Over 3 million new accounts were opened at Robinhood in the first quarter of this year – a resurgence in individual stock picking in the heart of the COVID-19 shutdown few could have anticipated. The renewed interest in individual stocks is in opposition to a trend of just a year or so ago, where the rise of passive investing, robo advisors and the challenges of trying to beat the market put a damper on investors buying individual stocks. But not everyone had given up hope on the fading stock picker.
Peter Lynch, the former star fund manager of Fidelity Magellan, in a December 2019 Barron’s article and interview, advocated for individuals researching and buying individual stocks despite the known headwinds many often face when trying to find top stocks. His timing and wisdom couldn’t have been better given the rush into individual stocks by retail investors since the start of the year. I think Lynch would be cautiously optimistic in the long-run about this renewed interest in individual equities, especially among young investors, but I also think Mr. Lynch, who is old enough to be the grandfather of most of these newly minted shareholders, would offer them up some sound and sage investing advice.
Here are a few lessons and words of investing wisdom I think Lynch would impart on these beginning investors. This is part one of a two-part series.
#1: Sixth Grade Math & Fundamentals
In the Barron’s interview, Lynch said, “Don’t invest in a company before you look at the financials. If you made it through fifth grade, you can handle the math.” Most beginning investors aren’t overly focused on the financials and fundamentals, but most have graduated from fifth grade.
You don’t need to be a Wall Street analyst with an MBA from a top college to get your arms around simple financials and valuation metrics. If you can do some very basic math, just like Lynch says, you can find these answers. Here are a few quick and easy measures to consider looking at before buying a stock.
- Is the company profitable? Look at the most recent year’s earnings and earnings over the last 5-10 years. Does the company make money? This is a very easy question to find the answer to.
- Does the company have a lot of debt? Debt can be very problematic for a company, particularly during recessions. Look at the balance sheet to see how must debt a company has relative to its assets or equity or even cash flow generation.
- Is the company growing? Look at things like sales and earnings growth rates. Both sales and earnings are on the income statement, and one can easily track the growth rates to see if the company is growing or contracting over time.
- What is the valuation? Valuation plays a very important part in future returns. You don’t just want to be blind to valuation. Things like the Price-to-Earnings ratio or Price-to-Sales ratios, are good places to start. Typically, the lower the number the better. One of Lynch’s favorite ratios was the PEG ratio, which is the Price-to-Earnings ratio over the growth rate. This measure allows you to compare companies’ valuations and growth rates. For example, a company with a P/E of 10 and a growth rate of 20% has a PEG of 0.50 whereas a company with a P/E of 20 and a growth rate of 10% has a PEG of 2.0. The company with the lower PEG ratio looks more attractive using this measure.
- Do insiders own the stock? Insider ownership shows that the founder of a company and/or management had a stake in their own business. This can be an important quality since management benefits as shares go higher. David and Tom Gardner, co-founders of The Motley Fool, and advocates for the individual investor, suggest looking for companies with at least 10% insider ownership.
- Does the company pay a dividend? Stocks offer capital appreciation potential and can pay dividends. Leading technology companies like Apple, Microsoft, Oracle, Broadcom, Intel and Qualcomm all pay dividends and these dividends contribute to the total return an investor receives over time when buying the stock. Young investors may not be buying stocks for the dividend income, but dividends will contribute to an investor’s total return, and you should know if the stock you own pays a dividend.
#2: Don’t Confuse Luck with Skill
First time investors who opened accounts during February and March and put money to work in the markets are potentially sitting on returns that only come around once every decade or so in such a short period of time. Consider this: from March 23rd to July 31st, the S&P 500 is up 47% while the NASDAQ 100 is up 56%. The performance almost mirrors how the markets performed from March 2009 to July 2009, which were the first three months of recovery in stocks coming out of the Great Financial Crisis. If you believe the returns you’ve achieved have to do with your skill as a stock picker, I would suggest that you check your ego at the door and realize you were lucky in your timing.
If you accept this premise, I think there are a few very important lessons one can take from this.
First, oftentimes the biggest returns in stocks, at least in the short run, come during the most uncertain times. If you miss those returns, you can significantly reduce the long-term returns that stocks provide. The second is these massive moves can happen very quickly (i.e. in a matter of months), which further shows the importance of staying invested. And third: it’s impossible to accurately predict the short-term moves in the market and there are far too many variables at play to make forecasting the market accurately over short periods of time achievable.
This doesn’t mean this first, early lesson in investing shouldn’t be a formative one, but investors shouldn’t blindly extrapolate these results into the future and give themselves too much credit for the last few months of ultra-strong returns.
The best advice regarding allocating to stocks through thick and thin, can be summed it up this way:
He [Lynch] reiterates his mantra: Buy stocks, regardless of whether things look rosy or bleak. “The thesis underlying everything, whether you’re an actively managed fund or a passive fund, is that the U.S. will be OK. If you don’t believe that, you shouldn’t be in the stock market,” Lynch says.
#3: Avoid Cutting Your Flowers and Watering Your Weeds
In Lynch’s One Up on Wall Street, he wrote: “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.” Warren Buffett loved this quote so much, he called Lynch directly to ask if he could use it in his annual letter to shareholders.
For investors what this really means is that usually it’s a few really great performing stocks that can have the most impact on your returns. This is consistent with the performance of stocks overall, which show that many stocks actually lose money over time, but the performance of the market is driven by a small group of top performing stocks – so the returns are largely driven from those right tail stocks that produce returns magnitudes greater than the market.
There are two challenges here. First you need to identify these stocks, which is difficult, but second is sometimes these great performers experience mind-bending drawdowns. At one point, the stock of Amazon was down more than 90%, and there are plenty of other examples of companies losing significant value at points in their history.
Lynch often talked about 10-20 baggers, which were stocks of growth companies that went up 10-20 times, but achieving these returns requires the patience needed to stick with the stocks over the long-run, which few investors have.
Next week, I am going to round out the last three points I think Lynch would drive home if he were giving grandfatherly advice to new investors. While Lynch isn’t actively managing money today, his wisdom and knowledge are still very relevant and can act as guideposts for all different types of investors both new and old.
Copyright: Photo: 123rf.com / mikekiev
Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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