Peter Lynch, Growth Investing Expert

Peter Lynch is one of the best-known names in investing. He ran Fidelity's Magellan Fund for thirteen years from 1977 and in that period, Magellan was up over 2700%. Lynch managed a vast portfolio, containing over fourteen thousand stocks at any time, and turned over the whole portfolio on average once a year. Yet even in difficult markets, he was almost always opposed to assets sitting in bonds and cash. Instead, he advocated holding good quality stocks with low volatility when going defensive.

Lynch's basic message is that an individual investor can actually find great stocks before Wall Street does: using a combination of intelligence, reflection, perseverance and discipline, it is possible for the average person to uncover great investments. His central point is that products and services you use and enjoy are often provided by excellent companies. If you research these companies and find out whether or not the stock that corresponds to them is priced favorably, you have an outstanding chance at compounding market-beating returns industries and businesses; investigating how a company treats its customers and vice versa. This is the only way I know to find great companies, and nothing beats the feeling when it pays off.

While a fund manager is more or less forced into owning a long list of stocks, an individual has the luxury of owning just a few. That means you can afford to be choosy and invest only in outfits that you understand and that have a superior product or franchise with clear opportunities for expansion. You can wait until the company repeats its successful formula in several places or markets (same-store sales on the rise, earnings on the rise) before you buy the first share.

If you put together a portfolio of five to ten of these high achievers, there's a decent chance one of them will turn out to be a ten-, a twenty- or even a fifty-bagger, where you can make ten, twenty or fifty times your investment. With your stake divided among a handful of issues, all it takes is a couple of gains of this magnitude in a lifetime to produce superior returns.

So what advice does Lynch give to the typical individual investor? Writing in his regular column in Worth magazine, he recommends:

Find your edge and put it to work by adhering to the following rules:

With every stock you own, keep track of its story in a logbook. Note any new developments and pay close attention to earnings. Is this a growth play, a cyclical play or a value play? Stocks do well for a reason and do poorly for a reason. Make sure you know the reasons.

Pay attention to facts, not forecasts.

Ask yourself: what will I make if I'm right, and what could I lose if I'm wrong? Look for a risk-reward ratio of three to one or better.

Before you invest, check the balance sheet to see if the company is financially sound.


Don't buy options, and don't invest on margin. With options, time works against you, and if you're on margin, a drop in the market can wipe you out.

When several insiders are buying the company's stock at the same time, it's a positive.

Average investors should be able to monitor five to ten companies at a time, but nobody is forcing you to own any of them. If you like seven, buy seven. If you like three, buy three. If you like zero, buy zero.

Be patient. The stocks that have been most rewarding to me have made their greatest gains in the third or fourth year I owned them. A few took ten years.

Enter early but not too early. I often think of investing in growth companies in terms of baseball. Try to join the game in the third inning, because a company has proved itself by then. If you buy before the line-up is announced, you're taking an unnecessary risk. There's plenty of time (ten to fifteen years in some cases) between the third and the seventh innings, which is where the ten- to fifty-baggers are made. If you buy in the late innings, you may be too late.

Don't buy cheap stocks just because they're cheap. Buy them because the fundamentals are improving.

Buy small companies after they've had a chance to prove they can make a profit.

Long-shots usually backfire or become no shots.

If you buy a stock for the dividend, make sure the company can comfortably afford to pay the dividend out of its earnings, even in an economic slump.

Investigate ten companies and you're likely to find one with bright prospects that aren't reflected in the price. Investigate fifty and you're likely to find five.

What Is Growth Investing?

Growth investing is one of the two classical styles of investment. There are numerous different definitions of the style and some confusion about the precise relationship between growth companies and growth stocks. But a focus on growth is generally contrasted with value investing, which tends to rely more on quantitative methods of analysis. Growth investing tends to be based more on qualitative judgments about the kind of companies that will offer remarkable growth rates and exceptional returns performance.

Growth stock investing arose as a definable concept in the United States of the 1930s the counterpoint to the safe, secure income investing of the depression years. It was presumed that companies with a past record of growth in revenues and earnings had the momentum to carry them into the future. And they had to go farther into the future or at greater rates of growth than the market had already accorded in its discounting through current prices. T Rowe Price, who first set out the principles of growth stock valuation in the 1930s, wrote:

Growth stocks can be defined as shares in business enterprise that have demonstrated favorable underlying long-term growth in earnings and that, after careful research study, give indications of continued secular growth in the future.

