Peter Lynch: 7 Tips to Consistently Outperform the Market

Would be terrific to know that the Dow Jones average a year for now would be X, that we're gonna have a full-scale recession, our interest rate is gonna be 12. That's useful stuff. You never know it though; you just don't get to learn it.

So I've always said if you spend 14 minutes a year in economics, you've wasted 12 minutes, and I really believe that. Now I have to be fair; I'm talking about economics on the broad scale, predicting the downturn for next year or the upturn, or M1 and M2, 3B and all these, all these Ms. There's a lot of times people buy on the basis the stock has gone down this much. You know how much further can you go down?

I remember when Polaroid went from 130 to 100, people said here's this great company, great record. If it ever gets below 100, you know, just buy every share. You know, and it did get below 100. A lot of people bought on that basis, saying look, it's gone from 135 to 100; now it's 95. What a buy! Within a year, it was 18. And this is coming with no debt. I mean as a company, it was just so overpriced it went down.

I did the same thing in my, I think my first or second year at Fidelity. Kaiser Industries had gone from 26 a year to 16. I said, how much lower can it go? It's 16. So I think we bought one of the biggest blocks ever on the New York, on the American Stock Exchange of Kaiser Industries at 14. I said, you know, it's gone from 26 to 16; how much lower can it go? Well, at 10 I called my mother and said, "Mom, you gotta look at this Kaiser Industries. I mean, how much lower can it go? It's gone from 26 to 10." Well, it went to six, it went to five, it went to four, it went to three.

And now I unfortunately have rapidly, I would probably be still caddying or working at the Stop & Shop, but it happened fast. I was able to, this was compressed to that. And at three, I figured out, you know, there's something very wrong here because Kaiser Industries owns forty percent of Kaiser Steel. They own forty percent of Kaiser Aluminum. They own thirty-two percent of Kaiser Cement. They own Kaiser Broadcast, they own Kaiser Santa Gravel, Kaiser Engineers, they own Jeep, they own business after business, and they had no debt.

Now I learned this very early; this might be a breakthrough for so many people. It's very hard to go bankrupt if you don't have any debt. It's tricky; some people approach that it's a real achievement, but they had no debt, and the whole company at three was selling at about 75 million. At that point, it was equal to buying one Boeing 747. I said there's something wrong with this company selling for 75 million. I was a little premature at 16, but I said everything's fine and eventually this worked out.

And what they did is they gave away all their shares to their shareholders. They passed out shares and kind of meant they passed their shares in Kaiser Aluminum, they passed out their public shares in Kaiser Steel, they sold all the other businesses, and you get about fifty dollars a share. But if you didn't understand the company, if you're just buying on the fact the stock had gone from 26 to 16, and then it got into 10, what would you do when it went to nine? What would you do when it went to eight? What would you do when it went to seven?

This is the problem that people have; they sell stocks because they didn't know why they bought it. Then it went down, and they don't know what to do now. Do you flip a coin? Do you walk around the block? You know, what do you do? Psychiatrists haven't worked so far; I've never seen them running in the psychological psychiatry fund. I've never seen for the SEC to make it through as a mutual fund. So, they haven't seemed to help.

I've tried prayer; that hasn't worked. So if you don't understand the company, this problem when they go down, eventually they always come back. This one is, this one doesn't work either. People think RCA is just about to get back to its 1929 high when General Electric took it over. A lot of double knits never came back. Remember those beauties? Floppy disks, Western Union, the list goes on and on. People say it'll come back; well, it doesn't have to come back.

Here's another one you hear all the time: it's three dollars, how much can I lose? I've had people call me up saying, "I'm thinking of buying this stock at three. How much can I lose?" Well again, you may need a piece of paper for this, but if you put, if you put twenty thousand dollars in a stock at fifty or your neighbor put twenty thousand at full at fifty into the stock, and you put twenty thousand dollars into three and it goes to zero, you lose exactly the same amount of money. Everything.

And people say it's three, how much can I lose? Well, if you put a million dollars on it, you can lose a million dollars. Just the fact that this is the only, this may be a reason researchers thought the fact that stock is three down from 100 doesn't mean you should buy it. In fact, short sellers, people that really make money in stocks, they don't short at Walmart, they're not short at Home Depot, they're not short the great companies like Johnson & Johnson. They short stocks down from 80 to 70.

They'd like to short it at 16 or 22, but they figured out at seven this company is going to go to zero; they just haven't blown taps on this thing yet; it's going to zero. And they're selling short at seven, they're selling short at six, at five, at four, at three, at two, at one and a quarter. And you know to sell something short you need a buyer; somebody has to buy the damn thing. And you want to know who's buying this thing? It's these people saying, "It's three, how much lower can it go?"

