Would Peter Lynch Buy Nvidia?
If you study him, the answer is clear
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Today, we released a podcast covering Peter Lynch. Perhaps the most famous investor besides Warren Buffett, Lynch is known for a common sense investing strategy that tries to simplify things as much as possible (but no simpler).
Below, you will find our full show notes from the podcast. I would also recommend listening or watching! It is the best way to support us and make this project sustainable.
Now, to the teaser question in the title of the email.
Would Peter Lynch buy Nvidia?
After reading One Up On Wall Street, the answer is clearly no.
There are two things Lynch avoids when investing:
The hot sector of the day
Premium-priced large-cap stocks
Nvidia is the quintessential answer for BOTH of these criteria today. Lynch may not have been opposed to buying Nvidia a few years back (although I’m not sure it would go into his circle of competence), but he would definitely be selling today.
He hated the risk of owning a mega-cap stock with a P/E way above the market average. He just thought the juice wasn’t worth the squeeze. His strategy is about finding a bunch of small-cap stocks in promising growth sectors and letting his winners run.
Similar to the Motley Fool, which — and don’t scoff, they have most likely outperformed you — takes a ton of inspiration from Lynch.
There are other details to the strategy which we hit on in the podcast.
Full show notes to follow.
Quick biography on Peter Lynch
Peter Lynch was born in 1944 in Massachusetts. His father died when he was young, which meant he had to take up caddying to make money for the family while he was a kid. As a caddy, he learned about investing in stocks.
He then went to Boston College, got an internship at Fidelity, and eventually became an analyst at the age of 25.
Likely due to his strong investing acumen, he was put in charge of the Fidelity Magellan Mutual Fund at 33 years old. This was in 1977. He ran the fund until 1990.
The fund returned 29% per year when Peter Lynch ran it, or around double the S&P 500 over the same time. It had $20 million in assets in 1977 and $14 billion in 1990. A strong investor AND money manager.
Side note: The average investor who put money in the Magellan Fund lost money. Why? Because people pile in after really strong performance. A lesson in betting on the right jockey before the race starts, not after finishing a Triple Crown.
The basics of Peter Lynch’s investing style
In this section, we will give both our thoughts on how we feel Peter Lynch invested. What is the synopsis of his style? Then, in the following sections, we will go through details, examples, and our favorite quotes from the book.
(Brett) From reading Peter Lynch’s book, I feel like he is similar to great investors such as Buffett or Druckenmiller in that he has a core investing philosophy fortified by being flexible in different market environments.
Without finding a direct quote, I believe Peter Lynch wants to build a portfolio of stocks with:
A good story that he has validated and/or believes in
A business model that he can understand
A long runway for reinvestment/growth
Focus on small, undiscovered companies/sectors. Avoid buying what is hot.
Let his winning stocks run.
On top of this, I found he is unafraid to move into another style if that is where the opportunities lie. He is definitely not afraid of style drift. Some examples include real estate/asset plays, timing cyclicals, and special situations with a promising subsidiary. These may not be his core portfolio but they can help provide more consistent returns.
While there is a lesson here, this may not be a strategy best suited for an individual. You just don’t have the time. It likely works best in a fund structure where a group of analysts can do a lot of the work together.
(Ryan) I agree that Lynch seems really flexible depending on the environment, but he also clearly outlines the kind of investment he’s most often looking for in his book. In fact, at one point he literally writes a 1-pager called “The Greatest Company of All” that highlights all the characteristics he looks for. I’ll talk about that in a bit.
But generally speaking, the characteristics that he seems to emphasize are:
An underfollowed company. He likes it when the company sounds dull or even does something dull/boring.
He prioritizes growth (but it doesn’t preclude him from investing). This often coincides with Brett’s 3rd point of a long runway for reinvestment.
To Brett’s first point, I think he likes to feel like a part of the company. He tells countless stories of visiting the operations of the business in person.
Don’t interrupt the compounding. I think he likes to let his winners run.
Not putting all his eggs in one basket. He says at times he owned upwards of 100 stocks. Not equal weighted, and probably easier with a team of analysts but he liked to own a lot of companies.
It was honestly very refreshing to look at how Lynch invests because it felt more replicable for the average investor. Aside from the diversification aspect, there was nothing in his process that couldn’t be done by an individual investor. He kept it simple and was able to boil down an investment to the few factors that really mattered most. He never seemed to face too much analysis paralysis.
(Brett) Why size matters in valuation
Peter Lynch cares about size. His strategy is to find as many companies he believes have a good chance of being ten baggers (stocks that go up 10x). It is much easier to find this in companies with smaller market caps.
