Beating the Street

Book by Lynch Peter

Chapter 1

THE MIRACLE OF ST. AGNES

Amateur stockpicking is a dying art, like pie-baking, which is losing out to the packaged goods. A vast army of mutual-fund managers is paid handsomely to do for portfolios what Sara Lee did for cakes. I'm sorry this is happening. It bothered me when I was a fund manager, and it bothers me even more now that I have joined the ranks of the nonprofessionals, investing in my spare time.

This decline of the amateur accelerated during the great bull market of the 1980s, after which fewer individuals owned stocks than at the beginning. I have tried to determine why this happened. One reason is that the financial press made us Wall Street types into celebrities, a notoriety that was largely undeserved. Stock stars were treated like rock stars, giving the amateur investor the false impression that he or she couldn't possibly hope to compete against so many geniuses with M.B.A. degrees, all wearing Burberry raincoats and armed with Quotrons.

Rather than fight these Burberried geniuses, large numbers of average investors decided to join them by putting their serious money into mutual funds. The fact that up to 75 percent of these mutual funds failed to perform even as well as the stock market averages proves that genius isn't foolproof.

But the main reason for the decline of the amateur stockpicker has to be losses. It's human nature to keep doing something as long as it's pleasurable and you can succeed at it, which is why the world population continues to increase at a rapid rate. Likewise, people continue to collect baseball cards, antique furniture, old fishing lures, coins, and stamps, and they haven't stopped fixing up houses and reselling them, because all these activities can be profitable as well as enjoyable. So if they've gotten out of stocks, it's because they're tired of losing money.

It's usually the wealthier and more successful members of society who have money to put into stocks in the first place, and this group is used to getting A's in school and pats on the back at work. The stock market is the one place where the high achiever is routinely shown up. It's easy to get an F here. If you buy futures and options and attempt to time the market, it's easy to get all F's, which must be what's happened to a lot of people who have fled to the mutual funds.

This doesn't mean they stop buying stocks altogether. Somewhere down the road they get a tip from Uncle Harry, or they overhear a conversation on a bus, or they read something in a magazine and decide to take a flier on a dubious prospect, with their "play" money. This split between serious money invested in the funds and play money for individual stocks is a recent phenomenon, which encourages the stockpicker's caprice. He or she can make these frivolous side bets in a separate account with a discount broker, which the spouse doesn't have to know about.

As stockpicking disappears as a serious hobby, the techniques of how to evaluate a company, the earnings, the growth rate, etc., are being forgotten right along with the old family recipes. With fewer retail clients interested in such information, brokerage houses are less inclined to volunteer it. Analysts are too busy talking to the institutions to worry about educating the masses.

Meanwhile, the brokerage-house computers are busily collecting a wealth of useful information about companies that can be regurgitated in almost any form for any customer who asks. A year or so ago, Fidelity's director of research, Rick Spillane, interviewed several top-producing brokers about the data bases and so-called screens that are now available. A screen is a computer-generated list of companies that share basic characteristics -- for example, those that have raised dividends for 20 years in a row. This is very useful to investors who want to specialize in that kind of company.

At Smith Barney, Albert Bernazati notes that his firm can provide 8-10 pages of financial information on most of the 2,800 companies in the Smith Barney universe. Merrill Lynch can do screens on ten different variables, the Value Line Investment Survey has a "value screen," and Charles Schwab has an impressive data service called "the Equalizer." Yet none of these services is in great demand. Tom Reilly at Merrill Lynch reports that less than 5 percent of his customers take advantage of the stock screens. Jonathan Smith at Lehman Brothers says that the average retail investor does not take advantage of 90 percent of what Lehman can offer.

In prior decades, when more people bought their own stocks, the stockbroker per se was a useful data base. Many old-fashioned brokers were students of a particular industry, or a particular handful of companies, and could help teach clients the ins and outs. Of course, one can go overboard in glorifying the old-fashioned broker as the Wall Street equivalent of the doctor who made house calls. This happy notion is contradicted by public opinion surveys that usually ranked the stockbroker slightly below the politican and the used-car salesman on the scale of popularity. Still, the bygone broker did more independent research than today's version, who is more likely to rely on information generated in house by his or her own firm.