In order to turn a capital commitment into appreciation, the growth investor needs prescience about earnings or rate of growth or the market's willingness to pay for future events. At certain times in the market for example, in the late 1960s and early 1970s and, more recently, in the late 1990s the growth investor has been rewarded with handsome returns. Those returns have in part been the result of an increase in the number of growth investors rather than a change in the valuation systems used by an existing population of investors.

And the agreement runs backwards in that those equities that have appreciated are assumed to have growth characteristics. Almost any list of the best managed companies a popular and recurring article in business publications will be composed of those stocks that have had an unusually favorable price performance for some past period. Growth stocks may see the future through the rear view mirror.

Future of Global Investing

Recent research indicates that Americans are more likely to invest in their local regional Bell operating company than in any other. Considering that everyone's local operator cannot be a better investment choice than any of the other six, this finding suggests the importance of investors' psychological need to feel comfortable with where they put their money. Perhaps it relates to the endowment effect, a phenomenon noted by behavioral finance, where people set a higher value on something they already own than they would be prepared to pay to acquire it.

But if people still do have a predilection for investing in familiar stocks, they are likely to leave largely unexploited international investment opportunities and hold sub-optimally diversified portfolios. It is tempting to conjecture that such a psychological attitude might be even more pronounced in the highly diverse cultural contexts of European countries. Such an attitude could explain the lack of cross-country portfolio investments within Europe, and suggest that the internationalization of European individual portfolios will be a slow process even in the wake of the euro.

On the other hand, the potential development of a European identity and the increasing tendency to think European rather than French or German a tendency that is likely to be enhanced by the advent of a shared currency could make European investors less reluctant to hold equity stakes in companies residing in a European state different from their own. Perhaps European home bias will fade.

Of course, none of the reasons for home bias apply to the individual global investor with the funds, access to broking services and time to conduct research on the opportunities in the international equity market. It seems likely that home bias and low market correlation will diminish over time as the interconnections of the global economy become closer and the confidence of investors in overseas markets grows. But in the meantime, by leaving some lower risk and higher return possibilities relatively unexplored, they might help an investor to formulate an international investment strategy that can beat the market consistently.

There is also now a vast amount of information on global investment opportunities available on the internet. Any point on the globe is as accessible as next door. It is cheap and often free. It shifts control of time, depth of information and source to empower the user. And it is open: anyone can come in taking its knowledge and offering skills. Financial centers are described on a satellite connection, not geographic coordinates or proximity to other financial talent centers. Work takes a different form in time and space with email, videoconferencing and the internet, all of which are available at a price for the single user at his or her own site. Location becomes irrelevant.

A visit to South Africa from the United States, for example, requires probably a week of preparation, a week there, and a week of decompression on the other side a total of three weeks, assuming we are efficient. Compare that with a day on the internet. How much information could one get on South Africa in the course of a few hours on the web? The information might be different, but it is going to be a large volume in a short period of time. You would understand the culture and the issues, and you could gain a lot of information that is hard to find out otherwise.

According to that well-known fan of investment management, Bill Gates: ''Anyone who is not intimately involved with the internet and the web does so at extreme peril." This statement applies with particular force to investment analysts and private investors. For those of us who are dedicated to moving our craft forward, being ahead of others and using the best tools available, the internet is our mandate.

Critics on Gary Brinson' Theory

If global investing is superior to investing in only one market, why do so many investors hold disproportionate amounts of their portfolios in equities of their own domestic markets? Even sophisticated institutional investors, such as pension funds and insurance companies, tend to concentrate well over three-quarters of their equity funds in domestically quoted shares, a phenomenon known as home bias. Evidence of wide discrepancies between national market performances over certain periods of time suggests that these investors would maximize their returns and minimize their risks more effectively by diversifying more fully across stocks in different countries.

Various explanations for home bias have been advanced. These include IMF officials' arguments that it is, in large part, due to the substantial risks of adverse exchange rate changes, which cannot be guarded against with standard hedging techniques. Currency risks may be compounded by the different supervisory environments in particular markets, by fears that capital controls may be instituted, by taxes on international trading or simply by a wish to avoid the time and expense of maintaining and researching a more widely spread international portfolio.

