Peter Lynch: How to Achieve a 29% Annual Return in the Stock Market

Peter Lynch is definitely someone you should be studying if you want to learn about investing. During his time running the Fidelity Magellan Fund, Lynch averaged a 29.2% annual return, consistently more than double the S&P 500 stock market index, making it the best-performing mutual fund in the world. Here are my nine favorite clips of Peter Lynch; number five is my personal favorite.

Enjoy 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. Actually, if you really pressed them down, they'd say the reason I own this is the sucker's 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 ten-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% of people that own stocks.

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 processors, sir, with an optimizing compiler, a 16 dual-port memory, a double-diffused metal oxide semiconductor monolithic logic chip with a plasma matrix vacuum fluorescent display. It has a 16-bit dual memory and has a Unix operating system for Whetstone megaflop polysilicon 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 a dozen 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 megaflop 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. 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-priced Korean imports; I mean, I just didn't, 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 the money. The public, when they buy a refrigerator, they get 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 or program trading. That is garbage. They didn't do any research; they put 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 it is; that's the way they're acting.

Another key element is that you have plenty of time. People are in an unbelievable rush to buy a stock. I'll give an example of a well-known company: Walmart went public in October of 1970. It went public; it already had a great record; it had 15 years of performance, a great balance sheet. You could have waited 10 years, saying you're a very conservative investor, you're not sure this Walmart can make it. You want to check; you see them operating in small towns; you're afraid they can only make it in seven or eight states.

You want to wait until they go to more states. You keep waiting; you could have bought Walmart 10 years after they went public and made 35 times your money. If you bought it when they went public, you would have made 500 times your money. But you can wait 10 years after Walmart went public and made over 30 times your money. You could wait three years after Microsoft went public and made 10 times your money. Now, if you knew something about software—I know nothing about software—if you know someone in software, you would have said these guys have it. I don't care who's going to win—Compact, IBM; I don't know who's going to win Japanese computers; I know Microsoft MS-DOS is the right thing.

You could buy Microsoft. Again, I'm repeating myself: stocks are not a lottery ticket; there's a company behind every stock, and you can just watch it. You have plenty of time; people are in an amazing rush to purchase the security; they're out of breath when they call up. You don't need to do this. 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, and 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—going from crappy to semi-crappy to good—that might take a couple of years or they're going to grow for a long time, and 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 400 that are great companies. CarMax was not in the S&P 500; they went up 200 fold. A lot of times they enter, and a lot of their great performances before they go in.

And then, I'll switch through to my long shots: avoid long shots. I've bought about 30 long shots in my life; I've never broken even on one. The ones that are really bad are what we call whisper stocks. If Arthur Levitt was here, he would create a lot. I appreciate these stories, but these are the times that somebody calls you and says, "Hi Peter, how's Carol, how are the kids? I'd like to talk to you about international blivet." And they keep whispering; all they say is, "What are you talking about? I don't understand it."

And these are now either they're so surrounded by people they're going to run out and buy this stock because it's so exciting, or they think the SEC is listening, and they'll get a shorter term, you know, they'll get six months in the camp rather than two years in the camp. But whisper stocks don't work.

Are you concerned about the volatility in the financial markets today? Do you think something needs to be done to reduce it? 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 closed. I started buying at 7, but I kept holding it, and it went to 1, and it was the largest position of Magellan in 1978 when it was bought out for 42 dollars by Pepsicola. 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 callers 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 keep the volatility down each day; it's important. But the market's going to go up and down. Well, human nature hasn't changed a lot in 25,000 years, and some of that will come out of left field, and the market will go down, or the market will go up.

So 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 8% 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 3800 today; 3700. 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? Don't know which way they're going.

So the market ought to double in the next 8 or 9 years; it ought to double again in the 8 or 9 years after that because profits will go up 8% a year, and stocks will follow—that's all there is to it. When you were actively managing money, you presumably were 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—it's funny: in a stock, all you can lose is 100%. 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 on the 10 baggers. So some of my mistakes are just 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 my two greatest mistakes 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 until things are getting better, and they're doing terrific, and then you sell it.

But with a growth company, you have to say—the Walmart case: ten years after they went public, you could have bought the stock and made 500 times your money because they still are only in 15 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 went 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 to 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 in 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 be right 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 twenty or thirty percent.

So when you buy, ask yourself how much can I lose and how much can I make; and you ought to be able to make a lot. 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 the 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 logics; I had a syllogism and studied these when I was at Boston College. They can't be that many people who can pick interest rates because there'd be lots of billionaires. And no one can predict the economy. I had a lot of people in this room around in 1981 and ‘82, and 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 it. I studied all this stuff; I remember every time we had 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 is going to do; it'd be terrific to know that the Dow Jones average year from now would be X, that we're going to have a full-scale recession, our interest rates going to 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 and all these M's.

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 with used car prices. When used car prices are going up, it's a very good indicator. When I own hotel stocks, I want to know about hotel occupancies. About chemical stocks, I know what's happened with 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; I own Fannie Mae or I own a housing stock; these are facts.

You can—there are 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 in 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 even the Federal Reserve can't do it?

Another point you've made—and this I think is particularly relevant ten years into a bull market—is that I think you said more money has been lost anticipating a downturn than actually in the downturn. Can you explain? Well, obviously the market's gone up tenfold since I stopped running Magellan, so you make more money on the upside. The market's been a lot higher in 10 years from now, 20 years from now, 30 years from now. Trying to predict the market is really a waste. I don't know what's going to do; it can go down.

When I ran Magellan, the market declined 10 or more nine times. The market—I had a perfect record; I went down more than ten percent every time where the market went down and went down more. But over the long term, the upside is more than the downside. So you're going to say something? Do I need the money in the next month? Do I need the money next year? Do I have kids going to college? I have a wedding coming up? Then you're a bad investor.

If you can keep putting money in, you have 5, 10, 15, 20, 25 years; you should do well. One of the things I find—a couple rules I want to throw out that I find useful—excuse me—there's a lot of times people buy on the basis the stock has gone down this much. How do you know how much further it can 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; it's now 95; what a buy!"

Within a year it was 18. And this is kind of no debt; I mean, there's 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 share 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 and 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've got to look at this Kaiser Industries. I mean, how much lower can it go? It's gone from 26 to 10." Well, it went to 6; it went to 5; it went to 4; it went to 3. And now, I unfortunately have—I would probably be still caddying or working at the Stop & Shop, but it happened fast. I was able to—this was compressed. At 3, I figured out, you know, there's something very wrong here because Kaiser Industries owns 40% of Kaiser Steel; they own 40% of Kaiser Aluminum; they own 32% of Kaiser Cement; they own Kaiser Broadcast; they own Kaiser Santa Gravel; they own Kaiser Engineers; they owned Jeep.

They owned 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 can approach that, it's a real achievement. But they had no debt, and the whole company at 3 was selling for about 75 million, and 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 in Kaiser Aluminum; they passed out their public shares in Kaiser Steel; they sold all the other businesses, and you got about 50 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 9? What would you do when it went to 8? What would you do when it went to 7? 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 the psychiatric psychiatry fund. I've never seen the list listed with the SEC to make it through as a mutual fund. So I—they haven't seemed to help; I've tried prayer; that hasn't worked.