Peter Lynch: How to Invest in an Overvalued Market

One thing you're trying to do is say all these public companies out there, here's the company I really like. The fundamentals are terrific, their earnings are doing well, the competitors are doing poorly. I think this company's doing terrific, and all of a sudden the stock might have gone from 40 to 30 because of this decline. That would say, wow, here's a chance to buy it. So, you're trying to say some companies might have been overpriced at 60 and all they did was go to 50 and say big deal. So, you're trying to find companies you liked anyway, right now you liked them, and now they've had a haircut. That's what you would do.

You're not just like the one from overpriced to fairly priced. Something was fairly placed at the start of this exercise and then had a very, you know, a five for four sale.

Hey guys, welcome back to the channel! In this video, we are going to be talking about some investing lessons that we can learn from Peter Lynch that we can apply for our own investing in 2021. So, we're gonna have a look at an interview from way back, 1997, a Charlie Rose interview that Peter Lynch did.

And I do have to say, apologies, some of the cuts in this interview are going to be quite abrupt. It's because I don't understand, like Charlie Rose, he just interrupts Peter all the time in this interview, so I apologize. I've tried to do the best I can to get to the meat of the argument because I think the whole interview is about 25 minutes, so I've tried to chop it down into the best bits.

So with that said, let's get stuck into it. Glad to be here! Explain to me what's going on.

Well, we had a huge run. I mean, the market was four thousand just, you know, two and a half years ago. Yeah, and it ran up to 8,300 in August. And, you know, like any big rally sometimes it backs off. I mean, it's healthy; everything is overpriced.

Yeah, and that doesn't help anything. The market since World War II has sold between 10 times earnings and 20 times earnings. If you look at the Dow Jones or the S&P 500, if you add up all the companies and take the earnings, you say there's a relationship and it follows. McDonald's earnings have been terrific the last 30 years and the stock's been direct. There's a direct relationship.

So the earnings of the S&P 500 have been between this range of 10 and 20. We were just about to go over the 20, which is the high end of the PE range. There wasn't a lot of PE. 20 is too—is it the top of how high it should ever be? Right? It's been over there only a few times ever over 20, and that's when usually inflation's about zero.

So this clip kind of just sets the scene because what Peter Lynch is describing in this clip is actually what we see today. He's talking about how the PE ratio of the market generally sits between 10 and 20 with 20 really being that upper end. Well, nowadays we have discovered what the ultra upper end of that number looks like, and it seems to be about 30.

Now, that's kind of scary because what we currently see is a PE ratio for the market at 35, and it's only been over 30 in three times in history: 1929, 1999, and right now. So, there's no question that the market is certainly hot, just like the market was hot back when Peter Lynch did this interview back in 1997.

But the question we've got to ask ourselves is, well, how do we go about our investing in this environment? The decline yesterday, in a sense, it led off some of this overvaluation. The market was even overvalued at where it was right, and by letting it off, right, then we got back to what was reasonable. Well, you know, I would say fairly priced made for the larger companies.

They're now—okay, there might be some small companies. We've had 3,000 companies come public the last four years, that's two of business day. Some of those companies have gone down dramatically, and that's sort of a research zone that average people in the stock shop—that's where we can find some.

People know a lot about this; 10,000 public companies, a lot of them are very attractive; no one's following them. And there's lots of people following IBM. That's what you've got—following companies that nobody else followed, right.

I'd like to go to see companies with unions or companies in trouble or companies that no one likes—hotels that have nice beds. Well, yeah, and you have to look at a lot of them. You look at pantyhose, your whiteboard—that's the story, okay? You got Pure One Imports, my wife found that one too, but you have to look at 20 to find one.

It's just, you know, go to the mall and find the stock. I mean, you have to say, my god, this sounds like it's good, then you have to do some steps. You have to do an organized method.

