The Amateur’s Edge: Why You Can Beat Wall Street’s “Smart Money”

Are you an average investor? Do you shop, eat, drive, and work? Good. Because according to Peter Lynch, one of America’s number-one money managers, the average investor can become an expert in their own field and can pick winning stocks just as effectively as Wall Street professionals.

The mantra is simple: You already have a built-in advantage over the experts. By simply observing business developments and taking notice of your immediate world—from the mall to the workplace—you can discover potentially successful companies before professional analysts do. This jump on the experts is what produces “tenbaggers,” stocks that appreciate tenfold or more and transform an average stock portfolio into a star performer.

Investment opportunities abound for the layperson. You don’t have to be trendy to succeed; in fact, many great investors, like Warren Buffett, are “technophobes” who don’t own what they don’t understand. Lynch himself was technophobic and understood companies like Dunkin’ Donuts and Chrysler, which both inhabited his portfolio.

The Disadvantage of “Smart Money”

Lynch’s Rule Number One is: Stop listening to professionals!. The so-called smart money is often exceedingly dumb, being wrong about 40 percent of the time. The amateur investor should outperform the experts, or else, why bother picking your own stocks?

Professionals often suffer from “Street Lag.” A stock isn’t usually attractive to large institutions until many respected Wall Street analysts have put it on the recommended list, meaning the amateurs have a huge head start.

For instance, the burial services company Service Corporation International (SCI) was overlooked by Wall Street oxymorons for years because it didn’t fit into standard industry classifications. Dunkin’ Donuts, a 25-bagger between 1977 and 1986, was followed by only a few regional brokerages, even as ordinary consumers noticed new franchises opening up.

Furthermore, fund managers frequently have restrictions, often being required to choose from limited lists of approved stocks, cutting out small, fast-growing opportunities that are often tenbaggers. Many portfolio managers are more concerned with not looking bad if they fail than with achieving unusually large profits. There is an unwritten rule: “You’ll never lose your job losing your client’s money in IBM”.

If you invest like an institution, you are doomed to perform like one, which often means performing poorly. As an individual, you don’t have a “Mr. Flint” hovering over your shoulder demanding immediate quarterly results or criticizing your choice of Agency Rent-A-Car instead of IBM.

Stalking the Tenbagger: Where to Look

The best place to begin looking for tenbaggers is close to home—at the shopping mall, the restaurant, or wherever you happen to work.

• The Shopping Cart: Lynch’s wife, Carolyn, discovered L’eggs hosiery by going to the grocery store, realizing it was a superior product sold conveniently next to the razor blades. The fact that L’eggs was sold in grocery stores (visited twice a week) instead of department stores (visited every six weeks) made it an immensely popular idea.
• The Workplace/Local Business: Executives, clerks, suppliers, and even cleaning contractors often observe a company’s success long before Wall Street analysts. For example, the success of Pep Boys was apparent to its employees and contractors. Similarly, customers and employees of 180,000 client firms could have known about the success of Automatic Data Processing, a 600-bagger over the long term, which uses computers to process paychecks.
• Firsthand Experience: You develop a sense of what sells and what doesn’t during a lifetime of buying cars or cameras. Lynch found his best stocks through eating or shopping, sometimes long before professional stock hounds. He was impressed by Taco Bell’s burrito and liked Dunkin’ Donuts’ coffee. Customers and parents of college students likely noticed Cisco’s networking success.

Important Disclaimer: Simply liking a product or store is not enough reason to own the stock. Liking it is a good reason to get interested and put it on your research list, but you must do your homework on the company’s earnings prospects, financial condition, competitive position, and expansion plans before investing.

The Quest for the Perfect Stock

The ideal company is easy to understand, even simpleminded. “Any idiot could run this joint” is a plus, because sooner or later, any idiot probably will be running it.

Lynch identifies several favorable attributes of the perfect stock:

