Beating the Street (16 page)

Between me and the trading floor was a walkway or bridge that crossed a nine-floor drop and gave you the sensation of walking a tightrope over a deep canyon. Fidelity must have designed it that way to keep the fund managers from bothering the traders in person. In my case, it worked.

At first, my head trader was my only trader, but by the end of 1983, when Magellan had grown and the buys and sells got more complicated, I was assigned a second person, Carlene DeLuca. Lyden did buys and DeLuca did sells. Both were very patient with me, and I tried to give them the leeway to do their jobs.

Trading was the least of my worries. In retrospect, I probably spent more time on it than I should have—an hour a day instead of 10 minutes. It was fun to buy and sell, but I would have been better off using the extra 50 minutes to call two more companies. This is one of the keys to successful investing: focus on the companies, not on the stocks.

Once my trading list was sent down, I returned to my main task—keeping
up with the companies. My methods were not much different from those of an investigative reporter—reading the public documents for clues, talking with intermediaries such as analysts and investor relations people for more clues, and then going directly to the primary sources: the companies themselves.

After every contact I made, on the phone or in person, I'd scribble a notation in a loose-leaf binder—the name of the company and the current stock price, followed by a one- or two-line summary of the story I'd just heard. Every stockpicker, I think, could benefit from keeping such a notebook of stories. Without one, it's easy to forget why you bought something in the first place.

As Magellan grew, so did my library of notebooks, and the amount of time it took to review all the stories. I cut back on the corporate lunches, as useful as those had been, in favor of the more efficient practice of munching on a sandwich in between phone calls. I'd developed enough sources from the earlier lunches that I could get most of the information I needed on the phone.

Outside my cubicle door, four secretaries, led by the unflappable Paula Sullivan, were busy routing the calls. They'd yell, “So-and-so on line one,” and I'd pick up. Rarely did anyone venture into my office for long. Since the seats of the chairs had become extra file cabinets, there was no convenient place to sit, except on the floor.

If I left my post, it was either to get another diet Coke from the office refrigerator or to use the bathroom. Between me and the nearest bathroom was a small lobby where corporate guests and visiting analysts waited for their meetings with the various fund managers on our floor. Usually there were people I knew out there. I avoided them by sneaking down a back stairway to a more secluded bathroom. Otherwise, I would have had to waste time making small talk, or snub these friends and acquaintances, which I didn't want to do.

Magellan was far from a one-man show. From 1981 forward, I always had one or more talented assistants who did the same thing I did, calling companies or calling analysts to keep me up to date on developments. My first assistant, Rich Fentin, set the standard for quality. He went on to run the Fidelity Growth and Fidelity Puritan funds. Fentin was followed by several others who learned so much
from my mistakes that they, too, ran successful funds: Danny Frank at Special Situations; George Noble, who started the Overseas Fund; Bob Stansky who took over Growth; Will Danoff at Contrafund; and Jeff Vinik, who now runs Magellan. Then there were Jeff Barmeyer, now deceased; Deb Wheeler; George Domolky; Kari Firestone; and Bettina Doulton, now Vinik's assistant.

These energetic surrogates enabled me to be in several places at once. They proved that the best way to get the most out of a staff is to give people full responsibility. Usually, they will live up to it.

Fidelity put this theory into practice by making all the fund managers responsible for doing our own research. This requirement was revolutionary, and not always popular with my colleagues. In the traditional setup, a fund manager chooses stocks that the analysts have recommended, based on the analysts' research. This is very convenient for the fund managers, and excellent for their job security, since if the stocks go kaput they can blame the analysts for providing faulty information. It's the same dodge that the average investor uses when he loses money on a stock tip from Uncle Harry. “How could Uncle Harry have been so stupid?” he says to his wife after she hears the bad news. This is exactly what the fund manager says to his bosses about the analysts.

Knowing that the blame will be passed along to them, the analysts soon learn to protect themselves by not sticking their necks out. Instead of making imaginative recommendations to the fund managers, they prefer to tout acceptable, worn-out companies like IBM. Because they recommend acceptable stocks, they don't get criticized as much when the fund managers have a lousy quarter.

