Beat The Markets With McNeel And Lynch

As the bull market of the 1920s got into high gear, investment newsletters became popular and McNeel's venture prospered. He advertised it as the newsletter for "An Envied Aristocracy of Successful Investors."

In 1927, McNeel wrote a fascinating summary of the fundamentals of investing titled Beating The Stock Market, a bestseller that went through many printings. Today, the work provides both insights into the timeless rules of successful investing and valuable historical perspective.

BENEATH THE SURFACE

In a sense, McNeel's writings about the stock market are paradoxical. On the one hand, he had an obvious passion for equities investment and believed that great profits could result from it. Yet he clearly thought that typical private investors were, in his brutal words, "suckers." This contradiction can be explained by McNeel's belief that most people are unwilling to undertake the study necessary to be successful. According to McNell, if you "can develop powers of independent thought, can be ruled . . . by reason rather than emotion, can keep . . . [your] head when others are losing theirs . . . [you] can make money through speculation in the stock market." He concluded that investing is "a problem of self-mastery and self-discipline."

McNeel repeatedly said it was essential to look below the surface. The reason typical investors do not do well, he wrote, was because they follow "surface indications in the market." He explained, "It is only by buying when surface conditions in the market show stocks to be unattractive and by selling when surface conditions are attractive to buyers that one may graduate from the ranks of the lambs."

It is understandable McNeel was somewhat cynical about the ability of a typical investor to prosper. During the era in which he was a financial journalist and editor, newspapers were not, as a rule, unbiased or evenhanded in their coverage of the financial markets. It was a common practice for stock market operators to make payments to newspaper publishers in exchange for publishing "planted" stories. In addition, many tycoons took over major newspapers specifically in order to gain control of the financial pages. Jay Gould, Jim Fisk, and Cornelius Vanderbilt were just a few of the Gilded Age business barons who engaged in this tactic. Less ambitious stock market manipulators bribed reporters to publish articles that served their purposes. Likewise, McNeel worked during an era when stock market fraud, such as phony "wash" sales and insider trading, was largely uncontrolled.

Yet McNeel saw that while the stock market is "not a game which pays something for nothing, or much for little," and was not for the uninformed investor, "it is a game which repays liberally careful study of the underlying conditions which cause stock market fluctuations." He did not believe rewards came easily. Profits are "apt to be more or less commensurate with the effort put forth" to understand the market, which "is a game to be beaten, not by disregarding the fundamental law of existence, but by remembering the old law that in order to reap the rewards of this world one must give something of himself, of his time and abilities."

SOUND INVESTING

Several basic principles can be derived from McNeel's writings:

First, investigate before investing. Learn all you can about the company you are considering, as well as the overall stock market.

Second, be willing to go against the crowd. As McNeel asserted, "It is not wholly surprising that the average speculator rushes to buy stocks when they are high, for they are only high because the crowd is enthusiastically buying. It is not surprising that the average speculator sells when prices are low — sells when he ought to be buying — for he is merely following the crowd, obeying his natural instincts." Yet in order to buy low and sell high, an investor must be independent, even a bit of a maverick.

Third, remember that conditions can change. Therefore, you must constantly review your investments and be willing to change course. Likewise, "don't ever try to speculate in too many stocks," because you must be able to devote time and energy to every stock in your portfolio.

A corollary to this rule, which McNeel also advocated, is the old Wall Street saying: "Cut your losses short, but let your profits run." He said that this means once the trend of a profitable investment has turned against you, be willing to sell.

Fourth, be objective. Don't let your emotions get in the way of profits. Never base your investment decisions on hope.

"If one is emotional," McNeel observed, "if he lacks the power of will to act on his own knowledge, he should keep out of the stock market."

McNeel was highly critical of investors who "spend too much time hoping and not enough time thinking; too much time dreaming of future profits, and too little time meditating on the probabilities of losing the money they already have at risk."

Fifth, be patient. Profits rarely come immediately. According to McNeel, patience is "essential to success" because "it requires the greatest patience to refrain from buying stocks until they are sufficiently low in the downward swing of the speculative cycle. It requires the greatest patience, too, to hold a stock, when once bought, until the speculative cycle turns around and shows signs of having reached its highest point."

The sixth and final principle that can be gained from McNeel's work is: don't fall in love with a stock. McNeel observed that "if there is anything in speculation which requires courage and power of will, it is selling stocks at high prices. Theoretically, it is just as easy to write a sell order as a buy order. But practically 99% of speculators find it a hundred times more difficult to get into the frame of mind to sell stocks than to buy."