1. It Sounds Dull or Ridiculous: Boring names keep the professionals away. For instance, Pep Boys—Manny, Moe, and Jack is the “most promising name” Lynch has ever heard because it sounds ridiculous.
2. It Does Something DULL: Crown, Cork, and Seal makes cans and bottle caps—nothing boring about what happened to its shares, though. A company doing dull things gives you time to purchase the stock at a discount before it becomes trendy and overpriced.
3. It Does Something Disagreeable: Anything that makes people shrug, retch, or turn away is ideal. Safety-Kleen, which cleans greasy auto parts and recycles the sludge, and Service Corporation International (SCI), which does burials, were initially shunned by Wall Street, allowing amateur investors to buy shares in proven winners at much lower prices.
4. It’s a No-Growth Industry: Lynch prefers low-growth or no-growth industries (like plastic forks or funerals) because high-growth industries attract flocks of smart competitors and venture capitalists eager to make the product cheaper.
5. It’s Got a Niche: This is an exclusive franchise that competitors cannot easily invade. Examples include local rock pits (aggregate business) where trucking costs prevent rivals from competing, patented drugs (like Tagamet, which took years to patent), or powerful brand names (like Marlboro or Coca-Cola).
6. It’s a User of Technology: Instead of investing in competitive computer companies, invest in companies that benefit from technology price wars, such as Automatic Data Processing or supermarkets that install cost-cutting scanners.
7. The Company Is Buying Back Shares: This is the best way a company can reward investors, as it shows faith in its own future and helps increase the value of existing shares.

The Six Categories of Stocks

To properly research a company, you must first classify it.

Category	Description	Key Investment Approach
Slow Growers	Large, aging companies growing slowly, generally around 3% annually.	Typically bought for the dividend. Avoid wasting time on these sluggards if looking for stock price appreciation.
Stalwarts	Multibillion-dollar companies (e.g., Coca-Cola, Procter & Gamble) growing 10–12% annually.	Good defense during recessions. Buy for a 30–50% gain, then consider selling and rotating into other similar issues.
Fast Growers	Small, aggressive new enterprises growing at 20–25% a year or more.	The prime source of 10-to-40-baggers. Look for room to expand within slow-growing industries.
Cyclicals	Companies whose profits rise and fall in regular, though unpredictable, cycles (e.g., auto, airlines, steel, chemical companies).	Timing is critical. If you have an edge (working in the industry), you may detect early signs of a falling off or picking up in business conditions.
Turnarounds	Battered, depressed, or failing companies (e.g., Chrysler, Lockheed, Con Ed).	Huge profits can be made if successful. Focus on whether they have rid themselves of unprofitable divisions or cut costs drastically.
Asset Plays	Companies whose stock value is understated relative to their hidden assets (e.g., real estate, timberland, oil, TV stations).	Look for the value of assets per share to exceed the stock price. Patience is key.

Developing the Story: Doing the Homework

Once you have a lead, the goal is to develop the “story” by checking the fundamentals. This ensures you don’t buy a stock just because you like the product.

The Two-Minute Drill

Before buying, you should be able to give a two-minute monologue covering why you are interested, what has to happen for the company to succeed, and the potential pitfalls.

• For a Slow Grower: Focus on the dividend record. Has it increased earnings for ten years? Has it raised the dividend during good times and bad?.
• For a Cyclical: Focus on business conditions. Is the slump ending? Are inventories down? Have prices turned up?.
• For a Fast Grower: Where and how can it continue to grow fast? Is the successful formula being duplicated (cloning) in new markets? Is debt excessive?.

Analyzing Earnings (The Real Bottom Line)

If you can follow only one bit of data, follow the earnings—assuming the company has earnings. Sooner or later, earnings make or break an investment. Corporate profits are up sixtyfold since World War II, tracking the stock market’s rise.

• Price/Earnings (P/E) Ratio: The P/E ratio is derived by dividing the current stock price by the company’s earnings for the prior twelve months. A P/E of 10 means it would take ten years for the company to earn back your initial investment if earnings stayed constant.
• P/E and Growth: The P/E should be put in context with the growth rate. A 20-percent grower selling at a P/E of 20 is a much better buy than a 10-percent grower selling at a P/E of 10. As a rough guide, calculate the long-term growth rate plus dividend yield, divided by the P/E ratio; a result of 2 or better is excellent.
• Five Ways to Increase Earnings: A company increases earnings by reducing costs, raising prices, expanding into new markets, selling more product in old markets, or closing/disposing of a losing operation. Use your “edge” to investigate which of these is happening.

Debt and Cash

• Debt: Check the balance sheet to see if cash exceeds long-term debt. Companies with no debt can’t go bankrupt. In capital-intensive businesses (like hotels or manufacturing), high debt is a major concern.
• Cash Flow: Focus on free cash flow, which is the cash left over after necessary capital spending is taken out. Companies that don’t depend on heavy capital spending (like Philip Morris or McDonald’s) have reliable cash flow.

Inventories

For a manufacturer or retailer, an inventory buildup (inventories growing faster than sales) is usually a red flag. If a retailer is holding on to old merchandise, the new stuff will compete with the old, eventually forcing price cuts and reducing profit.