At Fidelity, this didn't happen. For better or worse, fund managers did independent research and were held accountable for the results. Analysts did their own parallel research and passed it along to the fund managers, who were free to take or leave the analysts' advice. Thus, there was twice as much investigating going on as there would have been with the customary division of labor.

Each new Fidelity fund required a new fund manager, who also would function as a fact gatherer for the others, so as the number of funds increased, so did the quality of our in-house intelligence. My colleagues' tips and leads were particularly valuable to me because Magellan was a capital appreciation fund, and therefore I had the widest latitude to buy stocks that the special situations person, the small-stock person, the growth person, the value person, or the over-the-counter stock person had recommended.

I was a passionate advocate of launching new funds, such as the OTC Portfolio, the Overseas Fund, and the Retirement Growth Fund. Most have turned out to be quite popular, but even if they hadn't, they gave us more researchers to snoop in new areas of the market. I took full advantage of their discoveries. Danny Frank of Special Situations was the first to see the potential in Fannie Mae, and also several turnarounds; George Vanderheiden of the Destiny Fund led me to Owens-Corning; Tom Sweeney of Capital Appreciation gave me one of my best stocks, Envirodyne.

The new funds also gave us new slots into which we could promote our talented young analysts, who otherwise might have been lured away to rival firms. The result was one of the greatest teams of stock sleuths ever assembled.

Early in my tenure, we formalized the swapping of information. Our random powwows in the hallway near the refrigerator were superseded by a scheduled event in a conference room, where all the analysts and fund managers presented our picks of the week.

Later, I presided over these meetings with a small kitchen timer, which I pretended to set at three minutes—the official time limit for any defense or explanation of a pick. In fact, I was setting the timer at progressively shorter intervals, until I got it down to a minute and a half. I'm confessing this now that it's too late for anyone to demand a chance to make up the lost time.

People were too excited about their favorite subject to notice that I was fooling with the timer. Anyway, 90 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, and quickly enough so the fifth grader won't get bored.

These sessions of ours were not put-down contests. Wall Street tends to be a combative environment where only the glibbest survive, but combat is not the best way to arrive at the truth about stocks. When you are openly criticized for your ideas, you may tend to hold back the next time. And when there's a chorus of criticism, you're likely to lose faith in your own research.

A hostile reception might not affect your confidence immediately, but the brain never forgets a painful experience. It will remember that every person in the room ridiculed the notion that Chrysler was an exceptional bargain at $5 a share. Then one night a year or more later, when the stock's at $10 and the brain has nothing better to do, it will remind you that “maybe all those smart people were
right,” and the next day you'll wake up and sell your Chrysler about $30 a share too soon.

To avoid undermining one another's confidence, we allowed no feedback at our presentations—the listeners were free to follow up on the leads or ignore them as they chose. I tried to focus on the quality of each idea, as opposed to the quality of the speaker. Often, the most valuable leads came from people whose stockpicking skills far exceeded their forensic skills, and I made it a point to pick the brains of the nonverbal contingent outside the meetings, with the egg timer turner off.

Eventually, the weekly sessions were replaced by daily research notes, because we had too many analysts and fund managers to fit into one room.

Two other sources of leads that often proved valuable were analysts and fund managers from outside Fidelity. At least once a week, I'd talk to the manager of a competing fund, and occasionally we'd bump into each other on the street or at a meeting. “What do you like?” we'd say as soon as we'd gotten beyond “Hello.” This is the way stockpickers communicate. It's never “How's your wife?” or “Gee, did you see the shot that Larry Bird made?” It's always “What do you like?” followed by “Gee, things are getting better at Delta,” or “I'm expecting a turnaround in Union Carbide.”

We were competitors in the sense that our funds' performance was compared by Lipper,
Barron's, Forbes
, etc., and how well we did relative to the others would determine how much new money we attracted the following year. But the competition did not stop us from revealing our favorite stocks to one another at every opportunity—at least after we'd acquired all the shares we were planning to buy.

