Table of Contents
A good corporate manager (as opposed to a responsible corporate citizen) can be defined as a person who aims at maximizing the shareholder value, avoiding excessive taxation or manipulating the consumer and investor preferences. However, it is as early as at this stage that further implications could diverge drastically anywhere in between showcasing an anecdotal maverick that breaks the conventions while setting standards and trends versus someone who is always ready to go with the flow and look up to the ‘best practices’ that someone else has proposed. One may speculate that his early engagement as analyst in Fidelity’s Magellan Fund was a matter of personal networking at leisure, yet that would have to be reconciled with the spectacular posterior record of beating the market at an average of 29% amidst the index growth at half that rate.
Peter Lynch has boasted an altogether different profile in striking a careful balance between good schooling and avoiding unreasonable complexity which may ironically have been induced by state-of-the-art technology rather than being curbed. One’s strengths and weaknesses as an investor should be aligned with the core competencies as required in order to run or invest in a particular company. A candidate project should be chosen according to the strength of its value, irrespective of whether growth has materialized from initial undervaluation. At that rate, it has been proposed that the tossup between fundamentally driven DCF valuation as opposed to multiples based heuristic approaches should be weighed so as to match the gain against the deliberation cost involved. No technique can be deemed as unchangeable, as long as the alternates accommodate the grand imperative (of safety margin and straightforward value serving as the necessary and sufficient prerequisite) more properly.
The present study focuses on Lynch’s unique paradigm that could be reconciled with Buffett’s alternative, both referring to a commonly shared ex-ante theoretical core and ex-post policy implications. A critical analysis of the mainstream neoclassical legacy has some extra relevance to the systemic approach as proposed by Lynch.
Profiling Magellan as a Mutual Fund
This is by far the most heavily followed fund, whose mixed performance record has seen annualized gain at nearly 70% back in the mid-1960s and a major contraction in the value of assets under management by nearly as much in the mid and late 2008. Apart from the balanced portfolio strategies, the Fidelity Magellan’s key edge could be inferred from its ranking on top of categories as diverse as high-yield bonds, large cap growth, large and mid cap value, to name just a few (US News, 2015).
The name Lynch has been invented to dub the cocktail party metaphor amounts to anything but a misnomer while suggesting a host of contrary-to-expectations insights into the mechanism of predicting the trajectory of public sentiments. Such diverse categories as optimism versus enthusiasm tend to correlate in conventional thinking, yet Lynch has shown setups or states in which they diverge in meaningful ways when transitioning from bearish to bullish stages. The initial phase after the downturn features most experts and laymen shunning any talks of market or things related (“One Up,” 1989). As the market starts regaining grounds, the former category is the first off to notice this, with the naïve players jumping the bandwagon at the next stage. At the bullish peak, though, profession makes room for the dangerous phenomenon of adverse selection whereby the ignorant ones have grown so much more active in relative terms that they found a substitute for expert advice. One corollary is that upside rationality could be nearly as bounded as its downside extreme, albeit on very differential grounds.
Turnaround, Cyclical, Fast, Slow, & Stalwart Assets
In unemotive on non-normative terms, Lynch has come up with a taxonomy of stocks that has long since seemed commonplace and popular while being surprisingly parallel to one more renowned framework as proposed by Boston Consulting Group. The BCG matrix resembles Lynch’s account, among other things in that both inherently build on more than one metric in capturing the critical trade-off. In other words, fast versus slow growth is more than a matter of qualifying against the 20 percentage growth threshold. As for the slow growing stocks, it has been realized that a high dividend payout (or low retention and reinvestment) could act to both compromise and make up for the lack of momentum—and the same goes for stalwart types as far as a large cap or high turnover volume is concerned. Whereas the former could be akin to the ‘cash cow’ category along the BCG lines, the latter could prove either a ‘dog’ or a ‘question mark.’ In fact, the latter is what renders the company a turnaround. In fact, the cash cow analogy could be backed with literature on hedge funds as liquidity providers, direct and implicit (Aragon & Strahan, 2012).
When it comes to fast growing stocks, no qualifying criterion is warranted as binding. Finally, a cyclical stock has routinely pertained to a high beta, which may not discriminate between upside versus downside sensitivity or such details as financial and operational leverage. Although a high beta appears to inflate the expectations, that first and foremost has to do with the hurdle or RRR (required rate of return) not to be confused with actual performance, be it PI (profitability index) or IRR (internal rate of return), to put it in terms of DCF valuation.
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Benchmarking Lynch against Buffett: A Comparative Analysis of Paradigms
The two could rank as the world’s greatest fund managers or investor savvy types ever, each having either a strategy or a full-fledged paradigm boasting superior internal consistency. It might appear even more striking to see that they once embarked on a common doctrine of value investing in safety margin only to find their own implications largely divergent early on. Eventually though, their strategies have converged with an eye on down-to-earth portfolio management and standalone stock picking alike—for the entire apparent theoretical clash at the outset. Among other things it will be demonstrated that, once complete and all-polished, their approaches have shown the complementary compatibility one should have expected from the very beginning.
