The Hindu Business Line : Peter Lynch on markets

“An investment is simply a gamble in which you’ve managed to tilt the odds in your favour,” writes Peter Lynch. There is no stock which is a sure thing, as Lynch puts it ‘Fortunes change, there is no assurance that major companies won’t become minor, and there is no such thing as a can’t-miss blue chip’. He also writes about drawing distinctions between speculating and investing: “Gambling can be separated from investing not by the type of activity but by the skill, dedication and enterprise of the participant.” To borrow economic parlance, market participants are constantly working in an environment of incomplete information, one can never have all the information one needs to make an ‘informed’ decision.

More variables than constants

There are few ‘constants’ in a company or economy. Almost all aspects, such as earnings, profitability, product or service line, management and operating excellence, are variables’. Of the variables, the qualitative ones, such as management, company culture, operational excellence can be reasonably extrapolated based on current performance. The quantitative ones are impossible to extrapolate with certainty, but for a company’s stock to perform, earnings growth is the key variable.

‘Variables’ such as interest rates, inflation data, industrial growth have a strong bearing on the economy, but are close to impossible to predict with any certainty or vague accuracy. Peter Lynch advises investors to not base their investment decisions on macro-economic data. Focusing on a company and the relevant industry numbers should provide enough insight into a company’s potential performance.

Dealing with the market

Lynch also asks investors to match the ability to identify exceptional companies with the market’s tendency to do irrational things. There is always some depressing macroeconomic data or political news to drive stock prices lower. Ignoring this news and sticking with your picks, based on how the company is handling bad times, will determine how successful your investment turns out. Lynch also has a very interesting summary of the uninformed investor’s behaviour:

They exhibit concern over bad markets when valuations are reasonable.

They get complacent in rising markets when valuations are getting unreasonable. As Lynch puts it “stocks are likely to be accepted as prudent the moment they are not”.

They capitulate during falling markets as they sell their highly priced holdings for a fraction of the prices they picked it up for when they were complacent.

TO BUY OR TO SELL

“People think that things need to go from terrible to terrific before they can invest, but things only have to get to somewhat crummy for stocks to go up.” Lynch said, in Time magazine. This observation raises the question when is the right time to buy or sell, having decided what to transact in. Lynch suggests that an ‘overvalued market’ is one where you find very few ‘buys’.

Even exceptional companies are priced unattractively relative to their earnings prospects. As Lynch puts it: “It takes remarkable patience to hold on to a stock in a company that excites you, but which everybody else seems to ignore. You begin to think everybody else is right and you are wrong. But where fundamentals are promising, patience is rewarded.’

A euphoric market also leads investors to sell holdings whose prices have risen and hold on to those which are losing value in hope of a resurgence. This attitude to investing he titled ‘Pulling out the flowers and watering the weeds.’ The reasons for ‘watering the weed’ should be based on sound logic and not on wishful thinking. As Lynch aptly puts it “There is no shame in losing money on a stock. Everybody does it. What is shameful is to hold on to a stock or worse to buy more of it when the fundamentals are deteriorating.”