betting on shares of GOOG to rise rather than fall. Since ‘the crowd’ now believes that the stock will rise, we may be at an extreme that signals a turning point: it may be time to go against the crowd."

————–

Bill Bonner, with more gratuitous thoughts and opinions:

*** In the meantime, we await a reversal to the mean in the worldwide real estate market. Prices have already grown soft in Britain and Australian. A San Diego paper tells us that American prices will be mushing up soon, too.

"There is no reason a house should be worth 40 percent more today than it was two years ago," said UCLA economist Christopher Thornberg, co-author of a report on the housing market. "And this housing market is heated far beyond the point of sustainability."

The Anderson Forecast predicts California and national economic trends. The latest report says a drop in the housing market is inevitable…and that it will probably pull the whole economy down with it.

The UCLA economists say that today’s level of building is not sustainable given population growth. They look for fewer housing starts later this year, which will have an almost immediate effect on the economy. "There’s no stimulus that would push the housing sector higher," said Michael Bazdarich, the other co-author of the forecast. "It would be a miracle if housing just holds these present levels."

California has seen home prices increase 81 percent from 1997 to 2005, according to the forecast. Lately, prices seem to be settling down in some areas.

"We’re having mediocre employment growth and mediocre income growth," Thornberg said. "The type of home prices we’re seeing typically would not be supported by mediocre employment and mediocre income growth…What we have in California is population growth of low skilled immigrants who can’t afford an apartment, much less to buy a house."

*** "What’s that noise in the background? It sounds like popcorn popping…"

This question was posed to your editor’s wife about 15 years ago. She was on the phone with her brother, who wondered what was going on. At the time, we lived in a section of Baltimore known as Reservoir Hill, an area renown for its elegant 19th century houses and its murderous 20th century drug wars.

"Oh…that’s just someone shooting in the alley," Elizabeth replied. We had gotten so used to it, we barely noticed.

We left Reservoir Hill, selling our elegant 19th-century house for $67,000 – less than we had invested in it. It was a very nice house, but not nice enough "to die for."

But now we read in the Baltimore press that Reservoir Hill is "hot, hot, hot" in more ways than one. Statistically, you are still more likely to get shot in Reservoir Hill than in Baghdad. But mythologically, you’re likely to make more money too.

"The newcomers are believers. This time it’s different. This time – it’s for real," writes Lila Rajiva.

"Dave is showing me a house on the outskirts of Reservoir Hill which is ‘hot, hot, hot,’ according to the real estate web site where I first saw it. Dave is a broker officially, but actually, he tells me, he does this because it helps his own investing. He grew up in Baltimore and then spent ten years in California where he lived through the dotcom crash. Shortly after, he pulled his money out, clubbed together with some friends, and started buying property in San Francisco.

"Then I moved back here," he smiles wolfishly. "It was dirt cheap compared to SF."

"…Reservoir Hill and the fringes were once the home of the great merchants of Baltimore, and their streets have some of the grandest and most ornamental architecture in the city. Flourishes of woodwork, imposing marble mantels and floors, elegant spiral staircases, swirling wrought-iron work. In the 20s, Gertrude Stein once lived in a mansion here. Then things changed. The residents became absentee landlords, the mansions were chopped up into apartment blocks, drugs took over, and the neighborhood fell into the shadows.

"Until the last three years…"

"Five, ten, fifteen years ago, those …houses couldn’t be given away. And the landlords boarded up the windows and let them sit vacant for years, eyesores that destroyed the neighborhood. I knew an artist [?] who fell in love with one of those beautiful ruined ghosts and sunk his savings trying to breath life back into it. After ten years of smashed windowpanes, broken steering wheels, reefers and condoms tossed into his yard, he gave up, sold for a loss, and went to France. He had vision. I wondered what he was thinking now."

What are we thinking now? We’re glad we got out when we did.

*** Overheard while Addison was passing through immigration from Toronto to the US: "Where’s the price of gold gonna go?"

"Excuse me?"

"Where is the price of gold going to go?"

Not exactly the kind of question you expect when you pass through immigration. We were on our way back from The Supper Club meeting this week in Toronto. At the U.S. immigration booth, conveniently located in Toronto’s Pearse International Airport, the balding and extremely overweight man checking passports popped the question: "Where’s gold going to go?"

"Umnn…much higher. Yeah, a lot higher."

"Is it going to break $500?"

"Probably not this year, but…"

"Is it going to fall below $400 first?"

"No."

"Good…I don’t think so either."