Peter Lynch Told Me: ‘Just Cheap’ Doesn’t Work

When I was a young analyst at Fidelity, Peter Lynch told me, “Just cheap” does not work. I bristled, but he was right.

When I was a young analyst at Fidelity, Peter Lynch told me, “Just cheap” does not work. I bristled, but he was right.

When I joined Fidelity in 2001, I was a die-hard value investor-in-training. I read everything from the value investing greats that I could get my hands on. Benjamin Graham. Warren Buffett. Interviews with the then-current value investing masters. I was also learning from a Fidelity Portfolio Manager who was a real value-investing master, Joel Tillinghast, the manager of the Fidelity Low-Priced Stock Fund.

Peter Lynch was no longer managing the Magellan fund at this point, but he was still around as a mentor and a role model. So when Peter took a small group of us young analysts out to lunch, I was really excited.

In preparation, I read his books – One Up On Wall Street and Beating The Street. My hope was to get beyond the stories meant for a general audience and leave that lunch a better investor.

His statement struck at the core of my beliefs. I pushed back: “What do you mean it doesn’t work? Isn’t that what Joel does?” I asked him. He was kind and demurred as he probably didn’t want to get into a long argument.

The Problem with "Just Cheap"

Now, after decades of experience, I understand. Statistical cheapness alone is rarely enough. It usually means you're buying a company's problems right along with its stock.

So what's the missing ingredient?

You usually need one of two things:

1. A credible driver of business improvement (a positive cycle, a successful turnaround, secular change).

2. Corporate action (buybacks, a takeover, activism) that will close the value gap for you.

Think about it: if you have a cheap stock but there is neither positive change in fundamentals nor anything causing the stock to become less cheap, is this really an investment that is likely to do well?

Of course, you can come up with extreme examples where “just cheap” is still good enough. Take a company trading at a Price-to-Earnings (P/E) ratio of 5x whose earnings are not declining and that is paying most of its earnings out as a dividend. Under those circumstances the owner is very likely to get a 20%+ annual rate of return.

Sounds awesome, but there is a BUT. The above contrived example rarely, if ever, occurs in practice. Usually, one or more of the following will be true:

• You think the earnings will not decline, but they will.

• The company is highly leveraged and has a high chance of bankruptcy.

• Management is dishonest or incompetent and you won’t actually get your money in dividends.

In recent years, the valuation of the typical company has risen above historical levels. What’s more, companies perceived as having high quality have been priced at a substantial premium.

What does that imply? There has been a strong selection bias where the relatively small group of stocks that are still trading at low valuations are priced so for a reason.

In other words, the market is telling you that there is something wrong below the surface if it’s priced cheaply.

Consider the differences between today and the time when Benjamin Graham was operating. In Graham’s days information transparency was very low. Sometimes getting a hardcopy of an annual report before anyone else was a big advantage. Many stocks outside of a handful of blue-chips were poorly followed, if at all. There were few professional investors scouring for bargains.

Contrast that with today’s environment. Information spreads instantly. There are few unfollowed companies, even among small-caps. There is a deluge of investors hunting for superior returns, many of them well-versed in the standard value investing methods.

Does that mean we should not look for cheap stocks? Or that we should pay 30x to 50x earnings for high quality companies that everyone recognizes as such already?

No.

What it means is:

• We should not restrict ourselves to just statistically cheap stocks.

• A low valuation is a starting point for further research, not an investment thesis on its own.

Path 1: Finding a Driver of Business Improvement

Let’s go back to wanting either future business improvement or favorable corporate action to make a cheap stock truly an interesting investment and examine each in turn.

You might wonder, “Gee if there is business improvement on the horizon, wouldn’t it already be reflected in the stock price?” Sometimes, but not necessarily.

For example, with cyclicals, most investors, who have a very short-term time horizon, want signs of a turn before buying. If you correctly identified the issues are purely cyclical, then by definition the improvement will come. If you are willing to have a longer time horizon than others, you can sometimes benefit from positive change that’s not yet reflected in the price.

With turnarounds, I have found that markets frequently under-react to the initial signs of a turnaround. If you are following the company with a keen eye, it’s sometimes possible to recognize when the probability of a successful turnaround is greatly increased, but the stock price has moved up only a fraction of what is warranted.

Finally, many short-term market participants don’t think through long-term business changes, especially for smaller or less glamorous businesses. So if you devote your analytical efforts to thinking about whether this is becoming a better or worse business over the next 5+ years rather than 2-4 quarters, you will have less competition and will sometimes find a true bargain.

Path 2: Finding a Corporate Action Catalyst

The other path to improving your odds in cheap stocks is a catalyst in the form of corporate action. Some examples are:

• An activist launching a campaign (or already gaining board representation) with an agenda that is likely to create value.

• Management announcing a meaningful return of capital.

• Corporate restructuring, such as a spin-off or a sale of a problem division.

Not all such corporate actions will necessarily lead to unlocking value. I have been involved in some investments where I thought knowledgeable activists on the board would drive positive change. Instead, it turned out that they were as misled about the company’s prospects as I was.

The point isn’t that corporate action catalysts guarantee a good outcome. They just improve our odds of one.

Conclusion: From Cheap to Undervalued

If doing the extra research and analysis sounds like hard work, it is. However, the markets have become efficient enough to require it for long-term success. Don’t just look for cheap stocks; look for companies you understand that are undervalued. The two aren’t always the same.

Looking back at that lunch, I now fully appreciate the wisdom in Peter's simple statement. He wasn't dismissing value investing; he was teaching a more evolved form of it. The goal isn't just to find a statistically cheap stock, but to do the work to understand why it's cheap and, more importantly, what will cause its true value to be realized.

Cheap stocks are plentiful. Undervalued stocks are rare—and finding them is the real work of an investor.

That was the lesson I was hesitant to accept. Now I want to hear from you. What's an early investing lesson that you didn't want to believe at first? Leave a comment below — I'm looking forward to reading them and will reply to as many as I can.

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About the author

Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.