Newfangled brokers have many things besides stocks to sell, including annuities, limited partnerships, tax shelters, insurance policies, CDs, bond funds, and stock funds. They must understand all of these "products" at least well enough to make the pitch. They have neither the time nor the inclination to track the utilities or the retailers or the auto sector, and since few clients are invested in individual stocks, there's little demand for their stockpicking advice. Anyway, the broker's biggest commissions are made elsewhere, on mutual funds, underwritings, and in the options game.

With fewer brokers offering personal guidance to fewer stock-pickers, and with a climate that encourages capricious speculation with "fun" money and an exaggerated reverence for professional skills, it's no wonder that so many people conclude that picking their own stocks is hopeless. But don't tell that to the students at St. Agnes.

THE ST. AGNES PORTFOLIO

The fourteen stocks shown in Table 1-1 were the top picks of an energetic band of seventh-grade portfolio managers who attended the St. Agnes School in Arlington, Massachusetts, a suburb of Boston, in 1990. Their teacher and CEO, Joan Morrissey, was inspired to test the theory that you don't need a Quotron or a Wharton M.B.A., or for that matter even a driver's license, to excel in equities.

You won't find these results listed in a Lipper report or in Forbes, but an investment in the model St. Agnes portfolio produced a 70 percent gain over a two-year period, outperforming the S&P 500 composite, which gained 26 percent in the same time frame, by a whopping margin. In the process, St. Agnes also outperformed 99 percent of all equity mutual funds, whose managers are paid considerable sums for their expert selections, whereas the youngsters are happy to settle for a free breakfast with the teacher and a movie.

Table 1-1. ST. AGNES PORTFOLIO

Company 1990-91 Performance (%)

Wal-Mart 164.7

Nike 178.5

Walt Disney 3.4

Limited 68.8

L.A. Gear - 64.3

Pentech 53.1

Gap 320.3

PepsiCo 63.8

Food Lion 146.9

Topps 55.7

Savannah Foods - 38.5

IBM 3.6

NYNEX - .22

Mobil 19.1

Total Return for Portfolio 69.6

S&P 500 26.08

Total return performance January 1, 1990-December 31, 1991

I was made aware of this fine performance via the large scrapbook sent to my office, in which the seventh graders not only listed their top-rated selections, but drew pictures of each one. This leads me to Peter's Principle #3:

Never invest in any idea you can't illustrate with a crayon.

This rule ought to be adopted by many adult money managers, amateur and professional, who have a habit of ignoring the understandably profitable enterprise in favor of the inexplicable venture that loses money. Surely it would have kept investors away from Dense-Pac Microsystems, a manufacturer of "memory modules," the stock of which, alas, has fallen from $16 to 25 cents. Who could draw a picture of a Dense-Pac Microsystem?

In order to congratulate the entire St. Agnes fund department (which doubles as Ms. Morrissey's social studies class) and also to learn the secrets of its success, I invited the group to lunch at Fidelity's executive dining room, where, for the first time, pizza was served. There, Ms. Morrissey, who has taught at St. Agnes for 25 years, explained how her class is divided every year into teams of four students each, and how each team is funded with a theoretical $250,000 and then competes to see who can make the most of it.

Each of the various teams, which have adopted nicknames such as Rags to Riches, the Wizards of Wall Street, Wall Street Women, The Money Machine, Stocks R Us, and even the Lynch Mob, also picks a favorite stock to be included in the scrapbook, which is how the model portfolio is created.

The students learn to read the financial newspaper Investor's Business Daily. They come up with a list of potentially attractive companies and then research each one, checking the earnings and the relative strength. Then they sit down and review the data and decide which stocks to choose. This is a similar procedure to the one that is followed by many Wall Street fund managers, although they aren't necessarily as adept at it as the kids.

"I try to stress the idea that a portfolio should have at least ten companies, with one or two providing a fairly good dividend," says Ms. Morrissey. "But before my students can put any stock in the portfolio, they have to explain exactly what the company does. If they can't tell the class the service it provides or the products it makes, then they aren't allowed to buy. Buying what you know about is one of our themes." Buying what you know about is a very sophisticated strategy that many professionals have neglected to put into practice.

One of the companies the students at St. Agnes knew about was Pentech International, a maker of colored pens and markers. Their favorite Pentech product, with a marker on one end and a highlighter on the other, was introduced into the class by Ms. Morrissey. This pen was very popular, and some of the kids even used it to highlight their stock selections. It wasn't long before they were investigating Pentech itself.

