Peter Lynch, Warren Buffett, and the Mutual Fund Investor
by Ann C. Logue
Last week, someone asked me what my favorite investment books were. I told him to read "One up on Wall Street," by Peter Lynch, and the letters of Warren Buffett, free on the Berkshire Hathaway (NYSE: BRK.A) website; this week, both men ended up in the news. Lynch, who earned legendary returns when he ran Fidelity's Magellan Fund, settled charges with the SEC of directing trades in exchange for sports and theatre tickets. Meanwhile, Buffett released his company's most recent annual report on Feb. 29.
Each of the Berkshire Hathaway annual reports includes Buffett's thoughts on successful investing as well as his outlook for the market. Most fundamental investors can learn a few things by reading his reports, which are public information and readily available on the Berkshire Hathaway website: http://www.berkshirehathaway.com/letters/letters.html.
Berkshire Hathaway is a mutual fund of sorts. The company takes large stakes (sometimes 100%) in different companies that are expected to grow revenues and market share faster than the market due to a competitive advantage that usually stems from being a low-cost producer or a strong, global brand. Companies in the portfolio include Washington Post Co. (NYSE: WPO), Coca-Cola Co. (NYSE: KO), Geico Insurance and Dairy Queen, and it's proven to be hugely profitable over the years. Between 1965 and 2007, Berkshire Hathaway posted a compound average annual return of 21.1% versus 10.3% for the S&P 500.
Buffett has a few big concerns for 2008. He's concerned about the size of the U.S. trade deficit and a monetary policy that keeps the dollar's value low, and until that is corrected, he thinks that there will be serious problems ahead. (He's happy to make money for his shareholders speculating in currencies. For all of the Buffett mythology of picking great stocks, the company has long been helped on the margins by aggressive commodity and currency trading.)
Another of his worries is the general assumption among investors that equity markets should generate double-digit returns over the long run. Buffett points out that this is an enormous gamble on the part of pension fund managers, who often use high future rates of return in their assumptions to keep current funding obligations for accounting purposes low. Although few people remain eligible for defined benefit pensions, those companies that still have them may be forced to take big charges to meet their contractual obligations. Buffett also points out that taxpayers will be on the hook for big increases to meet state and municipal employee pension obligations, many of which have the same high assumptions for rate of return built into them. In the straightforward fashion that makes him so beloved of investors everywhere, Buffett also notes that investment return assumptions are built into loss reserves in the company's insurance business, so that could be a risk to his own company's future results.
Lynch was an active money manager between 1977 and 1990, earning a compound average annual return of 29%. He stayed on at Fidelity with the title of vice chairman, working on investment strategy and helping to promote their funds. His basic investment philosophy is similar to Buffett's. Namely, investors should buy simple businesses with good management and good prospects. He says that investors should look for great stocks all around them, in business that they frequent and products that they use, which may help them find great companies early and have a little warning on when things are deteriorating. It's not a perfect system; investors often cite Lynch when they have fallen in love with a fallen stock and are wishing and hoping that it will improve.
Some contrarians would say that Lynch and Buffett aren't smart, just lucky. In an efficient market, returns are normally distributed and most people will simply match the market. If that's the case, then investors should simply buy index funds as an easy, low-cost way to get that return. Under that argument, Lynch and Buffett are out at the lucky end of the normal curve. Someone at the other end loses almost every time he or she invests, perfectly offsetting their gain so that the average investor simply has an average return.
But markets aren't perfectly efficient. They are close, but not quite, so I go back to my original thesis: read Lynch and Buffett if you want to learn more about investing. Don't pay any attention to Lynch if you are looking for tickets to a hot concert, and buy your Easter candy from the Berkshire Hathaway-owned See's Candies. Even if you don't own the stock, Warren Buffett can make you happy.
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