Dollar cost averaging, the idea of investing a consistent amount of money in a stock over a protracted period of time, became very popular in the late 1990s, but McNeel advocated it more than 75 years earlier. He called the practice "buying on scale" and declared that "successful operators" make additional purchases of a sound stock even as the price declines, "which will bring the average cost of their purchases down to a relatively low figure." Likewise, once a downward movement ends, "they can complete their purchases at the same or higher levels, when it is certain that the turn in the market has definitely been made."

The key to profitable investing, McNeel concluded, is to take the time to understand the market. He knew that investing entails taking risks, but these risks should not be taken on blindly. "Those who win in speculation do not make a success of it because they take a chance. They win because before they take a chance they use every human power to eliminate risk."

BEATING THE MARKET

If McNeel's Beating The Stock Market sounds familiar, it might be because you remember Peter Lynch's Beating The Street, which he wrote as the followup to his One Up On Wall Street.

From 1977 to May 1990, Peter Lynch ran the Fidelity Magellan Fund, which was by far the best-performing general equity mutual fund of the time. An investment of $10,000 in 1977 was worth $280,000 in 1990, when he retired to spend more time with his family.

Thanks to his remarkably successful record, Lynch became the best-known money manager in the country. Lynch's ideas are deceptively simple. Like Warren Buffett, he believes in finding solid companies that are selling at reasonable prices. Also like Buffett, Lynch insists that you should only invest in companies you understand. "You have to know what you own, and why you own it." In his words, "Ninety seconds is plenty of time to tell the story of a stock. If you're prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth-grader could understand."

Another of his ideas is that as consumers, we are likely to come across companies that are good investments. He asserts that "if you like the store, chances are you'll love the stock." Lynch has used his family's experiences as consumers to spot retailers, restaurant chains, and consumer product companies that had superior products or services but were not yet big enough to come to the attention of most stock market professionals.

Be a long-term investor, Lynch urges. "It pays to be patient." Although stock prices may vary from a logical range in the short term, in the long term they reflect the underlying value of the companies. "Time is on your side when you own shares of superior companies."

Like McNeel, Lynch wrote that investors should diversify but not overdo, because they need to be able to monitor investments for changes in circumstances. Lynch believes that the typical person should invest in from five to 12 companies, noting that "you need to find only a few good stocks to make a lifetime of investing worthwhile." According to Lynch, five is a good number of stocks to own, because chances are that three out of five will perform as expected, one will significantly underperform, and the fifth will exceed expectations. Also like McNeel, Lynch stated that there are some times when investing in the stock market is not advisable. "If you can't find any companies that you think are attractive, put your money in the bank until you discover some," he wrote.

Lynch warns against overpaying. He is interested in companies with growth rates greater than their price/earnings ratios. A company with a P/E ratio that is greater than the growth rate is likely to be overvalued. Likewise, he warns that investors should "avoid hot stocks in hot industries," because they are often vastly overpriced.

McNeel and Lynch both ascribe great importance to an investor's ability to be dispassionate and unemotional, even during bear markets. Lynch wrote that "if you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether."

Lynch noted that in the past 70 years there have been 40 "scary declines" of 10% or more, including 13 "terrifying declines" of 33% or more. Price declines, according to Lynch, offer "a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic."

Lynch echoed McNeel's observation that knowing when to sell and being willing to do so is extremely difficult for the typical investor:

When to sell a stock is typically the hardest decision an investor has to make. While the temptation is great to sell a profitable investment, and to hold onto stocks that have declined in the hope that they will recover, all investment decisions (including whether to hold or sell) should be based on the stock's prospects.

Like Warren Buffett, Lynch warns against managements that waste stockholders' capital through unwise expansion. There is a tendency, he noted, for management to use earnings to invest in other industries. Instead of paying shareholders higher dividends or buying back shares, they "blow the money on foolish acquisitions." While this is usually rationalized as "diversification," Lynch calls it "deworseification," and Buffett named the phenomenon the "institutional imperative."

McNeel, who wrote during the first third of the 20th century, was cautious and a bit cynical about the stock market. This can be contrasted with Lynch's optimism based upon his experiences during the last third of the century. The contrast shows how far financial markets advanced over the course of the century.

Lynch popularized the term "10-bagger" to refer to a stock that increases 10-fold from the price at which it was purchased. While 10-baggers are the exception, not the rule, both McNeel and Lynch have shown that it is possible for a patient individual investor to realize spectacular gains in the stock market.

James Maccaro is an attorney and freelance writer. He has written articles for Newsday, Ideas on Liberty, the Massachusetts Law Review, and other magazines. He can be reached at jam@juno.com.

SUGGESTED READING

_____ [1996]. Learn To Earn: A Beginner's Guide To The Basics, Fireside Books.

_____ [2000]. One Up On Wall Street, 2nd ed., Simon & Schuster.

McNeel, R.W. [1995]. Beating The Stock Market, reprint ed., Fraser Publishing Company.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.