Picking Stocks? Study Firms, Not the Market

Want to become an expert at picking stocks? Then start by doing exactly what many so-called experts don’t do: Follow companies, not the market. And rely on what you already know about the industry or field you work in.

That’s the sage advice of Peter Lynch, one of the best stock pickers of all time as portfolio manager of the wildly successful Fidelity Magellan Fund. Lynch--whose fund gained more than 2,867% during the past 15 years, far and away the best for that period--says he is upset about how small investors lose money in stocks.

Accordingly, he has written “One Up on Wall Street,” which may be the most readable, witty and sensible book to come out in years on the often-dismal subject of stock picking.

Lynch’s ideas could surprise you, not only for their accessibility to small investors but also for his disdain of fellow institutional investment professionals, whom he calls “oxymorons.”

Far from being rigged in favor of professionals, the market offers many advantages to amateur investors, Lynch says. You can beat the pros by simply relying on common sense, what you already know and basic research, Lynch says.

Most institutional investors don’t study companies adequately, he says, instead relying on recommendations from analysts and others who don’t start following a stock until well after it has run up a great deal.

Many individuals fail for the same reason, relying on tips or hunches about companies they know little or nothing about. And they stumble further by trying to predict where the overall market or economy is going--an impossible task, Lynch says. If your research is sound, you will pick stocks that will do well under any market or economic scenario, Lynch says.

“A lot of people wake up in the morning and say, ‘I’m going to buy IBM.’ But they don’t know the first thing about IBM,” Lynch says.

Instead, you should apply the same care in buying stocks that you do in making other important purchases. “Do the same things you do when you buy a refrigerator or when you buy an apartment,” the legendary money manager says.

How to start? First, stick to industries and fields that you know something about. If you work as a tire salesperson, for example, you may know a lot more about trends and companies in that industry than professional investment managers do. Long before the so-called pros, you will know if Goodyear’s sales are picking up, if its inventories are shrinking and if its latest tire is superior to the competition’s in quality.

Unfortunately, he says, you probably will ignore such insights and instead succumb to the temptation to buy “hot” stocks in solar energy or biotechnology, fields about which you know little and have no edge against market professionals.

As an example of the power of using what you already know, Lynch cites the case of Federal National Mortgage Assn., better known as Fannie Mae, one of Magellan’s biggest winners and currently its biggest holding.

Anybody working in the mortgage, savings and loan or banking businesses could have foreseen the success of this company a few years ago, simply by noticing the phenomenal growth of mortgage-backed securities, in which Fannie Mae is a leader.

And there is still much growth ahead, Lynch reasons, because only 30% of all mortgages have been packaged as marketable securities. Also, regulatory pressures will require S&Ls; to sell more home loans into the secondary market.

Your “power of common knowledge” even applies to what you already know from your everyday activities--such as shopping for a car or eating out, Lynch says.

He bought one of his biggest winners, Taco Bell, after being impressed with its burritos on a trip to California. Another winner, Dunkin’ Donuts, came on board after Lynch loved its coffee. Lynch bought another winner, Hanes, after his wife bought its L’eggs panty hose at the grocery store and was impressed by their quality. Until then, panty hose had largely been sold at department stores.

Sounds a bit simplistic, you say? True, but don’t just stop there, Lynch says. After becoming convinced that a company’s product or trend is solid, you still need to assess its financial condition. How much of its revenue is derived from the hot new product or trend? What is its debt and cash position? Does it have a good track record of earnings?

Conversely, ignore such numbers as book value or net worth, which can be grossly undervalued or overvalued.

And once you pick a company, particularly a newer one with a great idea, don’t be in a big hurry to buy it. You don’t have to get in on the ground floor to make money with growth stocks, Lynch says.

“If a stock is going to go from $2 to $100, it’s OK to buy it at $6 or at $12,” he says. “Tune in later and see if the concept still works.”

Similarly, once you buy, have patience. You can lose money fast in stocks, but you can’t make money fast, he says. Some of Lynch’s biggest winners--companies like Pic ‘N’ Save, Taco Bell, the Gap and Dunkin’ Donuts--made him the most money during the third, fourth or fifth years he owned them.

Also, many people err by selling at the wrong time for the wrong reasons. Don’t sell because a stock’s price has doubled or been cut in half. Instead, see if the reason you bought it in the first place still applies. If not, then sell.

Such a strategy applies in the case of the Limited, the women’s specialty apparel retailer. Many women shoppers in the mid-1970s could have noticed the company’s crowded stores and quality merchandise at bargain prices--and thus could thus have bought the stock--long before the institutional crowd discovered it in the mid-1980s after it had already racked up impressive gains. But in recent years, the firm has been dogged by competitors and its edge has been eroded. Lynch himself bought the stock after its glory days and has yet to make money on it.

Lynch also advises to pick companies that are focusing on businesses they know best--even if such businesses are dull or dismal, such as funeral homes or waste disposal. Be wary of companies with fancy, esoteric names, or those spending corporate assets on diversification--what Lynch calls instead “diworsification.”

One stock he likes, American Express, has been focusing on its bread-and-butter travel-related credit card business, which is growing fast. Meanwhile, it has been reducing its exposure in banking, insurance and other fields.

Of course, not all investment pros agree with Lynch’s approach. Some may call it overly simplistic, particularly for small investors who often don’t know the difference between earnings and dividends.

Yet others may see an irony in Lynch’s prescriptions that you only need to hold about two or three stocks at a time, with about 10 others that you monitor on your watch list. Lynch’s Magellan Fund, by contrast, holds some 1,400 stocks with a total asset value of $9 billion.

But Lynch counters by noting that individuals should own mutual funds as well, investing in individual stocks with “incremental” money that they can afford to lose.

Right or wrong, it’s hard to argue with Lynch’s success. A $10,000 investment in Fidelity Magellan in 1977, when Lynch became manager, is worth nearly $190,000 today.

Bill Sing welcomes readers’ comments and suggestions for columns but regrets that he cannot respond individually to letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.