I love volatility. I think, I remember when in 1972 the market went down dramatically and Taco Bell went from 14 to 1. They had no debt; they never had a restaurant close. And I started buying at seven, but I kept on to it and it went to one. And it was the largest position of Magellan in 1978; it was bought out by 42 dollars by Pepsi-Cola. I think it would have gone to 400 if they didn't buy it out.

I think volatility is terrific; I think it is very, I think these calls are very important. I don't think the market going up 80 points one day and down 80 the next is a good thing for the public. I think that's not a very good thing, but I think all these callers and all these other things to keep the volatility down each day is important. But the market's going to go up and down.

Well, the human nature hasn't changed a lot in 25,000 years. And some of them come out of left field, and the market will go down or the market will go up. Volatility will occur and markets will continue to have these ups and downs. I think that's a great opportunity if people can understand what they own. If they don't understand what they own, they can own mutual funds, try to figure out mutual funds they own, and keep adding to it.

Over basic corporate profits have grown about eight percent a year historically. So corporate profits double about every nine years. The stock market ought to double about every nine years. So I think the next market's about 3,800 today, 3,700. I'm pretty convinced the next 3,800 points will be up; it won't be down. The next 500 points, the next 600 points, I don't know which way they're going. So the market ought to double in the next eight or nine years; it ought to double again in the 89 years after that because profits will go up eight percent a year, and stocks will fall.

That's all there is to it. Your investing philosophy is often summed up as "buy what you know," and there's some truth to that, and it's also often way oversimplified. Can you explain what you did mean by that and what you didn't mean?

Well, I think it bothers me that people are very dangerous when they invest. This word "play the market" – that's a dangerous term. But if you do some work, do some research, know what you own, look at the research, look at the balance sheet, if you could add eight and eight, get fairly close to 16, you find out this company has lots of debt, no cash, they're in trouble. You should know it.

So a little bit of research. People carefully buy a refrigerator; they can't take a vacation and they'll put five, ten thousand dollars into some stock they hear on the bus or the party. That's dangerous. So when you say "buy what you know," you also thought that the regular investor might be able to get an inside advantage by sticking to an industry he's familiar with or seeing something that she realizes is a great product.

Imagine if you were in a mall the last 50 years; you've seen Gap when it was hot. You were saying Limited was hot; we've seen what was not hot; we've seen when they were starting. People weren't excited about Gap anymore. Or then you do some research and say, "Well gee, there's a lot of Limited stores, but we're only at 20. You know, they can go to 400."

So you see a company I did really well, Dunkin' Donuts. It's a local company. I do well with Stop & Shop, but people could see that there's really, people showing up. Or guess the Sunglass Hut, no one's there anymore. So I mean that's research. That's fundamentals. So you don't leave the mall though, and by that day you have to do some more work; that’s the important point.

Yeah, so today there's so much information everywhere. Information overload, does that make it harder for active investors? The indexers say everyone's got access to the same information at the same time; you can't beat the market. Well, the way you beat the index is you avoid the stocks that go down. You avoid the steel companies and the oil companies and Sears and Penny where the companies are deteriorated.

I mean companies are dynamic. Behind every stock there's a company; these are not lottery tickets. So you're trying to find the companies within the S&P 500 that are doing better; they're going from crappy to semi-crabby to good. That might take a couple of years or they're going to grow for a long time; you're trying to avoid the companies that are going south.

That's how you beat them. Or you find some companies outside the S&P 500 that are great companies. CarMax was not in the S&P 500; they weren't 200-fold. So a lot of times they enter, and a lot of their great performances before they go in. Now a lot of people, when they're lucky enough or smart enough to get a company that's going up, they then take their profits, and you made the case in a book that you should actually hang in there with the really great stocks.

And you even got a call from Warren Buffett as a result. Yeah, in 1989 I'm at home; the phone rings, and that was one of my friends but one of my daughter's, she was six years old. Annie picked up and said, "There's a Mr. Buffett online." I said, "This could be a joke." I pick it up, and this is Warren Buffett from Omaha, Nebraska. You know, I read your book, but my aim reports doing two weeks. I use the line you said about watering the weeds and cutting the flowers. He said, "I want to put it in." He said, "If you ever come to Nebraska, don't call me; you nailed me, mud all over Nebraska."

