As Peter Lynch wrapped up chapter five of "Beating the Street," he had grown the Fidelity Magellan Fund past the $1 billion mark (April 1983). That's a billion in assets under management, a key metric for mutual funds. And, it was at that point critics began to say his fund had grown too big to succeed; in other words, he wouldn't be able to find enough good stocks to maintain his existing rate of growth.
He was not many pages into chapter six before addressing that sore point, writing:
"I was accused of managing the largest closet index fund on the planet.
This theory that a large fund can only be a mediocre fund is still in vogue today, and it's just as misguided as it was a decade ago. An imaginative fund manager can pick 1,000 stocks, or even 2,000 stocks, in unusual companies, the majority of which will never appear in the standard Wall Street portfolio. This is known as 'flying off the radar scope.'"
One of the ways in which Lynch managed to get around the size problem was by purchasing multiple stocks in the same industry or sector. For example, he owned "a passel" of saving and lending companies and retailers. In autos, he bought Chrysler (NASDAQ:FCA), Ford (NYSE:F), Volvo (OSTO:VOLV B) and even held General Motors (NYSE:GM) for a time.
He also went searching for what he called "unusual companies," small- and medium-sized companies that the market mostly ignored. He traveled extensively, attending investment conferences to listen to corporate pitches and getting even more leads by talking to companies that attended these events.
Some of his most important travel was done outside the United States. He wrote, "With the exception of John Templeton, I was the first domestic fund manager to invest heavily in foreign stocks." That began in 1984, when he had "a pile of cash to invest" and needed a flow of new ideas to take up that cash.
It was on a trip to Europe in 1985 when he found not only Volvo, but also Skandia, a Swedish insurance company that quadrupled its share price in 18 months, and Esselte, which made office equipment and was another big winner. Lynch reported:
"Ten percent of Magellan's assets were now invested in foreign equities, and the many happy returns I got from these stocks helped the fund keep its number-one ranking. My top eleven foreign purchases, Peugeot, Volvo, Skandia, Esselte, Electrolux, Aga, Norsk Hydro, Montedison, IFI, Tobu Railway, and Kinki Nippon Railway, made more than $200 million in profits for the shareholders."
The latter two companies are Japanese railways, discovered on a research trip to Japan. Tobu (TSE:9001) was a memorable stock for Lynch. He wrote, "Tobu Railway was the biggest gainer of all: 386 percent in five years. Alas, it was a small position, with only 0.13 percent of Magellan's assets devoted to it."
In 1984, the Magellan portfolio produced a return of just 2%, but that beat the S&P 500, which lost 6.27% for the year. The following year, 1985, brought back the big gains for which Lynch had become famous. Thanks to auto stocks and foreign stocks, the fund was up 43.1%, and that helped bring in another $1.7 billion for the year, more cash which had to be invested.
To find places to put the money, he reported he was "constantly on the offensive," looking for new positions and adding to existing positions. Regarding the latter, he posited Peter's Principle No. 11, "The best stock to buy may be the one you already own."
That was certainly true of Fannie Mae (FNMA). It had been one of the minor holdings in his portfolio, but based on its story, he kept buying until it represented 2.1% of his now multibillion-dollar fund. It turned out to be a good choice; he wrote:
"I was still partial to the autos, even though Ford and Chrysler had doubled or tripled in price, because the earnings were on the upswing and all the fundamental signs were favorable. But soon enough, Fannie Mae would take over where Ford and Chrysler left off as the key to Magellan's success."
In February 1986, just three years after hitting the billion-dollar mark, Lynch's fund shot past the $5 billion level. Notably, foreign stocks comprised 20% of the portfolio by that time. With great size came the need to make big finds, big enough to move the needle on $5 billion. It was at this point he realized he needed to have at least several $100 million positions.
For 1986, Magellan returned 23.8% to its clients, and in the first half of 1987 it was up 39%. The bull market was still going strong in mid-1987, but Lynch was getting nervous. He wrote:
"I made a major tactical shift--the first in five years. It seemed to me that we were far into the economic recovery and that people who were going to buy new cars had done so, and the analysts who followed the autos were making optimistic earnings projections that my research told me were unsupportable. I began to deemphasize the autos and to upgrade the financial companies--particularly Fannie Mae, but also the S&Ls."
In May 1987, the fund hit the $10 billion mark, just months before what Lynch called "The Great Correction" and others refer to as "Black Monday": Oct. 19, 1987. He was down 11% by December, but managed to claw his way back to a positive 1% return for the year, allowing him to record 10 profitable years in a row.
In the two succeeding years in which he managed Magellan, he posted gains of 22.8% (1988) and 34.6% (in 1989). When he retired in 1990, the fund had grown to $14 billion in assets, of which $1.4 billion was in cash.
To wind up the chapter, he reported on the losers in his portfolio:
"There were hundreds of losers in Magellan's portfolio, to go along with the winners I've just described. I've got a list of them that goes on for several pages. Fortunately, they weren't my biggest positions. This is an important aspect of portfolio management--containing your losses."
During the final seven (of 13) years at the helm of the Magellan Fund, Lynch continued to confound his critics by generating outsized returns from a portfolio that grew from $1 billion to $14 billion.
Along with savvy stockpicking, the years were marked by his decision to begin investing in foreign stocks, which helped him put all that new cash to work and generate above-average returns.
They were also marked by his big bets on a couple of industries, specifically autos, saving and lending and Fannie Mae. As for technology stocks, he wryly conceded, "I never had much flair for technology, but that didn't stop me from occasionally being taken in by it."
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Beating the Street: Lynch Takes Magellan to $1 Billion
- Beating the Street: Lynch's Early Years at Magellan
- Beating the Street: Peter Lynch on Mutual Funds
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This article first appeared on GuruFocus.