Dear Fellow Investors:

Peter Lynch was one of the most successful stock pickers of all time. From 1977-1990, he managed the Fidelity Magellan fund and produced returns of 29.2% per year, besting the S&P 500 Index returns of 15.8%. The Magellan fund grew from $18 million to $19 billion in assets during that time period. What Lynch said about market timing and investor sentiment appears very useful to long-duration common stock owners like us.

Lynch shared his wisdom with the press and in his books like One Up on Wall Street. He was conscious of the fact that stocks could decline at any given time. His advice for investors who wanted to make the most money over long periods of time in common stock ownership included this truth. This is an excerpt from a PBS Frontline interview in 1996:

Now no one seems to know when they [market declines] are gonna happen. At least if they know about ‘em, they’re not telling anybody about ‘em. I don’t remember anybody predicting the market right more than once, and they predict a lot. So they’re gonna happen. If you’re in the market, you have to know there’s going to be declines. And they’re going to cap and every couple of years you’re going to get a 10 percent correction. That’s a euphemism for losing a lot of money rapidly. That’s what a “correction” is called. And a bear market is 20-25-30 percent decline.

As for us, we have argued that the key to owning stocks for ten to twenty-year uninterrupted stretches is to buy out-of-favor and high-quality stocks. One of the main reasons that valuation matters dearly to us is that stocks with high expectations usually are more volatile and vulnerable to losing their premium in a downdraft. Second, it is one thing to be in a stock with a sizable temporary loss, but it is a totally different experience if you are relying on the maintenance of high P/E ratios and/or glamorous concepts to stay airborne.

We prefer a one step back and two steps forward modality, preferring to only go many steps back when a decline the size of the 2007-09 financial meltdown hits the stock market. Buffett always says that the enemies of your portfolio are “excitement and expense.” We try to avoid maniacally popular stocks and practice low turnover to keep expenses down.

What would Peter Lynch say about investor sentiment today? Peter described the cycle of a bull market through his experience at cocktail parties. Near the bottom of the market, people at these parties had no interest in talking stocks. They were more interested in hearing what’s the going on with the dentist. Halfway through a bull market, everyone at the party wanted to find out what stocks Mr. Lynch was buying. At the end of a bull market, the guest liked to tell Peter Lynch (one of the greatest stock pickers of all time) what stocks they were buying and why.

To gauge where we are in the Peter Lynch bull market continuum, let’s take a look at this week’s sentiment poll from the American Association of Individual Investors at their website, AAII.com. This is a group of individual investors who pay an annual membership fee and participate in a wide variety of online and in-person events to improve their stock picking and asset allocation prowess. In other words, these are folks that are naturally inclined to the stock market. Here is their latest poll:

As a 35-year student of the U.S. stock market, I am astounded at these figures. These are comparable sentiment numbers to the bottom of the bear market in 2002-03! This was after tech stocks got crushed in the three preceding years and the index had decline more than 40% from peak to trough. When we access the stock market within the context of these numbers and Peter Lynch’s continuum, we find it funny that hardly anyone ever asks us what stocks we bought lately. Certainly nobody touts their best and latest buys to us!

Putting all of this together, we like where we are. Our portfolio of stocks have met our eight criteria for stock selection, on average trade at about a 10% discount to the S&P 500 Index, and have far superior qualitative characteristics than the average stock in the index. We would not be embarrassed to go through a downdraft with this portfolio, but don’t expect the end to the secular bull market which began in 2009 to come with amazingly low levels of confidence among the investing public.

Lastly, we love what we heard Peter Lynch say in late 2008 on CNBC with the stock market as miserable as it ever gets. They asked him where he thought the stock market was going to go next. He said, “I’m the wrong guy to ask, I’m always bullish.”

Warm Regards,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

This Missive and others are available at smeadcap.com

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