In fact, it should come as little surprise that the entire host of the present-day economic theory and corporate strategy alike have stemmed from Smith’s careful account of the nature of value and wealth (Varian, 1999). Just like the world’s chief religious traditions have spawned a complex sectarian clash over centuries, it is evident that the core classical economic theory has grown disparate as a matter of varied interpretation as well as emphasizing selected facets of exactly the same body of knowledge.
The starting point dates as far back as the mid-1930s marking the advent of ratios and market multiples as the most important investment analysis tool. In essence, the notion of safety margin deals with the slack that intrinsic or fair value claims against the actual market price. For the most part, it would be reduced to the inverse of the market-to-book value early on, as there was nothing in the minds of the lay public and economic professionals pointing to Markowitz or CAPM (Bodie, Kane, & Marcus, 2009) style reasoning, let alone derivatives valuation, for the convention of informing educated choice. Bearing in mind that most companies would report ‘real’ or physical assets in their balance sheets and little if any intangible net worth or goodwill, it was deemed as all-natural to reduce the analysis of peer comparison or multiples based valuation to the P/B ratio.
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In a sense, a conservative perception of that kind could be rationalized on many grounds. With the advent of derivatives claiming a value far in excess of the ‘hard’ assets or the effective GDP, anyone would have difficulty coming to terms with the occasional propensity to get rid of the seemingly unbacked paper securities that have at best been collateralized in terms of similar fuzzy value. Regardless of how efficient or rational the conventional capital markets might be, it would be awkward to consider such opportunism, forcing bubbles to burst sooner rather than later, as sheer inefficiency or utter irrationality. After all, funds have their customers, and individual investors may well turn risk-averse, in which event downturns could be begged at one point; thus calling into question the entire point of relying on the higher-tier markets for securitization vehicles.
It is no wonder that both Lynch and Buffett would originally shun the largely speculative products or niches. In fact, it was not until late into his career that the latter tapped into the forex market. After all, unless one enjoys access to insider information pertaining to interbank conspiracy as has been the case with HSBC, it is unclear how the manipulative strategies such as currency rigging could either be bypassed or acted upon. Likewise, even the perfectly legitimate open-market operations that central banks or monetary authorities (the Fed included) are engaged in might be hindering one’s attempts to predict the exchange rates, whether it is on ‘technical analysis’ premises or along the lines of PPP (purchasing power parity) of the form the well-known Fisher parity takes on.
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Lynch’s sentiment has been even stronger, as he has long been explicitly skeptical about derivatives trading in any form. To begin with, few traders win in the market for options and future. Whereas forward contracts are less standardized and could be tailored to the manufacturer’s specifications as a vehicle of hedging the output price or the input costs, the aforementioned instruments are normally written by market specialists who are large-scale institutional speculators and are not in the business of any operational or exports hedging. In other words, this has nothing to do with going long on a project or sector one understands very well or much less given the intricate nature of the rationale behind derivatives valuation (Malliaris, 1983).
In fact, the latter pertains to an extensive, Nobel-winning literature on option pricing that proposes a very rigorous approach as for how a variety of derivatives as well as primary equity instruments could be reconciled or valued comparatively. Some of the analyses are based on CAPM-like (capital assets pricing model) premises to be addressed later in text. Alternatively, option valuation could be arrived at by resorting to stochastic calculus of the Ito type (Malliaris, 1983) whose assumptions are about as arbitrary as those underpinning the rational expectations approach and CAPM alike. Consequently, these could be deemed at odds over the assumptions of rationality or efficiency. Whilst CAPM allows for weak or ‘semi-strong’ forms, the ‘rational expectations’ school would never accept anything less than perfect foresight and full use of whatever information is available publicly. Moreover, it is argued that the rest of it, or private information, is nearly irrelevant over the long haul—much the way that individual projects’ idiosyncrasy could be diversified as part of portfolio management. Despite its elegance and modeling simplicity, it is unclear how this can be reconciled with the unethical practices of insider trading—bearing in mind that the bulk of the moral hazards are coped with by law without being solved on their own.
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Along these lines, Lynch argues that most players are not in a position of either beating the market or competing with the large institutional specialists that boast superior day trading and ultra-fast trading platforms. Although the computer aided technologies have become very cheap, no one can be sure that they understand the rationale behind automated decision making over which they have little conceptual control. In this regard, in light of the technically intractable algebraic routines that the lay public and most Wharton geeks alike would have difficulty penetrating, the expected payoff on derivatives and related securitized trading are easily not worth the effort or deliberation cost involved. Simply put, all of the above-mentioned implications point to sheer violation of Lynch’s grand cut-off criterion of complexity avoidance.