Now that method—we'll get to in a second, but in this clip, Peter inadvertently describes exactly how we should be approaching our investing right now. Because today, even though the market is really high, we're in an environment where actually a lot of businesses are going down.

And what we see is that an index like the S&P 500 is actually propped up by literally five to ten really high-performing massive behemoth companies. Now what Peter's telling us in this clip is to be a great investor even when the market's really overvalued. You have to get away from looking at just those massive behemoth companies.

Everybody's following these big companies; everyone's investing in them, and the prices for these big companies are all sky high. So we should be broadening our horizons and looking maybe at the companies that come after the 50th largest stock in the S&P 500, or maybe beyond the 20th largest stock in the ASX 200 because that's where you're more likely going to find value.

And then the other secret is that, of course, you just have to keep looking at a lot of businesses. The best investors are the ones that turn over the most stones, right? As Peter Lynch said in this interview, you have to look at 20 to find one.

All right, with that said, now let's have a look at the actual steps that we should all be taking to go ahead and make an investment in this sort of environment. Then you have to do some steps; you have to do an organized method.

People are careful when they buy a toaster. Careful—they're careful; they do some research. But they don't do it with stock. They call it the broker. They see somebody at lunch, and they said, man, I got this hot stock, and you run right out and you spend five thousand dollars—small investors. Yeah, well even more—they put an option in international data, which they don't even own.

International A—and it's like a download. Yeah, so it's like a casino; you get the same results as if there's more paperwork, right? So this morning, you get up and you go in and you look at those companies that fit that, you know, something about. You have to have an itch.

Let's say the cement industry goes from crummy to semi-crummy to fairly good, the stocks are going north, you're going to make money. That's the industry you know. If you know the publishing industry, some people have—you have an edge. You work.

I mean, one of your last 30 years, you worked in the restaurant. You would have seen Taco Bell; you would have seen some barrels; you would have seen Pizza Hut; you've seen Chili's; you've seen these companies doing very well. You should have bought those instead of trying to buy biotechnology stuff you know nothing about.

I mean, I know nothing about local area networking. A lot of people are buying this Cisco; they're buying the equipment, saying we're going to root together all these peripherals and put together the servers. But that's not a bad buy because they own a huge percentage of their market.

You know what that was—they're saying only a few people had that way, my god, if it works for us, other people try it. Then colleges will try it; high schools will try it; they'll go overseas; they knew they were early in the ball game and they should have been buying that company instead of out buying something they don't know anything about—some oil drilling company.

I mean, people have this tendency to always buy something they don't. All you need is a few, Charlie; all you need is a few good stocks. This is your song; this has been your song for a long time. But only buy what you know.

Now, but people wake up in the morning and say, there's 5,000 companies out there; which one should I buy? The average person ought to be able to follow four or five companies. There would be a lecture on them; they understand the companies and this forces you.

This tool says to you right down the street, but you keep saying this, so that makes sense. You have to start with, obviously, going ahead and doing some research. You know, he says people do a lot of research when they go to buy a toaster.

Why isn't it that people do a lot of research when they go to buy a stock? You know, don't treat the stock market like a casino. And then when you actually do sit down to learn about some companies, look at the companies that are really relevant to you. Warren Buffett would use the phrase stick within your circle of competence.

Peter Lynch's example here is, you know, if you're someone that works in the restaurant industry, look at Pizza Hut, look at Taco Bell. They're companies that you probably already understand to quite a high level. And don't go messing around with, you know, these biotechnology companies that nobody understands.

So once you find those companies that resonate with you, then you go in, you do that research. And as Peter Lynch says, you only need four to five good stocks in like a decade. Warren Buffet would argue you need even less than that, but you should know those companies well enough to be able to give a lecture on their business. So that's really the first step.

First step is to stay within your kind of circle of competence. Second step, go in and understand those businesses in depth. And then after that, what happens next? Well, let's listen in.

