This arti­cle is cour­tesy of Globes Online, Israel busi­ness news — www.globes-online.com — on Feb­ru­ary 18, 2010

A good place to be
The so-called lost decade has not shaken leg­endary investor Peter Lynch's belief that the stock mar­ket will con­tinue to offer the best returns.

The dis­mal returns of the past ten years have made them known as the lost decade on the US stock mar­ket, rais­ing the ques­tion whether invest­ment in stocks has lost its lus­ter. Who bet­ter to answer that ques­tion than the per­son con­sid­ered one of the best mutual fund man­agers in US his­tory, Peter Lynch?

Lynch, 66, the leg­endary man­ager of the Fidelity Mag­el­lan fund, took over the run­ning of the fund in 1977, and from then until he left the post in 1990, he man­aged to beat the S&P 500 Index in 11 years out of 13. Under his man­age­ment, the fund yielded an excep­tional annual return of 29.2%, almost dou­ble the aver­age for the index of 15.8%. The great­ness of Lynch's achieve­ment can be seen from the fact that even today, 20 years after he stopped man­ag­ing the fund, his books "One Up on Wall Street," "Beat­ing the Street," and "Learn to Earn," are still best sell­ers among investors.

Today, Lynch is a research con­sul­tant at Fidelity Invest­ments. He devotes the rest of his time to phil­an­thropy, through a fund that he man­ages that awards schol­ar­ships to chil­dren from low-income fam­i­lies who study in Catholic schools in Boston, where he lives.

In an exclu­sive inter­view with "Globes", Lynch gives his view of the recent cri­sis and its con­se­quences for the mar­kets, and has no hes­i­ta­tion is sound­ing opti­mistic about the next hun­dred years for the stock market.

We chose to start the inter­view with the obvi­ous ques­tion did some sub­stan­tial change take place in the econ­omy and the mar­kets because of which the past decade became the lost decade for stocks?

"The past decade is one decade out of a hun­dred years in which we have known the mar­kets," Lynch says, "We started it at an extra­or­di­nary peak in the stock mar­ket as a result of the sharp rises in 1999, but in a sense the past decade was the lost decade on the stock mar­ket mainly because stocks were overvalued."

Should we for­get what we knew about stocks? Are they no longer the best place to be?

"We had 11 reces­sions since World War 2, and this is the twelfth that we have expe­ri­enced in the US and the biggest, with­out a doubt. But you have to remem­ber that only 2–3 years ago, the mar­ket was at an all-time high. Now the ques­tion is how we will emerge from this reces­sion, and whether we will return to the growth pat­terns at the rate we saw before it."

At this point, Lynch briefly expounds his stock mar­ket the­ory, and explains why he thinks stocks are the best investment.

"Com­pany prof­its in the US have grown at 6–7% a year, basi­cally since World War 2. If we add to that the div­i­dend yield, which is 2% a year, that is approx­i­mately the aver­age annual return on stocks," he explains.

Lynch avoids mak­ing explicit stock rec­om­men­da­tions, but he does not stint with exam­ples. "Look at com­pa­nies like IBM, Proc­ter & Gam­ble, Coca Cola, Pep­sico, Wal­green, or Exxon Mobile. I esti­mate that they will make more money in ten years' time than they make today, so that their share prices will rise to reflect that growth," he argues, quickly adding the rider, "Not all of them will do that, but there is a close con­nec­tion between the share's behav­ior and the prof­its that the com­pany produces.

"Over the past 30 years, the prof­its of McDonald's have tripled and the stock mar­ket has risen three­fold, and that's true of other stocks," Lynch con­tin­ues. "How­ever, there's also the other side. Xerox, for exam­ple, makes less money than it did 30 years ago, and its stock is worth less than it was worth 30 years ago. Polaroid was a very excit­ing com­pany a few down years ago, and it ended in insol­vency. We have seen sim­i­lar things hap­pen at East­man Kodak and Gen­eral Motors.