Stocks I’d Avoid: The Danger Zones

Lynch advises avoiding several types of situations:

1. The Hottest Stock in the Hottest Industry: If every investor is talking about it, the stock has probably already levitated far beyond its underlying value, supported only by hope and thin air. When these stocks fall, they fall quickly. High-growth industries (e.g., carpets, electronics, disk drives) attract too much competition, often leading to price wars and no profits.
2. Whisper Stocks/Longshots: Companies with complicated, impressive concepts (like “gigaherz,” or monoclonal antibodies extracted from cows) but zero earnings. Understanding the P/E ratio is no problem because there is none. If the prospects are phenomenal, they will still be phenomenal next year. Wait for the earnings to be established.
3. The Middleman Trap: A company that sells 25 to 50 percent of its products to a single customer (e.g., a supplier heavily dependent on IBM) is in a precarious situation. The loss of that one customer would be catastrophic.
4. Beware of “Diworseification”: Companies that expand by buying unrelated businesses often overpay, expect too much, and mismanage them (e.g., Gillette expanding from razors into cosmetics and digital watches). Acquisitions should ideally be in a related business.
5. Beware of Oversized Companies: For a huge company like General Electric (nearly one percent of the entire U.S. gross national product) to double or triple in size in the foreseeable future is mathematically impossible. You generally do better with smaller companies in their rapid expansion phase.

The Long-Term View: Patience and Conviction

The stock market demands conviction. You must have the personal qualities to succeed: patience, self-reliance, common sense, tolerance for pain, persistence, humility, and the ability to ignore general panic.

Market Noise and Prediction

• Ignore Short-Term Fluctuations: Lynch advises checking stock prices every six months, the way you check the oil in a car. What the stock price does today, tomorrow, or next week is only a distraction.
• Predicting the market or the economy is futile. Lynch believes in buying great companies, especially those that are undervalued or underappreciated.
• Stocks vs. Bonds: Long-term returns from stocks are superior to bonds. Historically, stocks have paid off fifteen times as well as corporate bonds, and well over thirty times better than Treasury bills. If you own good companies that continue to increase their earnings, you will do well.
• Timing Traps (The Three Emotions): The unwary investor passes through concern, complacency, and capitulation. They are concerned after a drop (keeping them from buying bargains), complacent when stocks are rising (failing to check fundamentals), and finally capitulate and sell in a snit when prices fall below what they paid.

Dealing with Declines

Market declines (corrections of 10% or more, bear markets of 20% or more) occur every couple of years.

Market declines are great opportunities to buy stocks in companies you like.

• If you’ve done the research, calamitous drops should not scare you out of the game.
• A price drop in a good stock is only a tragedy if you sell at that price and never buy more.
• You must be able to convince yourself, “When I’m down 25 percent, I’m a buyer,” and banish the fatal thought, “When I’m down 25 percent, I’m a seller”.

When to Sell

Knowing why you bought a stock helps you know when to say good-bye. The correct time to sell depends entirely on the company’s story and fundamentals.

• For Stalwarts: Sell after achieving the expected 30-50% appreciation, especially if no new development suggests further upside.
• For Fast Growers: Sell if the company has stopped expanding into new markets (entering the saturation phase), if the successful “cloning” model fails, or if they begin relying on acquisitions. Also, be cautious if the stock becomes highly popularized (e.g., three national magazines fawn over the CEO, and institutional ownership swells).
• For Cyclicals: Sell when the market is booming, and you detect the beginning of the next business slump.
• General Rules: Sell if the fundamentals deteriorate (e.g., debt increases, inventories pile up faster than sales), or if the original story is no longer intact. Never sell an outstanding fast grower just because its stock seems slightly overpriced—you could miss a multi-bagger.

Remember, you don’t need to make money on every stock you pick. Six out of ten winners is enough to produce an enviable record because your losses are limited (to 100% of your investment), while your gains have no absolute limit. Stick with them as long as the story is intact, and you might be pleasantly surprised by the results.

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Final Thought: If you take away only one piece of data, remember this: the market ought to be irrelevant. Focus on the business, not the noise. You already possess the local knowledge and common sense necessary to succeed in this business; you just need to apply yourself to the research. Investing at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator will serve you well.

Investing successfully is not like high-stakes gambling; it’s more like playing a long game of stud poker where you observe the cards, calculate the odds, and stay in the hand as long as the facts support success. You accept periodic losses, confident that your basic method will reward you over time.

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