The Market-Beating Secret Buffett and Lynch Won't Tell You

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.

It's not.

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 lesson
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.

Anand Chokkavelu owns shares of Berkshire Hathaway. American Express, Berkshire Hathaway, and Coca-Cola are Motley Fool Inside Value picks. Berkshire Hathaway is a Motley Fool Stock Advisor recommendation. Coca-Cola is a Motley Fool Income Investor selection. The Fool owns shares of Annaly Capital Management, Berkshire Hathaway, and Coca-Cola. The Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (59)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 19, 2010, at 5:17 PM, goalie37 wrote:

    I'm reading "Snowball" right now, and your description is right on. Fortunately I am pretty obsessive about investing myself and thouroughly enjoy the hours and hours of work. I think you will find that your article is preaching to the choir. The Fool community is made up of some pretty dedicated people. +1 rec.

  • Report this Comment On August 19, 2010, at 7:31 PM, TMFBomb wrote:

    @goalie37,

    Thanks. Hopefully I am preaching to the choir, but I do like to occasionally remind myself (and anyone who reads my articles) that investing's tough, not to get too cocky or overvalue long shots, and that long-term ETF's and mutual funds should anchor most portfolios.

    Enjoy Snowball...it gets even better as it goes on.

    -Anand

  • Report this Comment On August 19, 2010, at 9:30 PM, TMFtheEdge wrote:

    Thanks for writing the article

    - I have been sharing the same thoughts with my friends as I have found Buffett's phrases in particular being over-simplified and quite frankly abused

    - Philip Fisher made the same point about extreme hard word needed for investing

    I think a lot of folks are not aware of the price to pay in order to be at the level of these investing giants especially on your point -- "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".

    I would settle for much less and am fortunate to have the Motley Fool do much of the heavy lifting for me.

  • Report this Comment On August 19, 2010, at 10:44 PM, Clint35 wrote:

    Great article Anand. You're absolutely right, people often equate simplicity with easiness. They're often two different things. Also like Buffet has said, It's more about the gut than the brain. How many people sold shares during this recession just because the price went down, even though they had stock in very companies with good dividends? Sometimes it's hard to hold on even though it's the smartest and simplest thing to do.

  • Report this Comment On August 20, 2010, at 8:05 AM, TMFBomb wrote:

    @HLChin,

    I wonder if anyone can name someone who has had wild investing success that has not been obsessed. Or any field, really. Anyone have a good counterexample?

    @Clint35,

    Great point. Temperament is underrated. It's one of the reasons the smartest folks aren't the best investors.

    Thanks for reading!

    Anand

  • Report this Comment On August 20, 2010, at 9:55 AM, YeOldPhart wrote:

    Hi there,

    Can I ask a rather foolish, with a small "f" question? Do you buy ETF's like regular stock with regular tickers or do you buy them on a special platform like for example CFD's etc?

    Thanks for your help

  • Report this Comment On August 20, 2010, at 3:27 PM, kwl1763 wrote:

    Reminds me a lot of the 10,000 hour rule that Gladwell and others have talked about.

    It takes 10,000 hours of doing something passionately to become expert. You have to have skill also but it has been proven very few "tops of field" are anything short of obsessive.

    There is no doubt there is skill involved and some who "practice that much will still be below average or worse but rarely will you see the other where somebody is just naturally gifted and doesn't practice hard.

  • Report this Comment On August 20, 2010, at 4:55 PM, TMFBomb wrote:

    @YeOldPhart,

    I buy plain ole ETF's. My favorite family is Vanguard b/c Jack Bogle (its founder) pretty much invented indexing. And their fees are rock-bottom. An example is Vanguard Total Stock Market ETF(NYSE: VTI)

    -Anand

  • Report this Comment On August 20, 2010, at 5:08 PM, TMFBomb wrote:

    @kwl1763,

    I'm glad you brought that up. I wrote about that in the unedited version of this article. We cut it b/c it's kind of a detour. But, just for you, but here is the excerpt (below) in all its unedited glory!

    -Anand

    In his book Outliers, Malcolm Gladwell gives example after example of people we term “geniuses” that are really hyper-dedicated people who worked at their craft relentlessly. Among the examples he uses are Bill Gates and the Beatles. He argues that both got to where they got because of the opportunity (and inclination) to hone their skills for 10,000 hours. That’s the equivalent of 5 full years of work. Or 1,000 weeks of practicing 10 hours a week.