Quote talking about the internet bubble of the 1990s:
“On the following page I also mention the bloated 500 times earnings shareholders paid for Ross Perot’s Electronic Data Systems. At 500 times earnings, I noted ‘it would take five centuries to make back your investment, if EDS earnings stayed constant.’ Thanks to the internet, 500 times has lost its shock value, and so has 50 times earnings, or, in our theoretical example, 40 times earnings for Dotcom.com.
In any event, to become a $100 billion enterprise, we can guess that DotCom.com eventually must earn $2.5 billion a year [25x reasonable earnings multiple]. Only thirty-three corporations earned more than $2.5 billion in 1999, so for this to happen to DotCom.com, it will have to join the exclusive club of big winners, along the likes of Microsoft. A rare feat, indeed.”
What Lynch is trying to get at is the worst type of investment is a premium-priced large-cap or mega-cap stock. As a note, you should adjust that quote for today’s stock market.
If you had some optimism about “Dotcom.com’s” future, and think it might earn $2 billion in annual earnings within the next 10 years, it might make sense to buy the stock at a market cap of $1 billion if its sales are negligible or less than $1 billion today. It might be worth it at a $5 billion market cap, even.
But buying it at $100 billion? That is foolish. I think there is a lesson for all of us there. Don’t be afraid to take a small position in a small-cap stock that has a lot of potential upside but still looks expensive today. A lot of “value” investors may overlook it even though it is a great risk/reward. You might want to make it a small position, but there is some logic to making these investments.
Discussion question: Do you have a market cap threshold when buying “non-stalwart” growth stocks at nosebleed multiples? Do you think you should? Would he have changed his mind with the Magnificent Seven?
(Ryan) Why he likes growth
Before we get into how he detects growth, which Brett will touch on, it’s probably important to look at why it cares about it to begin with.
“You won’t find a lot of two to four percent growers in my portfolio, because if companies aren’t going anywhere fast, neither will the price of their stocks. If growth in earnings is what enriches a company, then what’s the sense of wasting time on sluggards?”
Keep in mind, when he mentions growth he is talking about growth in earnings. However, the easiest way to grow your earnings for a long period of time is to grow your sales. Lynch witnessed this early on in his career when he was a research analyst at Fidelity.
When discussing Fast Growers, Lynch states: “These are among my favorite investments: small, aggressive new enterprises that grow at 20-25 percent a year. If you choose wisely, this is the land of the 10-to 40-baggers, and even the 200-baggers. With a small portfolio, one or two of these can make a career.”
I think he realized early on that the multi-baggers, which most often come from earnings growth, can carry a portfolio.
(Brett) Identifying a company’s growth stage
One part of his philosophy highlighted over and over in the book – and something I want to take to my own investing style – is focusing on a company’s growth stage and whether you can predict anything about its future growth. A small company with predictable earnings growth trading at a cheap price is the recipe for a 10 or even a 100-bagger.
Two examples highlighted are La Quinta and Taco Bell, which were growing restaurant (Taco Bell) and hotel (La Quinta) concepts back when Lynch was investing.
He likes physical retail concepts that have shown strong returns in a certain region and are planning to expand around the country. If you can get a predictable 15% return on invested capital (ROIC) and you have the opportunity to go from 200 to 2,000 stores across the country, the stock might be a buy.
There are two keys to these types of investments. First is finding out the “why” for what makes it so successful in its region. For La Quinta, it was an innovative model that took out some of the costs bloating other hotels, allowing it to offer travelers a good hotel room at a much cheaper price. Competitors would be behind because they can’t remodel their existing locations overnight.
The second key is seeing if the concept works in another region before investing. He highlights that Taco Bell proved it could work outside of its first market, but that a restaurant chain in the Boston area did not when it moved to other areas. Lynch invested before the other chain proved it could work outside of Boston, and he lost money. A lesson there, for sure. If a concept works in two separate regions, it will likely work in ten.
Restaurants are the quintessential winning stock in this category. A lot of times food concepts don’t travel, or brands like to stay in a local area. But if a management team decides to expand and proves that the whole country enjoys the concept, there is a long runway for reinvestment. You could have another Chipotle on your hands.
(Ryan) “The Greatest Company of All”
In Chapter 8 of his book, Lynch describes the 13 attributes he looks for in a stock.
I’ll go briefly through each and we can pause on the ones we think are important.
It Sounds Dull - Or, Even Better, Ridiculous
The example he uses here is Pep Boys - Manny, Moe, and Jack
It Does Something Dull
It Does Something Disagreeable
He calls out a company called Safety-Kleen here which goes around to all the gas stations and provides them with a machine that washes greasy auto parts.