Such reasoning is supported by arguments that the benefits of international diversification arise merely from the fact that different stock markets have their shares concentrated in different industries. For example, the UK privatization program of the 1980s means that utilities are a more important part of the London market than elsewhere. Similarly, investment in the Swiss market implies a disproportionate bet on banking stocks, and investment in the Swedish market a commitment to basic industries. The implication is that global investing offers nothing more than exposure to additional industries.

Yet home bias on the part of institutional investors seems to be more a result of government restrictions on the amount of foreign assets pension funds and insurance companies in any given country are allowed to hold. It also may arise from the way in which fund managers' performance is assessed through reference to a local market index: even if passive indexing is not their dominant strategy, there is inevitably a strong incentive to own a good slice of the index's components. And industry analysts are often more prevalent than country analysts in fund managers' offices, suggesting a disposition to choose industrial over international diversification.

There is evidence that the covariances of global markets may be sliding closer, though Japan may be a special case. For the other members of the G-7, coordinated banking policies and facilitated information flows should tend to drive markets into a more steady alignment. On the surface, such an increase in stability could be seen as beneficial for business but would be a lessened benefit for portfolio investors attempting to diversify risk.

For example, closer links between European economies following the introduction of the euro will increase the incentive for US investors to diversify into European markets. At the same time, this may also strengthen the relationship between different European stock markets, reducing the incentive for diversification within Europe.

Gary Brinson an Expert on Global Investing

Gary Brinson is a staunch advocate of asset allocation techniques and a pioneer of global investing. In 1974, the firm now known as Brinson Partners (then a unit of First Chicago) was one of the first to invest overseas. Brinson led a management buyout of the unit in 1989 and the firm was later acquired by Swiss Bank Corporation. The latter has since merged with Union Bank of Switzerland and as a result, Brinson directs over $300 billion in institutional assets, making it one of the world's largest money managers. Brinson is also co-author with Yale finance professor Roger Ibbotson of a book about asset classes, investment theory and international investing.

The Swiss banks were interested in Brinson Partners for its money management business but perhaps even more for its ability to bring North American investment techniques to Europe and elsewhere in its network. Features that are taken for granted in the United States like performance measurement, incentive compen sation, quantitative tools and hedging are less familiar in Europe (see Performance Measurement, Quantitative Investing and Risk Management). At first, the relationships were rather loose with interns coming to the Chicago headquarters for training and management coordination with the Swiss management largely by encrypted videoconferencing. More recently, the risk management and tighter controls at headquarters have dictated closer ties.

Brinson has promoted the professionalism of investment management by taking an active part in its industry association, the Association of Investment Management & Research (AIMR) and its Research Foundation. He is an advocate of small, steady incremental gains in improvement of standards. Similarly, he is an advocate for small changes in asset allocation. Consistent with the Swiss style of investing, major swings are generally unlikely to take place.

Brinson argues strongly that investment decisions should focus first and foremost on markets or asset classes since that explains roughly 90% of returns. The key is to consider overall portfolio risk rather than the risk of individual assets: a sound asset allocation combines diverse asset classes in ways that increase returns without an equal increase in risk or reduce risk without sacrificing returns.

His global asset allocation strategy rests on four basic principles:

• Think global.
• The value of asset classes should not rise and fall together.
• Focus on the long term.
• Monitor and adjust allocations to accommodate changed investment climates.

Brinson believes that in a relatively short time, it will seem as odd to most investors to discuss a Europe fund's country allocations as it does now to discuss a US fund's relative exposure to each of the fifty states. In his mind, country concerns will be minimal in comparison with company concerns.

What is Global Investing?

Don't put all your eggs in one basket, the principle of portfolio diversification, is widely accepted by investors. It is normally thought of in terms of the number of assets, industries or companies across which an investor is spread: a well-diversified portfolio contains equities (as well as bonds, cash, etc.) in industries whose returns do not move together. And the lower the correlation between the returns on the various equities or other assets, the less wildly the value of the whole portfolio should swing.
Less frequently is diversification considered in relation to owning equities and other assets from different countries. But with many national markets often highly uncorrelated, this form of diversification would seem to offer the strongest potential for reducing risk, while at the same time promising enhanced returns. Particularly for investors in one of the highly valued markets of the developed world, buying foreign equities uncorrelated with their domestic market should, in principle, make their overall equity portfolios less risky and more valuable.

