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Beating the Street: Lynch's Early Years at Magellan

Peter Lynch has one of the most outstanding investing records in the past century thanks to exceptional returns in the thirteen years he ran Fidelity's Magellan Fund. Between 1977 and 1990, he averaged gains of 29.2% per year, roughly double the performance of the S&P 500.

Surprisingly, he did it without much of a strategy, and that's just one of the insights in a wide-ranging discussion about his early years at Magellan (as described in chapter four of "Beating the Street").


During Lynch's first four years with the fund, he was spared the need to satisfy investors. The fund had been closed because the market was depressed. He wrote, "The fund business was so dismal that brokerage houses had disbanded their sales departments, so there was nobody left to sell the shares to the few oddballs who might have been interested in buying."

That gave him a chance to learn without undue pressure,


"I'm convinced that the obscurity in which I operated for the first four years was more of a blessing than a curse. It enabled me to learn the trade and make mistakes without being in a spotlight. Fund managers and athletes have this in common: they may do better in the long run if they're brought along slowly."



He began by getting rid of the stocks held by the previous manager and bringing in his own. At the same time, he constantly sold shares to handle what he called the "endless redemptions". Magellan had been a $20 million fund in 1966 but had fallen to just $6 million by 1976.

It was during this period that he began his visits to corporate offices to follow up on investment ideas. For example, he liked Taco Bell (now a subsidiary of YUM! Brands (NYSE:YUM)) because of the way its tacos tasted, the fact that 90% of the country had not yet been exposed to it, a strong balance sheet and because it had a home office that resembled a neighborhood garage.

That lead to Peter's Principle #7: "The extravagance of any corporate office is directly proportional to management's reluctance to reward the shareholders."

There was no real plan in his stock picking:


"The fact is that I never had an overall strategy. My stockpicking was entirely empirical, and I went sniffing from one case to another like a bloodhound that's trained to follow a scent. I cared much more about the details of a particular story--for instance, why a company that owned TV stations was going to earn more money this year than last--than about whether my fund was underweighted or overweighted in broadcasting."



One tactic that appears to have been a constant, though, was asking executives about their strongest competitors. He would then check out that competition, and he often bought the competitor rather than the original target. This is how he found one of his most notable discoveries, La Quinta.

He attributed some of his success to a lack of constraints; he operated a capital appreciation fund and could buy anything, which worked well with his bloodhound style. Someone who operated a growth fund, on the other hand, was forced to buy overpriced stocks when the entire growth sector was overvalued.

Flexibility was the key, according to Lynch. "There were always undervalued companies to be found somewhere." As to the commonplace idea he ran a growth fund, he doubted he ever had more than half of the portfolio in growth stocks at any given time.

Another of his tactics was to keep looking for stocks that were even more undervalued than those he currently held. Yet another was to buy companies that were easy to understand, which helps explain his attraction to fast-food chains such as Taco Bell. That was one of the reasons he like Cracker Barrel (NASDAQ:CBRL), which turned out to be a 50-bagger (meaning the price rose to 50 times his purchase price).

Another on-site research visit involved Home Depot (NYSE:HD), then a relatively new concept that impressed Lynch:


"This was the infancy of Home Depot, with the stock (adjusted backward for later splits) selling for 25 cents a share, and I'd seen it with my own eyes and bought it, but then lost interest and sold it a year later. Figure 4-1 has caused me eternal remorse. Imagine a stock that goes from 25 cents to $65, a 260-bagger in 15 years, and I was on the scene at the creation and didn't see the potential."



Figure 4-1, referenced in this quotation, was a chart of Home Depot's rocketing share price. This and Toys "R" Us, he wrote, were the two worst sell orders of his whole career. Despite these missed opportunities, the "tiny band" of Magellan shareholders enjoyed a 69.9% gain in 1980 (more than doubling the S&P 500's 32%).

The author also noted his early years were marked by extreme turnover--343% in his first year, then 300% in each of the next three years. "Beginning on August 2, 1977, when I sold 30 percent of the holdings, I maintained a dizzy pace of buying and selling as oil companies, insurance companies, and consumer stocks came and went from month to month."

None of this buying and selling was based on a strategy; Lynch explained that there was no shift in investing policies, "but by my having visited some new company that I liked better than the last."

In retrospect, he thought he should have held many of those stocks a lot longer than just a few months. He had what he called a "seller's remorse list", made up of companies like Albertson's (which could have been a 300-bagger), and Federal Express (NYSE:FDX), which he bought for $5, sold at $10, and then watched climb to $70 in just two years.

He added, "By abandoning these great companies for lesser issues, I became a victim of the all-too-common practice of "pulling out the flowers and watering the weeds," one of my favorite expressions." Warren Buffett (Trades, Portfolio) later borrowed that expression for use in one of his annual reports.

Conclusion

Lynch may not have articulated a strategy in those early years with the Magellan Fund, but one can see a pattern emerging from his writing.

In chapter four of "Beating the Street," he had a habit of buying undervalued stocks. He took what he called an "empirical" approach to selecting stocks by talking to executives of target companies. In addition, we see a growing awareness that holding for the longer-term might be better than rapid buying and selling.

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.