It’s a Spinoff
The Institutions Don’t Own It, and The Analysts Don’t Follow It
The Rumors Abound: It’s Involved with Toxic Waste and/or The Mafia
Doesn’t seem quite as applicable these days.
There’s Something Depressing About It
He calls out a funeral home roll-up here which had fantastic returns. People just don’t want to talk about that kind of thing until they have to.
It’s a No-Growth Industry
“In a no growth industry, especially one that’s boring and upsets people, there’s no problem with competition. You don’t have to protect your flanks from potential rivals because nobody else is going to be interested.”
It’s Got a Niche
People Have to Keep Buying It
It’s a User of Technology
The Insiders are Buyers
“When management owns stock then rewarding the shareholders becomes a first priority, whereas when the management simply collects a paycheck, then increasing salaries becomes a first priority.”
The Company is Buying Back Shares
Discussion question: Which of these do you like the most? Which do you feel like you want to prioritize more in the future?
(Ryan) Stocks He Avoids
This will be a short segment, because Lynch has a pretty simple answer.
“If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train – and succumbing to the social pressure, often buys.”
Discussion Question: Any stocks come to mind today?
(Brett) The P/E equals the growth rate hurdle
This is the PEG ratio. Here’s how it works:
“To better analyze growth companies, Lynch used the PEG ratio, which is the price-to-earnings ratio divided by the firm’s growth rate. This was one of Lynch’s favorite stock investing criteria; here's how it works:
Assume we are comparing two different stocks, and both have a price-to-earnings ratio of 30. On the surface, they may look the same but now let’s look at the growth rates. Let's say Company A is growing earnings at 40% while Company B is growing earnings at 15%. Company A has a PEG (price-to-earnings to growth rate) of 0.75 (30 divided by 40 equals 0.75) while Company B has a PEG of 2.0 (30 divided by 15 equals 2).”
Lynch said that as a rule of thumb, he buys stocks where he believes the earnings growth will be greater than the P/E. So if he buys a stock at a P/E of 10, he wants it to grow earnings by 10%. If he buys it at a P/E of 15, it needs to be growing at 15%. At 30, it needs to be growing by 30%.
Simple on its face. But predicting earnings growth is hard. You can look at any company and proclaim “the future will be incredible!” and excuse yourself for buying at 40x earnings. Most of the time, great companies will only grow earnings at a 15% - 20% rat over the long haul, and only when they are smaller (excusing a very depressed starting earnings margin, of course).
Discussion Question: Is there a single large-cap stock out there today that passes this test?
Would Peter Lynch buy Costco, Chipotle, Or Nvidia today? I doubt it.
Avoid the macroeconomic doom
Some perspective to close out the episode:
“Lately we’ve had to contend with the drumbeat effect. A particularly ominous message is repeated over and over until it’s impossible to get away from it. A couple of years ago there was a drumbeat around the M-1 money supply. When I was in the Army, M-1 was a rifle and I understood it. Suddenyl M-1 was this critical digit on which the entire future of Wall Street depended, and I couldn’t tell you what it was. Remember One Hour Maritinizing? Nobody can tell you what that is, either, and millions of dry cleaning patrons have never asked. Maybe the M-1 actually stands for Martinizing One, and some guy on the council of economic Advisors used to run a dry-cleaning business. Anyway, for months there was something in the news about the M-1’s growing too fast, and people worried that it would sink our economy and threaten the world. What better reason to sell stocks than that “the M-1 is rising” – even if you weren’t sure what M-1 was.”
Tbe suddenly we heard nothing further about the dreaded rise in the M-1 money supply, and our attention was diverted to the discount rate that the Fed charges member banks. How many people know what this is? You can count me out once again. How many people know what the Fed does? William Miller, once Fed chairman, said that 23% of the U.S. population that the Federal Reserve was an Indian reservation, 26% thought it was a wildlife preserve, and 51% thought it was a brand of whisky"
Ignore the macroeconomic discussions! It is a crapshoot and frankly almost everyone has no idea what they are doing.
Is it fun to talk about? Yes. But should it impact your investment portfolio if you have a 10 - 15 year time horizon? No.
Takeaways from Studying Peter Lynch
(Ryan) A couple things for me.
Stay alert. No matter what you’re doing, pay attention to the services you’re using. What is providing value to you? What are you paying for on a recurring basis? Dig into that stock if it’s publicly traded.
You don’t need to own 5 stocks to outperform. I think this is probably the biggest takeaway I had from the book. I don’t need to complete some rigorous research process and model out 10 years to the exact decimal before I buy. Find the few factors that will most impact the business, confirm it’s trading at a reasonable price, and own some shares. You can adjust your position from there.
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Awesome writing!