One thing you're trying to do—all these public companies out there, here's the company I really like; the fundamentals are terrific, their earnings are doing well, the competitors are doing poorly. I think this company's doing terrific, and all of a sudden the stock might have gone from 40 to 30 because of this decline.

That would say, wow, here's a chance to buy it. So you're trying to say some companies might have been overpriced at 60, and all they did was go to 50 and say big deal. So you're trying to find companies you liked anyway, right now you liked them, and now they've had a haircut. That's what you would do.

You're not just like the one from overpriced to fairly priced. Something was fairly placed at the start of this exercise and then had a very, you know, a five for four sale. You know, if you had been managing the Magellan fund this morning, you would have been buying like crazy.

I would have been researching like crazy. I've been saying, which companies are the same story? Is there anything really happening? This is a non-event for them. They're still doing well even if we have a recession. There's nothing to do with them, and that's the kinds I'm trying to buy.

But let's say if a company—just think of this as being, you say to yourself, I think this company's gonna earn something in the future. If it's already discounting that, if it's selling at a huge multiple, you say, it's already—it has to work. And then it's only going to stay even.

So you have to say to yourself, if I'm right, how much am I going to make? If I'm wrong, how much am I going to lose? That's the risk-reward ratio in stock shop we talk about. If I'm right, I hope I'm going to double/trip my money; if I'm wrong, may I lose 30, 40 percent. That's a favorable ratio.

You say if I'm right, the stock's not going to go up; it's already discounting terrific things. If discounting terrific things are already in the stock, I don't know, okay?

So first step is to find a company where you've got the edge. The second step is to really understand the business, understand the financials, understand the fundamentals. But then what Peter Lynch talks about in this environment where basically everything's overvalued, what you want to do is you want to try and find companies that are just fairly valued even in this extreme overvalued environment.

Because, as investors, what we do is we buy undervalued stocks, right? We always buy at a discount to intrinsic value, and that's how we know we make money in the long run. Now, if you find a company that's really great but it's also really expensive in this environment and then there's some sort of, you know, 10, 15 market dip and it brings the stock back down to fair value, well, then remember, you're still—it's still like paying full retail for that stock.

So what we're looking for is great businesses that in this overvalued environment are just fairly valued. So if anything does happen suddenly in the market, something causes a 10 percent dip or a 15 dip, then all of a sudden that business goes from being a fair value to now being undervalued. So they're the kind of situations we're looking for.

Imagine this: the new Xbox One X console full retail price, I think, is 750 Australian dollars. If you went into, say, EB Games and they were selling that Xbox for, you know, that it was a thousand dollars and now it's dropped down to 750, you're not getting excited by that deal because it's just come back down to full price.

But if that same store was offering, you know, it started at 750 full retail and then it dropped down to 500, well obviously that's a much better deal. Exactly the same thing with businesses in the stock market.

And just quickly, the other thing to note from what Peter Lynch said in this little clip was when he said if a stock is trading at a huge multiple, it basically has to work, right? And if it does work out, then you're still just even. Now, even today, what we're seeing is some companies—they might be great companies, but they're trading at PE ratios in hundreds if not literally the thousands.

Like some companies, for instance, like Tesla, I think has a PE ratio of 1,300. Now what this means is it means that the price that investors are paying today, this is already—they are expecting flawless continued growth for years and years and years to come. That's what the share price is telling us.

Now, if you invest in a company like this at these prices, then there's very little room for upside and there's a whole lot of room for downside because investors right now are already expecting years and years and years of perfection.

Right? As Peter Lynch says, you have to factor in if I'm right, how much am I going to make, and if I'm wrong, how much am I going to lose? And that's a very—there are very important couple of questions to ask yourself before buying into a stock. And that's where you go back to your discounted cash flow analysis and you look at the growth rates to figure out what that risk ratio is for the company that you're looking at.