You wouldn't expect the coach of the Washington Redskins to share his favorite plays with the coach of the Chicago Bears, but we were eager to share our buy lists. If one of us gave a competitor a good idea, he or she would return the favor.

The advice of the analysts from other firms and salespeople from the brokerage community I took more selectively. There is great variation in quality here, and it's dangerous to follow a recommendation put out by a brokerage house without knowing something about the person who made it. Some highly regarded analysts are resting on their laurels in air-conditioned comfort. They may be listed as all-stars in
Institutional Investor
magazine, but that doesn't mean they've talked to Colgate-Palmolive in the last two years.

The out-of-touch expert is part of a growing crowd on Wall Street. Analysts spend more and more time selling and defending ideas to their superiors and/or clients, and less and less researching the ideas. It's unusual to find an analyst who calls several companies each day, and even rarer to find one who gets out and visits them.

Whenever I ran across such a person, I made it a point to keep in touch. Maggie Gilliam at First Boston, who saw the virtue in Home Depot and provided astute coverage of the Limited, is a good example. Others include John Kellenyi of NatWest on utilities; Elliot Schneider at Gruntal on financial services; and George Shapiro at Salomon Brothers on aerospace. Analysts of this caliber are always worth listening to, especially when you've called them, rather than vice versa.

Analysts love to brag about how they “initiated coverage” on a company when the stock was selling for 25 cents, and ten years later it is selling for $25. What's more important is whether they reinforced their opinion with a second or third and fourth favorable report when the stock hit $5, then $10, then $15. An initial buy signal is quickly forgotten, and if that's all the analyst has provided, the audience has missed the chance to profit from the stock farther up the line.

By the time Magellan was opened to the public in 1981, I had become a more patient investor. So had the shareholders. Redemptions were down, which meant I wasn't forced to sell stocks to raise cash. The fund's annual turnover rate dropped by nearly two thirds, from 300 percent to 110 percent. My biggest positions (Nicor, a natural gas producer; Fedders, the air conditioner people; Service Corporation International, the funeral home chain) now stayed that way for several months in a row.

Magellan was still small, $100 million, which put it in the bottom fifth of all general equity funds. I divided the money among 200 different stocks in every kind of company imaginable: John Blair, a broadcaster; Tandy, owner of Radio Shack; Quixote, which made plastic safety barriers used by construction crews on highways; Telecredit; Zapata Corporation, which added to George Bush's fortune; ChemLawn; Seven Oaks, a processor of grocery store
coupons; Irving Bank; and Chart House and Skipper's, both fast-food restaurant chains.

I was progressively more impressed with the long-range potential of restaurant chains and retailers. By expanding across the country, these companies could keep up a 20 percent growth rate for 10 to 15 years. The math was, and continues to be, very favorable. If earnings increase 20 percent per annum, they double in 3½ years and quadruple in 7. The stock price follows suit, and often outpaces the earnings, as investors are willing to pay a considerable premium for the company's future prospects. (A list of my 50 most important retailers appears on page 138.)

The Rule of 72 is useful in determining how fast money will grow. Take the annual return from any investment, expressed as a percentage, and divide it into 72. The result is the number of years it will take to double your money. With a 25 percent return, your money doubles in less than 3 years: with a 15 percent return, it doubles in less than 5.

From watching the ups and downs of the various industries, I learned that whereas it was possible to make two to five times your money in cyclicals and undervalued situations (assuming that all went well), there were bigger payoffs in the retailers and the restaurants. Not only did they grow as fast as the high-tech growth companies (computer manufacturers, software manufacturers, medical enterprises), but they were generally less risky. A computer company can lose half its value overnight when a rival unveils a better product, but a chain of donut franchises in New England is not going to lose business when somebody opens a superior donut franchise in Ohio. It may take a decade for the competitor to arrive, and investors can see it coming.