"In gen­eral, stock mar­ket com­pa­nies have suc­ceeded in grow­ing their prof­itabil­ity, and that's the rea­son to buy shares," Lynch sums up. "When you buy shares in a com­pany, if it man­ages to pro­duce prof­its, you are a part­ner in those prof­its. On the other hand, if you buy an IBM bond, after 20 years, the com­pany will repay you the money and say 'thank you very much.' It will pay you the inter­est, but it will not be loyal to you, and you cer­tainly will not enjoy the fruits of its suc­cess. That's the big dif­fer­ence between bonds and stocks."

You need 3–4 good stocks

What's the right way to be exposed to the stock mar­ket today?

"The aver­age per­son can get to know 5–10 com­pa­nies very well, and once every few years he will come across an oppor­tu­nity to make a good invest­ment. In prin­ci­ple, you need 3–4 good com­pa­nies to invest in over ten years. You don’t need 3–4 good stocks every week, if you are a pri­vate investor.

"You can't under­stand and be famil­iar with all of the mar­ket all of the time. You have to exploit your advan­tage to invest in what you really under­stand in depth, and not in what you don’t. If you gam­ble and buy oil stocks one year and retail stocks the next and elec­tron­ics stocks the year after that, that's not invest­ment. That's just a bet.

"Another pos­si­bil­ity of course is to invest through a mutual fund or an index fund, in the belief that the prof­its of US com­pa­nies will rise nicely over the next 5, 10, or fif­teen years, and you let some­one else make the deci­sions for you."

What about ETFs, that allow spread­ing of invest­ment over indexes?

"I'm not a big expert on ETFs, but logic dic­tates that if the mar­ket falls over the next five years, the ETF will fall with it, no?"

Against that, there's the argu­ment that less than 15% of invest­ment man­agers beat the index, and the rest lag behind it.

"At Fidelity, we had count­less funds that beat the indices over peri­ods of tens of years. In the past ten years, the mar­ket has been dif­fi­cult, but I believe that in the next ten years, active fund man­agers will pro­duce a bet­ter return than index funds and ETFs."

As for other vet­eran invest­ment man­agers in the US mar­ket, for Lynch too the lat­est cri­sis was the worst he had expe­ri­enced in his years in the indus­try. Despite the sever­ity of the cri­sis, Lynch believes that it was only an excep­tional, ran­dom event, and that, in the long run, the mar­kets will get back on track.

Asked to share his lessons from the cri­sis with us, Lynch pauses for a moment's thought, and responds, "I'll tell you the same thing I would have said 10 or 20 years ago as well. To pre­dict the market's direc­tion in any given year is a com­pletely ran­dom act. You can't know what the mar­kets will do in a period of six or twelve months.

"On the other hand, you do know that, over the past 40–50 years, com­pany prof­its grew at good rates, and in my view they will con­tinue that way in the com­ing years too. I esti­mate that cor­po­rate prof­its will dou­ble them­selves every ten years. If you add to that the div­i­dends that the com­pa­nies dis­trib­ute, you get an excel­lent return," adds Lynch. "You have to believe that, in gen­eral, com­pa­nies in the US will con­tinue to grow. Nat­u­rally, along the way some of them will dis­ap­pear and some new ones will join.

"When you par­tic­i­pate in com­pany prof­its, the most impor­tant point is whether you believe that they will be higher in another ten or twenty years or not," Lynch insists. "If not, then per­haps it would be bet­ter for you not to be exposed to them, not in an ETF, not in an index fund, and not in a man­aged fund. When you look at the alter­na­tives for invest­ment, the choice for investors today is between a money mar­ket fund, that pro­duces a zero return, Trea­sury bonds, that yield 3.8%, or some expo­sure to the stock mar­ket that, over time, yields dou­ble that on average."