What you're saying to people today about the future of the market over the near term is what? What's your feeling? We can have to buy business and flip it. I have no idea what the next thousand points going to do. The next six thousand points can be up. The next fourteen thousand points will be up. The next twenty thousand points will be up. But you don't know where the next thousand is gonna be down.

Could be up; nobody does! And it's futile to try and guess it. Corporate profits will be a lot higher ten years from now; it'll be a lot higher 20 years from now. That's what you could rely on.

The third key step that Peter Lynch highlights in this clip is to always focus on the long term. Don't be worried about what the market will do next week, next month, or even next year. What you should be really focused on is what is this company going to look like in five years from now, in 10 years from now?

Always focus on the long term, because if you can do that, then short term market fluctuations, they really don't matter, and you just don't stress about them at all. In fact, when prices go down, you get excited; you don't get scared.

As Peter Lynch says, you know, corporate profits will be a lot higher in 10 years from now; they'll be a lot higher in 20 years from now, and that's what you have to rely on. So, we rely on the fact that, yes, businesses are going to continually improve—not maybe not over the next year or two, maybe there's something like what we saw with the lockdown, where business is impaired for like a whole year or two, it still doesn't matter to us because we look for situations where what's going to happen over five years? What's going to happen over 10 years?

And if that situation is favorable, that's when we invest. What about all the criticism of derivatives and the impact they have had? That's a little complicated for me; all I know is, I mean, I don't know about it for you, it's way over my head.

I've never bought an option in my life; I never bought your—I—time's on your side when you're on stock. You know, I don't know about putting, you know, three percent down and buying a future in a strap and a straddle; that's way over my head. Can't do that, right? Somebody else deal with it.

All right, so you're optimistic about the future of the American economy. Earnings potential for most well-run companies will do all right, but people have to understand we've had nine recessions since World War II; we'll have other recessions, but we're not in one now.

But we may have one in the future, and don't get worried. It will happen. And no one will tell you when it's going to happen. It's won't; the fundamentals tell you, no. You'll find out after the fact. You'll all of a sudden notice orders slowing, prices get more competitive, then earnings are down.

I mean, usually, you find that effect. No one declare—the everybody's saying we're going to have recession for five years, and it just hasn't happened.

It's great to see you; I hope you'll come back anytime, Peter. You know, I really like this last clip from Peter Lynch—it’s just a lesson: you don't have to get too fancy, right? You don't have to drift into things that you don't understand. Like a lot of stock investors, they are just all over options.

Peter Lynch is the first to put his hand up and says, look, I love investing in companies; I don't have a clue what's going on when it comes to options. Never bought an option in my life. So, you know, step one: find the businesses you know, you understand. Step two: you know, make sure that you can make sure you're looking at fairly valued businesses that can go undervalued.

Step three: focus on the long run. Find solid businesses with low debts, high cash flows, and just keep focused on that stuff because that's the winning formula.

You know, we are going to see recessions in the future; we've seen recessions in the past. It could happen tomorrow; it could happen next week; it could happen in a year's time or five years from now. But the main thing is that strong companies with solid cash flows that you understand, that you're going to hold for a long period of time— they're the ones that are going to make it through, and they're the ones we should be ultra-focused on in any stock market environment.

So anyway guys, I hope that you enjoyed this video. I always like listening to what Peter Lynch has to say even in these really, really old interviews like this is from 1997, and yet just because the market was high then, the market's high now. Everything that he's saying is almost directly applicable into what we're doing with our investing today, and I love it.

I love it when we can draw those kind of parallels; it's like poetry. But anyway, guys, hope you enjoyed the video. Leave a like on it if you did; subscribe to the channel if you have not done so already, and make sure you check out Profitful links down in the description below if you'd like to learn about how I go about my investing.

If you'd like to learn about, you know, a lot of key points in Peter Lynch's strategy in much more detail and kind of like step by step, then feel free to check out Introduction to Stock Analysis. But that will do me for today, guys. Thank you guys very much for watching, and I'll see you all in the next video.