So did he call him? Oh yeah, I said several times. We play bridge together; we've had several meetings. Great guy. The single most important thing to me in the stock market for anyone is to know what you own. I'm amazed how many people own stocks; they would not be able to tell you why they own it. They couldn't say in a minute or less why they own it. And if you really press them down, they'd say the reason I own this is the sucker is going up, and that's the only reason. That's the only reason they own it.

And if you can't explain, I'm serious, you can't explain to a 10-year-old in two minutes or less why you own a stock, you shouldn't own it. And that's true. I think about 80 percent of people that own stocks, and this is the kind of stock people like to own. This is the kind of company people adore owning. It's a relatively simple company; they make a very narrow, easy to understand product.

They make a one megabit SRAM CMOS bipolar risk floating point data I/O array processor with an optimizing compiler, a 16 dual port memory, a double diffused metal oxide semiconductor monolithic logic chip for the plasma matrix vacuum fluorescent display. It has a 16-bit dual memory; it has a Unix operating system for Whetsone megaflop poly-silicon emitter, a high bandwidth that's very important, six gigahertz double metallization communication protocol, and asynchronous backward compatibility peripheral bus architecture, four wave interleaved memory, a token ring interchange backplane, and it does in 15 nanoseconds of capability.

Now if you don't want a piece of crap like that, you will never make money. Never. Somebody will come along with more wet stones or less wet stones or a bigger mega flop or a smaller megaflop; you won't have the farthest idea what's happened. And people buy this junk all the time. I made money in Dunkin' Donuts; I can understand it. I, when there was recessions, I didn't have to worry about what was happening. I could go there, and people were still there. I didn't have to worry about low-price Korean imports.

I mean, I just think that, you know, I can understand it. And you laugh; I made 10 or 15 times my money in Dunkin' Donuts. Those are the kind of stocks I can understand. If you don't understand it, it doesn't work; this is the single biggest principle. And it bothers me that people are very careful with their money. The public, when they buy a refrigerator, they get a Consumer Reports; they buy a microwave oven; they do that. They ask people what's the best kind of radar range, what kind of car to buy.

They do research on apartments. When they go on a trip to Wyoming, they get the mobile travel guide. Or California; when they go to Europe, they get the Michelin travel guide. People will hear a tip on the bus on some stock, and they'll put half their life savings in it before sunset, and they wonder why they lose money in the stock market. And when they lose money, they blame it on the institutions and program trading. That is garbage. They didn't do any research; they bought a piece of junk; they didn't look at the balance sheet, and that's what you get for it.

And that's what we're being driven to, and it's self-fulfilling. The public does terrible investing, and they say they don't have a chance. It's because that's the way they're acting. I'm trying to convince people there is a method; there are reasons for stocks that go up. Coca-Cola, this is very magic, it's a very magic number, easy to remember. Coca-Cola is earning 30 times per share what they did 32 years ago. The stock has gone up 30-fold.

Bethlehem Steel is earning less than they did 30 years ago; the stock is half its price of 30 years ago. Stocks are not lottery tickets; there's a company behind every stock. If a company does well, the stock does well; it's not that complicated. People get too carried away. First of all, they try and predict the stock market; that is a total waste of time. No one can predict the stock market. They try to predict interest rates; I mean this is a, if anybody predicted interest rates right three times in a row, they'd be a billionaire.

Concern, there's not that many billionaires on the planet. It's very, you know, I took, I had logic, so I had a syllogism, and studied these when I was at Boston College. They can't be that many people who can break interest rates because there'd be lots of billionaires. And no one can predict the economy. A lot of people in this room were around in 1981 and 82 when we had a 20 prime rate with double-digit inflation, double-digit unemployment. I don't remember anybody telling me in 1981 about it.

I didn't read; I studied all this stuff. I remember every time we got the worst recession since the depression. So what I'm trying to tell you, it'd be very useful to know what the stock market's going to do. It'd be terrific to know that the Dow Jones average year from now would be X, then we're gonna have a full scale recession, our interest rate's gonna be 12. That's useful stuff; you never know it though; you just don't get to learn it.

So I've always said if you spend 14 minutes a year in economics, you've wasted 12 minutes, and I really believe that. Now I have to be fair; I'm talking about economics on the broad scale, predicting the downturn for next year or the upturn, or M1 and M2, 3B and all these, all these Ms. The, I'm talking about economics to me is when you talk about scrap prices. When I own auto stocks, I want to know what's happening to used car prices. When used car prices going up, it's a very good indicator.

When I own hotel stocks, I want hotel occupancies. About chemical stocks, I don't know what's happening the price of ethylene; these are facts. If aluminum inventories go down five straight months, that's relevant. I can deal with that home affordability; I want to know about when I own Fannie Mae or I own a housing stock. These are facts; you can, they're economic facts.