After leav­ing Mag­el­lan 20 years ago, Lynch reduced the scope of his activ­ity in the mar­kets. In the two decades since then, great changes have taken place in the finan­cial indus­try and in the mar­kets, one of the most promi­nent being the tech­no­log­i­cal devel­op­ments that now enable investors all over the world to be exposed to a far larger amount of infor­ma­tion, and in real time. Lynch him­self sees no dif­fer­ence between 20 years ago and today in the way investors need to approach the markets.

"In the course of my work at Mag­el­lan, I bought small com­pa­nies that grew over the years. This is a strat­egy that worked, and still works today," he says. "I bought com­pa­nies whose per­for­mance was weak and that turned their busi­nesses around. This method still works today. If you invest in com­pa­nies whose assets are worth more than their mar­ket cap, you have found a great invest­ment opportunity."

This infor­ma­tion spreads faster today thanks to the Inter­net. Doesn't that affect the abil­ity to act in the market?

"It mainly affects the aver­age investor, who now has greater access to infor­ma­tion that was once the province of pro­fes­sional investors. In the end, the work is the same work you have to find com­pa­nies traded at below their real value, and that will grow in the com­ing years."

Can your achieve­ment at Mag­el­lan be repli­cated in the cur­rent mar­ket environment?

"That's a slightly more dif­fi­cult ques­tion, because to beat the mar­ket in eleven years out of thir­teen is a tough assign­ment, but there are a few fund man­agers who have done it in the past and who are doing it today as well."

Fol­low­ing the changes that have occurred in the mar­kets and the "lost decade", has it become nec­es­sary to adjust the cri­te­ria for choos­ing stocks for investment?

"The sig­nif­i­cance of the lost decade is very sim­ple. Com­pa­nies earn more than they did ten years ago, and they are traded at lower prices than they were then. There's an invest­ment oppor­tu­nity here. There are com­pa­nies on the mar­ket with good bal­ance sheets and won­der­ful rep­u­ta­tions, that make bet­ter prof­its today than ten years ago, and will con­tinue to grow. This is an extra­or­di­nary period for investment."

Are price earn­ings ratios and growth rates as rel­e­vant now as in the past?

"When you look at big com­pa­nies, you see that their growth slows down even­tu­ally, because they're too big to grow at high rates over time. On the other hand, small and medium size com­pa­nies, which are gen­er­ally con­sid­ered riskier, grow faster over time. There­fore, there are oppor­tu­ni­ties in every kind of com­pany. But I achieved my suc­cess thanks to a focus on com­pa­nies of a small and medium order of size. I try to buy big com­pa­nies only when they are at a turn­ing point, after their posi­tion has improved fol­low­ing a cri­sis. That's how it is in the vehi­cle indus­try, air­lines, and other industries."

Is that what you look for today com­pa­nies that were hard hit by the cri­sis and can change direction?

"Exactly. The vehi­cle indus­try is a bat­tered indus­try fol­low­ing the cri­sis, but peo­ple still con­tinue to drive cars. The only dif­fer­ence is that the cars are get­ting older, and in the end they will have to be replaced with new ones. Some­thing sim­i­lar can be seen in the hous­ing mar­ket. And these are just two of the biggest indus­tries in the US, that fell to a vey low level. It's hard to believe that they will soon get back to where they were before the cri­sis, but they will clearly strengthen to some extent."

How do you iden­tify those com­pa­nies that will suc­ceed in mak­ing the turn­around and won't crash along the way

"That's what is called home­work. You have to do your homework."

And what do you exam­ine when you do that home­work? The man­age­ment that can turn things round?

"I look for indus­tries that I believe will make the change, not man­age­ments that will lead the change. I've said in the past, that I pre­fer to be invested in com­pa­nies that any idiot can man­age, because in the end, that is what will hap­pen. When I buy Toys "R" Us, I act on the assump­tion that the next decade will be very straight­for­ward for the com­pany, no mat­ter who man­ages it. They have a sim­ple for­mula, they have prac­ti­cally no com­pe­ti­tion, so the next decade will be easy for them.