The stock was selling for $5 at the time, and the students discovered that the company had no long-term debt. They were also impressed by the fact that Pentech made a superior product, which, judging by its popularity in house, was likely to be just as popular in classrooms nationwide. Another positive, from their point of view, was that Pentech was a relatively unknown company, as compared, say, to Gillette, the maker of Paper Mate pens and the Good News razors they saw in their fathers' bathrooms.

Trying to come to the aid of a colleague, the St. Agnes fund managers sent me a Pentech pen and suggested I look into this wonderful company. This advice I wish I had taken. After I received the research tip and neglected to act on it, the stock nearly doubled, from 5 1/8 to a high of 9 1/2.

This same kid's-eye approach to stockpicking led the 1990 St. Agnes fund managers to the Walt Disney Company, two sneaker manufacturers (Nike and L.A. Gear), the Gap (where most of them buy their clothes), PepsiCo (which they know four different ways via Pepsi-Cola, Pizza Hut, Kentucky Fried Chicken, and Frito-Lay), and Topps (a maker of baseball cards). "We were very much into trading cards within the seventh grade," Ms. Morrissey says, "so there was no question about whether to own Topps. Again, Topps produced something the kids could actually buy. In doing so, they felt they were contributing to the revenues of one of their companies."

They got to the others as follows: Wal-Mart because they were shown a videotaped segment of "Lifestyles of the Rich and Famous" that featured Wal-Mart's founder, Sam Walton, talking about how investing benefits the economy; NYNEX and Mobil because of their excellent dividends; Food Lion, Inc., because it was a well-run company with a high return on equity and also because it was featured in the same video segment that introduced them to Sam Walton. Ms. Morrissey explains:

"The focus was on eighty-eight citizens of Salisbury, North Carolina, who each bought ten shares of Food Lion stock for one hundred dollars when the company went public back in 1957. A thousand dollars invested then had become fourteen million dollars. Do you believe it? All of these eighty-eight people became millionaires. These facts impressed all the kids, to say the least. By the end of the year they had forgotten a lot of things, but not the story of Food Lion."

The only clunker in the model portfolio is IBM, which I don't have to tell you has been the favorite of professional adult money managers for 20 years (yours truly included -- grown-ups keep buying it and keep wishing they hadn't). The reason for this destructive obsession is not hard to find: IBM is an approved stock that everybody knows about and a fund manager can't get into trouble for losing money on it. The St. Agnes kids can be forgiven this one foolish attempt to imitate their elders on Wall Street.

Let me anticipate some of the criticisms of the St. Agnes results that are sure to come from the professional ranks. (1) "This isn't real money." True, but so what? Anyway, the pros ought to be relieved that St. Agnes isn't working with real money -- otherwise, based on St. Agnes's performance, billions of dollars might be pulled from the regular mutual funds and turned over to the kids. (2) "Anybody could have picked those stocks." If so, why didn't anybody? (3) "The kids got lucky with a bunch of their favorite picks." Perhaps, but some of the smaller portfolios chosen by the four-person teams in Ms. Morrissey's class did as well as or better than the model portfolio selected by the class at large. The winning foursome in 1990 (Andrew Castiglioni, Greg Bialach, Paul Knisell, and Matt Keating) picked the following stocks for the reasons noted:

100 shares of Disney ("Every kid can explain this one.")

100 shares of Kellogg ("They liked the product.")

300 shares of Topps ("Who doesn't trade baseball cards?")

200 shares of McDonald's ("People have to eat.")

100 shares of Wal-Mart ("A remarkable growth spurt.")

100 shares of Savannah Foods ("They got it from Investor's
Daily.")
5,000 shares of Jiffy Lube ("cheap at the time.")

600 shares of Hasbro ("it's a toy company, isn't it?")

1,000 shares of Tyco Toys (ditto.)

100 shares of Ibm ("premature adulthood.")

600 shares of National Pizza ("nobody can turn down a pizza.")

1,000 shares of Bank of New England ("how low could it go?")

This last stock I owned myself and lost money on, so I can appreciate the mistake. It was more than counteracted by the boys' two best picks, National Pizza and Tyco Toys...