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An Investing Secret from a Successful Fund Manager

Peter Lynch was the head of the US-based Fidelity Magellan fund in 1977, where he managed to deliver 29% annualized returns for his clients over 13 years. To put this into perspective, every $1,000 invested into his fund would have turned into $27,200 over his 13 year tenure.

In an interview with the Public Broadcasting Service (PBS) after his stunning performance, the investing maestro had many thoughts to share that were useful for the individual investor. In particular, he shared one secret about his successful run:

Well, I think the secret is if you have a lot of stocks, some will do mediocre, some will do okay, and if one of two of ’em go up big time, you produce a fabulous result. And I think that’s the promise to some people. Some stocks go up 20-30 percent and they get rid of it and they hold onto the dogs. And it’s sort of like watering the weeds and cutting out the flowers. You want to let the winners run. When the fun ones get better, add to ’em, and that one winner, you basically see a few stocks in your lifetime, that’s all you need.

Water your flowers, not your weeds

In his book One Up on Wall Street, Peter Lynch explained more about this behaviour. He felt that the act of selling your “winners” (the shares that gone up), and holding on to your “losers” (share which have gone down) did not make a lot of sense to him. In his view, the strategy would fail because it was tied to the movement of the share price.

And, the problem with share prices is that it does not always lend itself as a good indicator of fundamental value of a company.

Dairy Farm International Holdings Ltd (SGX:D01) is a pan-Asian retailer providing food, health and beauty, and home furnishings. If the individual investor bought this company on 1 Jan 2000 and held it to 31 Dec 2004, he or she would be sitting on handsome total returns of 274% (including dividends re-invested). Looking at the share price alone, it may be tempting for the anxious investor to “cut off the flower” to lock in that 274% gain.

As it turns out, that individual investor would have been better off just “watering the flowers” and holding on. If Dairy Farm International was held from 1 Jan 2000 up till the closing price on 15 September, the total returns would be 2,157%.

The key would be to shift our view from the share price to what matters more: the business fundamentals, and the addressable market for Dairy Farm.

In this instance, the Dairy Farm had sales of about US$4 billion at the end of financial year 2004, and an earnings-per-share (EPS) of US$0.19. It also paid a dividend of US$0.074 per share for that year.

For a potential comparison, we could look at Wal-Mart Stores, Inc. Wal-Mart is a global retailer with stores in 27 countries. Around the same timeframe (Jan 2005), global retail giant had around US$288 billion in sales.

From that comparison alone, it would seem that the addressable market for the pan-Asian retailer would remain large enough for further growth.

For the financial year ended 2013, Dairy Farm managed to move on from there to clock in approximately US$10.4 billion in revenue, and a corresponding EPS of USD$0.37. The company paid out a dividend of US$0.23 per share for that financial year.

Foolish take away

The key here is to keep doing what a Foolish investor should be doing. And, that is to focus on the business behind the ticker and to keep an eye out for the addressable market ahead for the company.

If the addressable market is still wide open for a company, the best action to take might be just to stay the course (“water your flowers”) and let your investment compound. Instead, if we must sell, we should consider selling companies which might turn out to be the “weeds” of our portfolio. My fellow Fool Stanley Lim discussed some of the indicators for troubled companies in an earlier article.

Stay tuned for more tips from the investing master and potential examples of “weeds”. Or you can also get more tips through a FREE subscription to our weekly newsletter, Take Stock Singapore. So sign up here now!

Read the second part of this article here.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.