As it is evident, this lax paradigm does not set in stone any particular instruments as preferred at all times. For instance, now that computer-processed techniques could be facilitated, one might well opt to go for the derivatives, bearing in mind the mediocre performance of market indices such as DJIA (Chart 1). The Pareto-efficiency (Varian, 1999, p. 16) or Occam Razor style prescription would just be about shunning the relatively inferior products rather than any risk or uncertainty whatsoever. As Buffett would put it, a decent instrument might help to grow faster than either a safe or underpriced pick, whose upside correction might take awhile to materialize at full.
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It is about time for the two paradigms to be compared and contrasted in greater detail, with an eye towards inferring further theoretical and policy implications from the basic core of value investing. To begin with, Lynch’s point could be construed as strong preference for stocks that are undervalued vis-à-vis their strong fundamentals. Among other things, this is not about favoring utterly underpriced stocks that show a downside trend. First and foremost though, it is about discarding the emotive or speculative component of value at odds with the fundamental or intrinsic parameters. It is possible that high P/E can be accepted last, or at any rate, it should be compared against the respective industry or index composite category. However, is it not about preferring small-cap or otherwise penny stocks that may either be diluted from the standpoint of the number of shares exceeding or being less relevant with an eye on a low free float.
It would appear that by contrast, Buffett would take the value criterion with a grain of salt. As a generalized decision making formula, a strong and fairly priced asset might grow faster than a mediocre and undervalued one. Although this should sound most reasonable in hindsight given Apple’s and Facebook’s explosive growth that began to decelerate months ago (Charts 5-12), one might consider this point to perceive the emotive add-on hallmark as the key point the two gurus could be at loggerheads over. Say, Lynch is known to have shunned “hots stocks in a hot sector” and would rather opt for companies with a “boring sounding name” and a plain concept that lacks analyst following. In fact, that would again best apply to the selfsame tech stocks whose downside correction over the past weeks resembles the dotcom bubble burst of the late 1990s. In other words, it is not necessarily about the ongoing media hype over the social network platforms and smart phone applets but rather about this over-heeded sector apparently hovering about its saturation or over-heating point. In other words, it is not about the sector categories as chosen ex ante, but rather about the general symptoms of having dissipated the value slack and the growth momentum alike.
Choose your discount
With that said, Buffett would hardly qualify the otherwise formerly hots picks, based on their past growth alone, now that the balanced value criterion has been violated, i.e. the strong companies have most probably been overvalued. The careful reader should be able to grasp a major reconciliation of value and growth in Buffett’s version, which in fact goes beyond either or both.
To further bridge the gap, Lynch has provided for an even more balanced cut-off, which is neither growth alone nor P/E as such. More specifically, the PEG ratio is based on both in ways that prescribe that, with risk attitude set aside, the rational investor should only settle for a higher P/E as long as it is the price or flip-side of higher growth.
On the other hand, any of these rules-of-thumb should apply in a ceteris paribus manner, or as standalone facets that cannot amount to the ultimate choice. For one, a long list of would-be companies can be made shorter gradually as per each of the aforementioned pivotal points. All else held the same, or by deciding on margin, any such filter could be based on an arbitrary subset of the standalone criteria. In addition, the savvy investor would do wise if they augment the big picture with an inter-temporal perspective. In other words, trends could be studied in terms of either generic growth (Table 1) or the dynamics for multiples such as P/E, P/S, P/EBITDA, or P/B. In any event, these trends should be compared statically (i.e. within each standalone category).
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A host of concerns could readily be raised along with the directions proposed. To begin with, growth is routinely measured as either interim moving averages or as YoY CAGR (cumulative average growth rate on a year-per-year, or annual basis) percentage differential, which overlooks any interim volatility. In fact, largely the same refers to inflation variance that may assume away the money velocity or multiplier as accounted for in macroeconomic or banking studies.
Alternatively, some of the advanced analysts may resort to fully legitimate shortcuts by focusing on whichever multiple-based approaches have worked best historically. In other words, they make use of statistical or econometric regressions or even more involved calibration techniques in order to come up with the more winning selection strategies. On the one hand, this has very little to do with both market efficiency and investor rationality per se, as all what matters is to know how the market will move en masse. On the other hand, although such ‘positive’ knowledge may not help over the long haul as the market updates its priors, still both gurus have taught ways of cashing in on the public’s excesses in the interim run.
A more serious concern might pertain to the very perspective the two have implicitly assumed. As it happens, their strategies are primarily applicable to standalone picks, whereas different strategies should accommodate portfolio based approaches. As a hint, it is not about individual fundamentals or performance per se, but rather about the correlations or covariances that should be best proven negative, if the overall portfolio variance or risk is to be minimized.
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