Hall of Fame investors Warren Buffett and Peter Lynch aren't stingy in sharing the secrets to their success.
By success, I mean mind-blowing, market-thrashing returns in the stock market.
Buffett has generated 20% annual returns over decades in his Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) holding company. Over a shorter period of time from 1977 to 1990, Lynch led Fidelity's Magellan Fund to returns of almost 30% a year!
Since both have been generous enough to explain why they've succeeded where others have failed, we mere mortals have access to a lot of good insights. In fact, I detailed Buffett's top 10 investing secrets here, and I explained Lynch's eight steps to beating the market here.
But what frequently gets lost in all this is the key secret of their success -- the secret Buffett and Lynch are loath to divulge.
What we wrongly think
Buffett gets painted as the folksy grandpa of investing -- as likely to hand you a Werther's Original as a stock tip.
He shuns new-fangled technology stocks in favor of old-timey brands he's grown up with such as Coca-Cola, The Washington Post, and American Express. He eats more hamburgers than Ronald McDonald and polishes them off with Cherry Cokes. He runs his company with his best buddy, Charlie Munger. Each day, he sits in his office in Omaha, Neb., far from the distractions of Wall Street, and reads his annual reports. He makes investing sound like the simplest thing in the world, spouting his version of "buy low/sell high" -- "Be fearful when others are greedy. Be greedy when others are fearful."
Meanwhile, Lynch is painted as the "buy what you know" guy based on advice he gives in his two best-selling investment books. Eating a McDonald's hamburger? Buy its stock. Is there one store at the mall that's got tons of foot traffic? Buy shares!
But that's far too simple
We've made these two complex, brilliant investing giants two-dimensional because we want the path to success to be simple. Because Buffett and Lynch are masters at distilling their success down to basic principles a caveman could understand, it's easy to believe it's easy.
When asked what the most underrated part of Buffett's success is, his official biographer Alice Schroeder answered:
How hard he worked -- because he tends to make it look effortless in public and it wasn't at all. It is, to some extent, the way that you do it. The rules that he uses are simple. People have mistaken that for the fact that it might be easy. I have never seen anybody who has put more effort into investing than Warren Buffett, over the course of a lifetime.
Her book, The Snowball, shows exactly how hard he works and how laser-focused he is. There's a price for his commitment. He's the kind of guy who leaves dinner parties at his house to read up on his latest potential investment. The kind of guy who hears but doesn't really listen to small talk. The kind of guy who's so specialized in his field of knowledge that, like a disheveled professor, he relies on others to function in the real world.
Lynch retired at 46. This isn't because he's lazy. It's the opposite. To achieve his returns, he had to work excruciatingly hard. He retired because he knew that he wasn't capable of giving his family the attention he wanted to give them as long as he kept running the Magellan Fund.
This is hard work
This type of dedication is the price Buffett and Lynch paid to beat the market. But how does all this relate to us as individual investors? It's a reminder that investing isn't as easy as it can appear. Let me explain with two current examples.
Example No. 1: Big-time dividend yields
There are some huge dividend yields out there right now.
- Real estate investment trusts American Capital Agency (Nasdaq: AGNC ) , Chimera, and Annaly Capital sport cartoonish yields of 20.6%, 17.3%, and 15.7%, respectively, as they're making big profits on the currently high yield spreads.
- Frontier Communications (NYSE: FTR ) recently lowered its dividend payout to preserve capital for a big deal with Verizon and still pays out a 9.8% yield. The deal has the upshot of tripling Frontier's size.
- Apollo Investment (Nasdaq: AINV ) and Ares Capital (Nasdaq: ARCC ) are business development companies that pay out 11.7% and 9.5% yields, respectively. For another eye-popping number, Ares Capital has a trailing price-to-earnings ratio of 3.6.
The allure of these companies is that their stock prices can do absolutely nothing and still double as investments if the dividends hold up for a few years. Of course, the question you need to answer is: "Will they?" We can look at metrics like payout ratios (either on earnings or free cash flow) and analyst estimates of future earnings, and sometimes the numbers are still compelling. But proper analysis requires a knowledge well beyond the numbers.
Example No. 2: Beaten-down stocks
- Cell Therapeutics (Nasdaq: CTIC ) trades for well under $1 a share because its initial Food and Drug Administration application to market its non-Hodgkin's lymphoma drug, Pixantrone, was rejected. Now, investors wait to see if an additional late-stage clinical trial is successful. This is a classic binary situation.
- E*TRADE still has a very legitimate discount brokerage hiding underneath its subprime balance sheet risks. Trading at a price/book of 0.8, there's upside if its balance sheet has been righted.
- YRCW Worldwide is a trucking giant with almost $5 billion in sales, but bankruptcy risk has it trading for about a quarter per share. Hence, its price-to-sales ratio is under 0.1!
The allure of these companies is the potentially tremendous upside if you're right. The back-of-the-envelope justification frequently used is: "It could go to zero, but if it doesn't then it's a multi-bagger." The implicit assertion is that it's a 50/50 bet with more upside gain than downside loss. That kind of thinking can be a dangerous road, though.
The problem is that neither of these situations -- big-time dividend yields nor beaten-down stocks -- is as simple as it sounds. A few metrics, a basic understanding of business models, and an upside theory aren't sufficient. Even with their massive brainpowers, Warren Buffett or Peter Lynch have had to dedicate most of the waking hours of their lives to figuring out which companies are worth the risk. They know that the price of being wrong can be a massive downside. They also know that they're going to be wrong quite often, even with all their due diligence.
Despite my warnings, I believe individual investors can beat the market. I try to do so myself. But I still hold a significant portion of my investments in index ETFs and mutual funds. If you're not Warren Buffett or Peter Lynch, it's something you should consider as well.
If you're looking for the next stocks to do your homework on, check out these big, bad dividend stocks by clicking here.