    Gates had access to an ultra-high-end computer terminal because his exclusive middle school started a computer club. In high school, his access went up a notch as he gained access to the computers at the University of Washington. He talks of getting 20 to 30 hours of programming time in each weekend. On weeknights, he’d slip out of his house to take advantage of the open time-sharing slots from three to six in the morning. The Beatles were just as obsessed. By the time they broke out on the Ed Sullivan show in 1964, the Beatles had played an estimated 1,200 shows, some lasting eight hours!

  • Report this Comment On August 21, 2010, at 12:32 PM, pinestholdings wrote:

    This is the best article I've read on here in a while. Thanks for the heads up on YRC worldwide. Will spend the weekend checking them out. I appreciate the thoughtful article - and I doubly appreciate that instead of recommending nonsense like "Petrobras as a dividend stock!" you give us good ideas with caveats to research ourselves. Kudos.

  • Report this Comment On August 22, 2010, at 4:41 PM, ThongLover854 wrote:

    It seems to me that the recommendations on MF waiver back and forth with complete randomness. For example, just a week before this article, there was an article titled "5 stocks we're buying" that had Annaly (NLY) listed. So over the course of a week, NLY is listed as a buy of the week and then you are saying it's too good to be true as you mention you need analysis "well beyond the numbers".

    Then the MF Caps rank AIB (Allied Irish Bank) a 5-Star stock and one of the "Top 10 Buys in Banking" in articles on an almost daily basis. You really can't look at AIB as anything more than a crapshoot...a gamble...

    My point is it seems the writers at MF are all over the place with their opinions, some saying buy this super risky stock, other saying beware! It's a little frustrating. I'm not ranked or haven't ever put in my rankings for 4 or 5 star, etc., but i really can't believe that AIB is a 5 Star ranked stock...come on. That's just irresponsible.

    Any thoughts would be appreciated...and by the way, i think the article about Buffett, etc, was great...hope you can appreciate my concerns...

    Cheers...

  • Report this Comment On August 22, 2010, at 8:21 PM, TMFBomb wrote:

    @ThongLover854,

    Thanks for sharing your concerns. One thing to keep in mind is that the Motley Fool isn't a monolith -- i.e. each of us have our own views on each stock that we write about.

    We also have our CAPS community where stocks are ranked based on the community's collective intelligence. AIB is a 4-star rated stock there. This is a collective ranking of the community as a whole.

    As an individual investor, it's up to you to do your own due diligence. Our articles (and CAPS community) highlight stocks to consider or stocks we think are overvalued and reflect each writers' view, but ultimately it's up to you. My point on needing analysis "well beyond the numbers" is true of any stock (not just Annaly).

    Hope that helps. Fool on!

    -Anand

  • Report this Comment On August 23, 2010, at 11:20 PM, PauvrePapillon wrote:

    I like the article.

    Simple is not to be confused with easy.

  • Report this Comment On August 25, 2010, at 4:16 AM, Jehnavi wrote:

    We also have the CAPS community, where stocks are classified according to the collective intelligence. AIB is a 4 star vehicle there. This is a list of the collective whole. Gates was to obtain computer terminal ultra-high-end as he began the exclusive secondary school computer club. In high school, she got up to use the article when it was given access to computers at the University of Washington. He speaks of 20-30 hours of programming every weekend.

    http://www.financemetrics.com/

  • Report this Comment On August 25, 2010, at 6:58 PM, hbofbyu wrote:

    Good article but I find a paradox in the "art" of investing (if it was a science it would have been conquered long ago and all the employees at The Fool would be on the same page). It is a game that pits people against each other and by design we all can't win - for every winning trade there is a losing trade. Granted, that is better than the odds in Vegas. But just like Vegas, you can always find winners after the fact; and those winners will be renowned - but who would mistake their success for skill except those who think it can be replicated. There is skill in crunching numbers, in knowing history, in reading balance sheets and convincing others but I don't think there's much skill at all in choosing a winning stock. A dillusioned attempt to manage chaos.

  • Report this Comment On August 28, 2010, at 8:23 PM, philkek wrote:

    Thanks MF and fellow fools. Good article and thoughtful comments here. This is continuing education that has proven to be profitable over time.

    Smart Fools have to work hard. "geniuses", "...hone their skills 10,000 hours". Wow ! I've still got 9,900 hours homework to go.

    Better Business Bureau warns all fools to investigate BEFORE you invest. MF gives investors the same advice to "investigate BEFORE". Keep up the good work. Fool on for profits.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1275402, ~/Articles/ArticleHandler.aspx, 11/28/2014 8:25:22 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement