One Up on Wall Street

Peter Lynch · 1989

Thesis

An ordinary investor who pays attention to the companies and products around them can spot promising stocks before professional investors do, and by sorting each company into the right category, researching it, and judging its price against its growth, can beat most of the experts.

The main ideas

The amateur has an edge: they see products and companies at work and in shops before Wall Street notices them.
Noticing is only the start. Investing without research is like playing poker without looking at your cards.
Every stock belongs to one of six categories, and each category calls for different expectations.
The biggest winners, tenbaggers, often start as dull companies with dull names in dull industries.
Before buying, be able to explain in two minutes why the stock will succeed and what could go wrong.
A fairly priced company's price-earnings ratio roughly equals its growth rate.
Market timing is futile. Watch companies, not the market.

The amateur's edge

Peter Lynch, who ran Fidelity's Magellan Fund, opens with what he calls the advantages of dumb money: an ordinary investor can do as well as, or better than, the average Wall Street expert. Professionals are bound by committees, rules about what they may buy and the need to avoid looking foolish; they often reach a company only after it has already risen.

The amateur's advantage is proximity. Lynch's tenbaggers, stocks that rose tenfold, often first showed themselves as great products rather than as stocks. His wife Carolyn discovered L'eggs pantyhose at the grocery store, and her report was worth more to him than his own research on the textile industry. He noticed Taco Bell after eating a burrito on a road trip, and Dunkin' Donuts as a customer.

But noticing is not buying. Lynch insists that "Investing without research is like playing stud poker and never looking at the cards." A product you like is a lead to investigate, not a reason to buy the stock.

Implication: pay attention to the companies you know through work and daily life, and use that knowledge to decide which ones to research. Then do the research before buying.

Six kinds of stock

Lynch sorts companies into six categories, because each behaves differently and should be held for different reasons. Slow growers are large, mature companies growing about as fast as the economy, bought mainly for dividends. Stalwarts are big, solid companies such as Coca-Cola and Procter & Gamble that grow faster than slow growers; Lynch looks for gains of 30 to 50 percent and then considers selling. Fast growers are small, aggressive new enterprises growing at 20 to 25 percent a year, where the tenbaggers are found. Cyclicals rise and fall with the economy, and timing their cycle matters more than their quality. Turnarounds are battered companies that may recover; Chrysler was one of his greatest successes. Asset plays are companies sitting on something valuable, such as real estate or cash, that the market has overlooked.

The mechanism is that a stock's prospects, risks and right selling point depend on its category. Holding a stalwart for tenbagger returns, or a cyclical as if it were a stalwart, leads to disappointment.

Implication: before buying, decide which category a company is in, and set your expectations and selling rules to match.

The perfect stock and the ones to avoid

Lynch's ideal company sounds dull, or better yet ridiculous. A boring name keeps analysts and fund managers away, so the stock stays cheap until the results are impossible to ignore. He also likes companies in disagreeable or depressing businesses, which put off professional investors for the same reason. His example of a promising name is the auto parts chain Pep Boys – Manny, Moe and Jack, which he says sounds like the Three Stooges.

The opposite is the stock to avoid: "If I could avoid a single stock, it would be the hottest stock in the hottest industry." Popular stocks in popular industries are priced for perfection and fall hard when the excitement fades. He also warns against "diworseification," his term for companies that use their profits to make unwise acquisitions outside what they know.

The mechanism is attention. Stocks that nobody is watching can be underpriced; stocks that everybody is watching rarely are.

Implication: be suspicious of the stocks everyone is talking about, and look harder at the boring ones nobody mentions.

The two-minute drill

Before buying a stock, Lynch says, you should be able to give a short monologue, a two-minute drill, covering why you are interested, what has to happen for the company to succeed and what could stand in its way. What the story must cover depends on the category: for a cyclical, the state of the cycle; for a turnaround, what the company is doing to recover; for a fast grower, where and how it can keep expanding.

His example of a story told in a sentence is La Quinta Motor Inns. An executive at a competing Holiday Inn franchise told Lynch that La Quinta was killing them in Houston and Dallas. La Quinta offered rooms of Holiday Inn quality at about 30 percent less, saving money by doing without restaurants and meeting rooms. That single observation explained the company's advantage.

The mechanism is that putting the reason for a purchase into words exposes whether there is a reason at all. If the story cannot be told simply, the investor does not understand the business.

Implication: write down, in a few sentences, why you own each stock and what would make you sell. Recheck the story periodically, not the price.

Price against growth

Lynch's rule of thumb for value is simple: "The p/e ratio of any company that's fairly priced will equal its growth rate." A company growing earnings at 15 percent a year is fairly priced at about 15 times earnings; one selling at half its growth rate may be a bargain, and one at twice its growth rate is probably overpriced.

He refines the rule for dividends: add the dividend yield to the growth rate and divide by the price-earnings ratio. A company growing at 12 percent with a 3 percent yield and a price-earnings ratio of 10 scores 1.5. Below 1 is poor, 1.5 is acceptable, and 2 or better is what to look for.

The mechanism is that a company's value follows its earnings over time, so a fast-growing company deserves a higher multiple than a slow one, but only up to a point.

Implication: never judge a price-earnings ratio on its own. Compare it with how fast the company's earnings are actually growing.

The cocktail party theory

Lynch does not believe market timing works, and illustrates the market's moods with his cocktail party theory. Early in a rise, when people at a party learn he manages a mutual fund, they move away to talk to the dentist about plaque. As the market climbs, they listen a little longer. Near the top, they crowd around him and then start telling him which stocks to buy. When the guests are giving the fund manager tips, Lynch suggests, the market has probably peaked.

He offers the theory half in jest. His serious point is that nobody can predict the market, so an investor's time is better spent studying companies.

Implication: ignore market forecasts, including your own, and spend the time on the businesses you own.

Limits

Lynch has repeatedly said his advice was misread. In the introduction to the book's 2000 edition, he wrote that he does not advise buying stock in a favorite store just because you like shopping there, and in a later interview he said he never told people to buy a company's stock because they liked its coffee.
Most investors cannot repeat his results. Lynch himself told Barron's in 1990 that most investors would be better off in an index fund. Magellan's managers after him did not match his record: under Robert Stansky, from 1996 to 2005, the fund failed to match its benchmark.

The Intelligent Investor — the value framework that Lynch's growth-adjusted approach builds on.
Market Wizards + The New Market Wizards + Stock Market Wizards + Hedge Fund Market Wizards + Unknown Market Wizards + Market Wizards: The Next Generation — other exceptional records, and the question of how many investors can repeat them.
The Essays of Warren Buffett — another case for understanding the business behind the stock.