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Beating the Street: Lynch Takes Magellan to $1 Billion

In what Peter Lynch modestly calls "The Middle Years" at Fidelity's Magellan Fund, he increased the fund's assets under management from $100 million in 1981 to more than $1 billion by 1983.

That story, and some of the lessons he learned along the way, are detailed in chapter five of "Beating the Street," a 1993 follow-up to his bestseller, "One Up on Wall Street."


Lynch began by noting that part of his success stemmed from the team atmosphere at Fidelity. As the firm grew, and stocks and mutual funds were regaining their popularity, new funds were being added frequently. As a result, there were many more analysts and fund managers discovering new investment opportunities. Just as important was the culture of sharing ideas freely within the firm.

For his part, he described his research this way: "My methods were not much different from those of an investigative reporter--reading the public documents for clues, talking with intermediaries such as analysts and investor relations people for more clues, and then going directly to the primary sources: the companies themselves."

One of the ways in which they shared ideas at Fidelity was through meetings, where analysts and managers laid out their new ideas. When Lynch chaired the meetings, he used a three-minute egg timer to ensure each presentation was focused. Later, he cut that time in half, to 90 seconds, saying that if you are ready to invest in a company, you should be able to explain the opportunity--in language a fifth grader would understand, and quickly enough that a fifth grader would not get bored.

By the time Magellan reopened to the public in 1981, the author reported he had learned to be more patient. Fortunately, shareholders learned the same lesson and redemptions dropped off significantly. This meant Lynch no longer had to continually sell stocks to raise cash for redemptions, and much more cash became available for new or increased investments.

For the previously impulsive stockpicker, that led to a major reduction in the fund's turnover, from 300% per year in the first four years to 110% per year. Here's an example of his new, longer-term thinking:


"I was progressively more impressed with the long-range potential of restaurant chains and retailers. By expanding across the country, these companies could keep up a 20 percent growth rate for 10 to 15 years. The math was, and continues to be, very favorable. If earnings increase 20 percent per annum, they double in 3 1/2 years and quadruple in 7."



Such calculations are quick and easy with the Rule of 72, which Lynch said will tell you how quickly your money will grow. Start with the annual return from any investment, then divide it into 72; the output is the number of years needed to double an investment. For example, if an investment returns 15% per year, it will take 4.8 years to double (75 / 15 = 4.8 years).

He also discovered companies like Pep Boys, Seven Oaks and Cooper Tire (NYSE:CTB). They had strong balance sheets and good prospects, but other fund managers weren't buying them. He wrote, "A portfolio manager who cares about job security tends to gravitate toward acceptable holdings such as IBM, and to avoid offbeat enterprises like Seven Oaks".

If a company like Seven Oaks fails, the fund manager will wear the blame, but if an IBM (NYSE:IBM) fails, then the company itself is blamed for "disappointing the street". Lynch was able to take risks that other fund managers could not because no one was looking over his shoulder at Fidelity. He wrote, "I was spared the indignity of being second-guessed by my superiors."

While things went well for the market in 1981, the shock of double-digit inflation rates led to a rocky market in 1982:


"The first half of 1982 was terrible for the stock market. The prime rate had hit the double digits, as had inflation and unemployment. People who lived in the suburbs were buying gold and shotguns and stocking up on canned soups. Businessmen who hadn't gone fishing in 20 years were oiling their reels and restocking their tackle boxes, preparing for the shutdown of the grocery stores."



Thanks to operating a fund with few restrictions, Lynch bought long-term Treasury bonds; he noted that Uncle Sam was paying him 13% to 14% interest, which was better than yields in the stock market. Once again, though, the market rebounded, with the S&P 500 turning in a fourfold gain between 1982 and 1990.

It was deep in the gloom of 1982 when he discovered Chrysler (NASDAQ:FCA); an opportunity he learned about while researching Ford (NYSE:F). At the time, it was selling for $2 per share because investors expected it to go bankrupt. Lynch, on the other hand, saw $1 billion in cash on a strong balance sheet and loans guaranteed by the U.S. government.

He also spent a day talking with Chrysler executives, including Lee Iacocca, and learned the company had some exciting new cars about to roll out. What's more, Iacocca was excited about an entirely new product for the auto industry, the T-115 (now known as the Chrysler minivan), which would be coming out soon.

According to the author, "This was probably the most important day in my 21-year investment career." Chrysler recovered, as we know with hindsight, and was one of the key companies that established Lynch's reputation as an outstanding stockpicker. While other fund managers were trying to get out, he was jumping in with both feet.

By the end of July 1982, Magellan had 5% of its holdings in Chrysler, the maximum allowed by the Securities and Exchange Commission. Lynch would have liked to have gone 10% or 20% of the fund's value. That faith in Chrysler paid off almost immediately--it doubled in value in the first eight months he held it.

In the autumn of 1982, Lynch got one of the biggest breaks of his career; he was invited to be a guest on the popular PBS television show, "Wall Street Week," with Louis Rukeyser. It turned out to be a turning point for his fund. He wrote:


"As jittery as I must have looked, the appearance on Rukeyser's show did wonders for Magellan. The Fidelity sales department got very busy answering phones and taking orders. What had been a $100 million fund after the merger with Salem in 1981 became a $450 million fund by the end of 1982. New money was pouring in at a rate that would have been inconceivable four years earlier."



As the money poured in, Lynch got to do what he loved, finding and buying value-priced stock. He wrote, "Bargains are the holy grail of the true stockpicker." With the economy recovering, buyers returning to the market, his reputation growing and new money arriving every day, the Magellan fund hit $1 billion in assets under management in April 1983.

There was one downside, a constant irritation for Lynch in this newfound success: The idea that his fund had grown too big to succeed!

Conclusion

In the middle years of Lynch's 13-year stay as manager of the Magellan Fund, we find the author of "Beating the Street" maturing in both his thinking and action.

In effect, he was becoming more of a value investor as he doubled down in his search for undervalued stocks with strong fundamentals. He also saw the recession of those years as an opportunity, and when the economy and market recovered, he was well-positioned for it.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.