So global investing is in the first instance about asset allocation between equities, bonds, cash and other instruments; and second, about investing in global markets. Asset allocators benefit by diversifying across asset classes; international investors benefit by diversifying their portfolio across assets in a range of different countries. The key factor for the latter is the degree of integration of the real economies of the countries concerned. It is important to understand co-movements among different markets: the more markets move together, the fewer the benefits of international diversification.

Global data for 1998 reveals significant performance differentials between regions. The MSCI World Index rose 19.7% but only two regions Europe at 26.5% and North America at 27.1% ex ceeded that. Across the emerging markets, performance ranged from a spectacular 137.5% gain in South Korea to an 83.2% decline for Russia (see Emerging Markets). Though somewhat narrower, differences in the developed world are just as striking: Finland gained 119.1% while Norway declined 31.2%. This large regional performance differential underscores the importance of a global portfolio strategy. An asset allocation strategy that on average correctly anticipated these differences would have added significant value.

Global investment provides a security hedge and a currency hedge. Frequently, investors do not separate the two (see Foreign Exchange). Nearly all academic studies suggest that the question of currency hedging should be dealt with explicitly and should not be treated as incorporated automatically within the overall global allocation. And it is important to recognize that currency hedging may be costly and can increase risk. The Asian meltdown in 1998, for example, led to the double whammy of currency devaluation and stock market collapse.

Richard Olsen’s Reactions on Critics (Part 2)

Currency attacks are becoming a depressingly common feature of the global economy. But the exact timing of the onset of an attack is notoriously difficult to predict. Richard Olsen has developed a global financial early-warning system, which tries to do the same thing as a gadget that tells someone when they are getting their next heart attack.

Olsen comments:
We have been looking at the data now for many years and we have learned a lot about what really makes a market function successfully. And, most importantly, how the components within the market that is, the market makers, the medium and long-term investors interact, and what is required to build a healthy market or, in reverse, what leads to a negative market with large-scale shocks.
For obvious reasons, such a system would be of immense interest to regulators and speculators.
The core determining factor of a currency's value is the health of the real national economy, especially the balance-of-payments. current account. If there is a surplus in the current account, that is, a country sells more goods than it buys, then buyers have to acquire that currency to purchase goods. This adds to foreign reserves and bids up the price of that currency. Conversely, a current account deficit implies the need to sell the local currency in order to acquire foreign goods. Persistent current account deficits, particularly if allied with relatively low foreign reserves, indicate a problem.

A currency's value is also affected by levels of inflation and the domestic rate of interest. High rates of interest and low inflation make a currency attractive for those holding assets denominated in it. So typically one country raising interest rates while others remain the same will raise the value of its currency as money flows into the country. This will have a limited effect if the fundamentals are wrong.

Comparative inflation rates, interest rates and balances of payments will all give clues to likely medium-term movements of a currency. But a key factor determining short-term currency values is market sentiment. There can be a self-fueling process in which enthusiasm for a currency, or the lack of it, drives the exchange rate. Speculators might decide, as they did during the European Monetary System debacle of 19923 and the Asian and Russian crises of 19978, that a currency is overvalued or simply that there are speculative gains to be made by selling it.

Currency attacks are triggered when a small shock to the fundamentals of the economy is combined with systemic weaknesses in the corporate and banking sectors. One facet of such systemic weaknesses is the effect of belated hedging activity by some economic actors in the economy whose currency is under attack. The more these actors try to hedge, the greater is the incentive for others to follow suit. This unleashes a whiplash effect, which turns a potentially orderly depreciation into a collapse of the currency. In other words, if speculators believe a currency will come under attack, their actions will precipitate the crisis; while if they believe the currency is not in danger, their inaction will spare it from attack attacks are self-fulfilling. The magnitude of the shock necessary to trigger an attack need not be large, which makes predictions very difficult. Nevertheless, it is possible to draw some broad conclusions on the vulnerability of currencies to attack. In particular, there must be a pre-existing weakness, which will prevent the authorities from conducting a fullfledged defense of the currency by raising interest rates. The weakness may not be lethal in itself (though it can become lethal once the situation deteriorates) so it is a necessary condition but not a sufficient condition for a speculative attack.

Self-fulfilling attacks may affect any country with a fixed exchange rate and high capital mobility that is in the gray area between fully safe and sure to be attacked. Recent research suggests that countries with strong trade links with a country that has recently experienced a currency crisis is highly likely to face an attack itself the growing phenomenon of contagion in foreign exchange markets.