In this economic predictions and economic predictions are a total waste. And interest rates, Alan Greenspan is a very honest guy; he would tell you that he can't predict interest rates. He can tell you what short rates are going to do the next six months; try and stick them on what the long-term rate will be three years from now; they'll say I don't have any idea. So how are you the investor supposed to predict interest rates if the Federal Reserve can't do it?

And history is the important thing; you learn from what you learn from history is the market goes down, it goes down a lot. The math is simple; there's been 93 years a century; this is easy to do. The market's had 50 declines of 10 percent or more. So, 50 declines in 93 years; about once every two years the market falls 10. We call that a correction; that means that's a euphemism for losing a lot of money rapidly. We call it a correction.

And so, 50 declines in 93 years; about once every two years the market falls 10. All those 50 declines, 15 have been 25 percent or more; that's known as a bear market. We've had 15 declines in 93 years. So every six years the market's gonna have a 25 percent decline; that's all you need to know. You need to know the market's gonna go down sometime. If you're not ready for that, you shouldn't own stocks. And it's good when it happens; if you like a stock at 14, it goes to six, that's great.

You understand the company; you look at the balance sheet and they're doing fine. You're hoping to get to 22 with it. 14 to 22 is terrific; 6 to 22 is exceptional. So you take advantage of these declines; they're going to happen. No one knows when they're going to happen. It would be very, people tell you about it after the fact; they predicted it, but they predicted it 53 times.

So you can take advantage of the volatile market if you understand what you own. When you were actively managing money, you presumably are under the same pressures as other fund managers to show performance results. Did that incline you to sell too quickly sometimes?

Well, I think my greatest mistakes are probably, you know, it's funny; in the stock, all you can lose is 100 percent. I've done that, but your great mistakes are selling a good company and then it doubles, then it triples and quadruples because you make a lot of mistakes since those ones that go up tenfold like the 10 baggers. So some of my mistakes are saying, "Oh my god, this stock is too high."

And I was wrong, and you had to figure out what inning am I in this baseball game. I sold Toys "R" Us way too early; it went up 20-fold after I sold. I did the same thing at Home Depot. Those are probably two of the greatest mistakes I ever made.

When should you sell? Well, you ought to find out why you bought a stock. If you're saying it's a cyclical company and they're doing poorly and they're doing awful, you wait till things are getting better and they're doing terrific, and then you sell it. But with a growth company, you have to say, Walmart's case, 10 years after they went public, you could have bought the stock and made 500 times your money because they still are only in 15 percent of the United States, and they could say why can't they go to 17, why can't they go to 19, why can't they go to 23?

So for the next four decades, they're around the country. So you have to say to yourself, in this stock, I have a 10-year story, a 20-year story; I'll be able to write that down and follow that. That's what I do with the company, and that's your decision; that's how you sell it.

We have a novel element from many investors today in the trust issue. We also have security problems that we didn't traditionally have in America. Have they changed the way you pick and believe in stocks?

No, you still buy a company, and you buy a company to grow. And if it's a textile company or it's an electronics company, a software company, you better understand what they do. And if they do well, the stock will do well no matter what happens in the market. If the Dow Jones today was a thousand or 500, you would have made a lot of money in McDonald's. You would have made a lot of money in Johnson & Johnson. You would have made a lot of money in Gillette. These companies' earnings have gone up a lot the last 30 years.

And if the market was 50,000, you would have lost money in Burlington Industries. I recommended that in 1969. I think it's gone from 34 to 2 with no stock splits; these earnings have been terrible. Well, your modesty actually makes an important point, which is people with the best batting averages in the world don't bat a thousand.

I sometimes get angry mail, particularly during bear markets, saying so-and-so recommended such-and-such and it went down. Well, how often did you come up with a clinker? Well, this is a funny business; you don't have to write even five times out of ten. If the times you're right, you make a double and triple; it offsets all those times you lose 20 or 30 percent.

So when you buy a cycle, say to yourself how much can I lose and how much can I make? And you ought to be able to make a lot. You see stocks are risky; I mean, look, look at how much we lost on AT&T; look how much less than Xerox. These were quality companies; you know, you could lose a lot in a stock. It's gonna say to yourself how much can I make because I want to buy a stock.

If I'm right, I'm going to make a double or triple. Does your own confidence ever get shaken? Every day! I think the market's going to go up, you know; I keep calling a lot of my company, so I keep calling the company you want.