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An Investing Secret from A Successful Fund Manager: Continued

A couple of months ago, I wrote about the musings of a successful fund manager, Peter Lynch. As a recap: Mr. Lynch 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 that previous article, I also highlighted a key comment which Mr. Lynch made during an interview (emphasis mine):

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… 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. I mean stocks are out there.

The last time around, I showed an example of how “watering the flowers,” or holding companies which have done well for the long term, could lead to out-sized returns for the Foolish investor. Today, I would like to look at the other side of the coin – “the weeds” – and explore why we may be better off for not “watering the weeds”.

Get your pesticide at the ready

Let’s use Global Yellow Pages Limited (SGX:Y07) for illustration. Global Yellow Pages is a publisher of classified directories and provider of marketing services. Recently, the company had began to venture into different sectors. One of the reasons for the company to go into new lines of businesses is demonstrated in the chart below (click for a larger view): Unfortunately, over the last decade, the company’s revenue has been sliced by more than half.

yellow pages graph 1

Source: S&P Capital IQ

Revenue for Global Yellow Pages has fallen from $65.4 million in the financial year ended 31 March 2003 (FY2003) to a little under $27 million in FY2014. With the benefit of hindsight, the financials of the company visibly took a turn for the worse on FY2010. To show more, the table below contains the company’s revenue, net income, and earnings per share for FY2003, FY2010, and FY2014.

FY2003 FY2010 FY2014
Revenue $65.4 million $41.5 million $26.8 million
Net Income $13.3 million $11.5 million $5.2 million
Earnings per share (EPS) 13.3 cents 2.1 cents 0.75 cents
Share Price $1.66 (IPO price) $0.16 cents $0.08 cents

Source: S&P Capital IQ & Google Finance; Share price at the end of the financial year; Share price for FY2003 represents the initial public offering (IPO) price  

By the end of FY2010, Global Yellow Pages’ revenue had suffered a 36.5% drop compared to FY2003. Net income followed suit with a 14.8% fall, while earnings per share plunged 84.2% due to a large increase in the company’s share count.

The massive decline in earnings per share led Global Yellow Pages’ share price to plunge more than 90% from its listing price of $1.66 (IPO date: 9 December 2004) to its closing price on 31 March 2010 (the end of FY2010).

So, it is possible that the massive fall in share price by the end of FY2010 might bring about a seductive idea that the shares of Global Yellow Pages had “bottomed out”, and might be ripe for doubling down.

The problem with that seductive idea is that it focuses only on the share price, and not the underlying business.

As it turns out, despite the 90% share price drop by the end of FY2010, doubling down on Global Yellow Pages’ shares in the face of deteriorating financials would have been a terrible idea. The company’s revenue and earnings per share continued to fall, and by the end of FY2014, the company’s share price would end up 50% lower compared to where it was at the end of FY2010.

In other words, “watering the weeds” would not have worked in this case.

Foolish take away

The key here is to keep focusing on the business behind the ticker. If the assessment of the business has largely turned negative, then Foolish investors might want to avoid adding to the ticker, or in Mr. Lynch’s parlance – to avoid “watering the weeds”. Most likely, it would not make sense to double down on a share position based on a lower share price alone with the hope of “coming out even” at the end. As the example with Global Yellow Pages shows, the attempt to “come out even” could lead to even worse outcomes.

Instead, Foolish investors may be better served by selling the weeds, taking the lessons learnt, and studying other businesses which are more durable.

Stay tuned for more tips from investing masters by signing up for a FREE subscription to The Motley Fool’s weekly investing newsletter Take Stock Singapore. 

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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.