"The sec­ond way of mak­ing money is to go for com­pa­nies with poor per­for­mance now, but that have a strong bal­ance sheet, and are likely to recover as their indus­try recov­ers. Then, all that's left is to wait for the sit­u­a­tion to improve. That is what's called cyclic change."

No need to look for stocks every day

What turns an investor into a suc­cess­ful stock picker?

"It takes hard work and flex­i­bil­ity. If you look at ten stocks, it could be that you will find one stock at an attrac­tive price and nine at fair prices. If you look at a hun­dred stocks, you'll find ten. So the more com­pa­nies you exam­ine, the more oppor­tu­ni­ties you'll find. The sec­ond char­ac­ter­is­tic is flex­i­bil­ity, and here is where Fidelity's advan­tage lies. It employs hun­dreds of ana­lysts who exam­ine com­pa­nies from all over the world. We look at every indus­try, and don't rule any­thing out. We don’t say that this or that indus­try is the best and focus just on that, but sur­vey the entire market."

Does that mean investors have to devote most of their time to the stock market?

"You can exploit the infor­ma­tion that already exists in you to invest in 5–10 com­pa­nies, and that's all that is nec­es­sary. You don't need to spend all day look­ing for stocks for invest­ment. It's enough if you invest two to three hours a month research­ing com­pa­nies that you know and under­stand well in order to succeed."

What advice would you give investors today?

"The most impor­tant organ in the body as far as the stock mar­ket is con­cerned is the guts, not the head. Any­one can acquire the know-how for ana­lyz­ing stocks. We've had many reces­sions on aver­age once every eigh­teen months we have had a 10% fall on the stock mar­ket over the past 50 years, and once every five years we have had a fall of 20–30%, which is called a bear mar­ket. Usu­ally, this goes along with bad news, with your neigh­bor who lost his job, and with the value of your house that falls. The news is bad, and so you get out of the mar­ket, and when you read in the news­pa­per that the sit­u­a­tion has improved, you go back in.

"You buy when you see that things are fine, and sell when you see that they are bad. But that's not the way. You have to decide what posi­tion in shares you will be com­fort­able with, and to under­stand that even in a bear mar­ket, time is on your side. What the mar­ket will do for a period of a year ahead is ran­dom. If you need the money for your child for col­lege or for a wed­ding in a year's time, it's impor­tant that you should know that the mar­ket will be ran­dom over that year. But if you're look­ing at an invest­ment range of 10 or 20 years, com­pany prof­its will be on your side, and stock prices will be higher.

"You have to under­stand what you're doing and rec­og­nize the fact that things can go wrong. Reces­sions hap­pen, and right at the point that things seem gloomi­est, peo­ple with­draw their money from the mar­ket, and just then the mar­ket start to climb. Look at the lat­est rally that we have had since March. The econ­omy still isn't suf­fi­ciently sta­ble. We have an unem­ploy­ment rate higher than 10%, and the recov­ery in many areas of the econ­omy is frag­ile, but we had an impres­sive rally nev­er­the­less. The stock mar­ket looks to the future and not to the past. The ten­dency of peo­ple to run when the sit­u­a­tion is bad and go in only when it's good is a good for­mula for los­ing money.

"You have to look in the mir­ror and ask your­self, 'What will I do if the stock mar­ket falls 10% over the com­ing year? Will I sell every­thing?' If your answer is pos­i­tive, maybe it would be bet­ter for you to sell today. The stock exchange is a good place to be. In fact, it was the best place to be in the last 100 years, even if it wasn't like that in the past decade."

And what about the next 100 years?

"I think it will be a good place to be in the 10, 20, and even 100 years to come."

Source: Globes [online], Israel busi­ness news — www.globes-online.com — on Feb­ru­ary 18, 2010

Read more from the author/contributor here.

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