Peter Lynch is one of the most celebrated fund managers in history, managing Fidelity’s Magellan fund with such skill that its return was almost double that of the S&P 500 over the period spanning 1977 – 1990. Multiple analyses have been performed with the purpose of deconstructing and explaining Lynch’s success (see AQR here and Daniel Sotiroff here), and the conclusion seems to be that higher beta (i.e. more risk than the overall market), momentum, and size were among the primary sources of Magellan’s amazing performance.
While these are the academic explanations for much of Lynch’s success at Magellan, I believe a good deal of his success can be attributed to less quantifiable variables, many of which he outlines himself in his excellent book, Beating the Street. In Beating the Street, Lynch states that the fact that Magellan was a capital appreciation fund was crucial:
“My colleagues’ tips and leads were particularly valuable to me because Magellan was a capital appreciation fund, and therefore I had the widest latitude to buy stocks that the special situations person, the small-stock person, the growth person, the value person, or the over-the-counter person had recommended.”
In fact, Lynch states that many of his best-performing stocks like Fannie Mae, Envirodyne, and Owens-Corning came to his attention via his colleagues who ran focused funds, but, unlike they, Lynch had the flexibility to capitalize not just on one or two of their best ideas, but on all of them.
Additionally, Lynch was not restricted to opportunities in equities; in fact, in a display of nimble portfolio management, Lynch’s top holding for a period of time were long-term Treasurys paying double-digit interest. Lynch explains:
“I didn’t buy bonds for defensive purposes because I was afraid of stocks, as many investors do. I bought them because the yields exceeded the returns one could normally expect to get from stocks…When yields on long-term government bonds exceed the dividend yield of the S&P 500 by 6 percent or more, sell your stocks and buy bonds.”
Throughout his tenure at Magellan, Lynch seems to have displayed an ability to rotate among industries at opportune times, rotating out of insurance companies in favor of bank stocks (largely regional banks) in 1981, – an implicit bet on lower interest rates, – and betting heavily on the resurgence of demand for automobiles throughout the 1980s, which was was, of course, a bet on a more confident consumer after a decade of malaise and stagflation:
“It seemed to me that recession or no recession, people were going to have to return to the showrooms. If there’s anything as certain as death and the collapse of the Red Sox, it’s that Americans have to buy cars.”
Early on, Magellan’s turnover was over 300% a year, settling down to over 100% in the 1980s. Clearly, Lynch was not afraid to pull the trigger on a good investment, but also not afraid to take profits when a stock had reached its potential, and he had spotted a more attractive opportunity.
It has been stated by some that perhaps Lynch was a product of his time in that he took the helm of Magellan toward the end of the long bear market of the 1970s and profited from the great bull market of the 1980s. However, I think this is unfair. Consider, as stated above, that Lynch had the freedom to invest his portfolio wherever he saw opportunities, and the greatest bull market of the decade was not in the U.S., but in Japan. Japanese stocks outperformed U.S. stocks by more than 11% per year in the 1980s, and lesser managers would almost certainly have fallen victim to the allure of such a disparity in returns. However, Lynch saw through it all, wisely avoiding the growth trap of Japanese equities:
“Japan was a nightmare for a fundamental analyst. I saw example after example of companies with bad balance sheets and spotty earnings, and overpriced stocks with wacky p/e ratios[.]”
It is interesting to speculate how Lynch would have fared in the 1990s as technology shares gained ascendancy; Lynch stated that, for the most part, he avoided technology stocks (among Magellan’s ’50 most important stocks’ can be found exactly zero tech stocks), because they were especially subject to disruption from innovation:
“A computer company can lose half its value overnight when a rival unveils a better product, but a chain of donut franchises in New England is not going to lose business when somebody opens a superior donut franchise in Ohio.”
Perhaps Lynch’s most important lesson for investors is that in order to beat the benchmark, you have to have a differentiated portfolio from the benchmark:
“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.’ He or she can own 300 S&Ls and 250 retailers and no oil companies and zero manufacturers, and his results will zig when the rest of the market zags. Conversely, an unimaginative fund manager can limit his portfolio to 50 stocks that are widely held by institutions, and create a miniature S&P 500.”
That Lynch ran Magellan with a high degree of active share is evident from this table of “Magellan’s 50 Most Important Stocks.” The vast majority are consumer-related and financials, with little exposure to energy, – which was the largest S&P sector for the early years of Lynch’s tenure at Magellan, – and industrial stocks:
In short, it seems fair to say that Lynch was the perfect man for the perfect opportunity when he was named Magellan’s manager in 1977. It is also fair to ask whether his ideas would have found similar favor against a different economic backdrop. However, while his exact strategies cannot be perfectly emulated, – it seems a stretch to think we will see a similar time of so many banks trading below book value and Treasury bonds yielding 13%, – his core principles of flexibility, conviction, and differentiation are timeless, and all investment managers would do well to adhere to them.
Note: In graphic above, some companies like Owens-Corning entered bankruptcy and reemerged, but I have elected to leave the bankruptcy note there as that was the fate subsequent investors would have faced.
