In August 2003, legendary mutual fund manager Peter Lynch made a regulatory filing indicating that he personally owned nearly 8% of the stock of a small company called SafeScript Pharmacies. Once this filing became public, many investors bought the stock based solely on Mr. Lynch’s ownership and reputation.
It is basic human nature to sometimes act on impulse and ignore warning flags and common sense. Rationalization has given life to many bad ideas, so let’s look at some of the ways investors get themselves into trouble.
The greater fool – This trap applies to professional sports teams and some real estate as well as to stocks. Essentially the purchase price is irrelevant as long as there is a greater fool out there who will pay more. Unfortunately, to gain entry to this game you have to be the greater fool for some lucky seller.
I love the company – Mr. Lynch himself has long advised investments in companies whose products and services you use and like. But that enthusiasm can increase the price of these stocks, and when used alone this criterion often leads to companies that are trendy or soon collapse under the weight of expansion.
The copycat – Copycats are a primary reason why mutual fund managers resist more frequent disclosure of portfolio holdings, and Warren Buffet is so tired of copycats that he unsuccessfully petitioned the SEC to get special dispensation from having to disclose certain of his holdings. Even with today’s real time information, reporting delays make it impossible to fully benefit from a copycat strategy. In fact, big investors have often already made most of their gains by the time the initial purchase was even made public.
The better mousetrap – The fundamental product idea is so logical and compelling that it has to be successful. Technical and marketing difficulties, however, get easily overlooked. And the true innovators are seldom the ones who develop and profit from new products and markets (personal computers, for example).
The thundering herd – In recent years obscure companies attracted attention by researching cures for cancer, or having some unlimited opportunity in China, or developing “power cells”. Everyone loves these ideas, and everyone just knows there’s big money to be made. Usually the big money is made by the promoters of these stocks. As part of the stampeding herd, you can’t see the cliff until it’s too late.
The crusty contrarian – The flip side of the thundering herd, the contrarian smugly buys what nobody else wants. To some extent this is the basis of value investing, which is a proven long term investing strategy. The problem, though, is that there are often legitimate reasons why these stocks are cheap, and they just keep getting cheaper. Or the company may be out of favor but still be overpriced, leaving plenty of risk.
The evening news – The smart money has been long invested by the time most trends hit the mainstream media. Of course, this money looks smart mainly in hindsight, and professional investors follow a specific strategy and carefully asses risk. Oil may prove to be a good example of this rule; while energy has long been a part of diversified portfolios, venturing into speculative energy plays now is unlikely to pay off.
All of these ideas can pay off due to luck rather than skill, and that’s why they should only be pursued with risk capital, the industry’s fancy term for money you can afford to lose. It is also critical for impetuous investors to employ strict rules on when to sell, to either capture gains or limit losses.
The best way to avoid these pitfalls, of course, is to develop and follow an investment plan that fits your goals and circumstances and maintains sufficient diversification. If you must invest in individual stocks, conduct a comprehensive analysis that includes financial, market, industry and management evaluations.
How did the investors in SafeScript Pharmacies fare? The share price rose from under $2 in August 2003 to $5.66 in January 2004. In February the SEC announced an investigation, in March the company filed for bankruptcy and in October the SEC sued the company and four officials for fraud. The company had allegedly been misrepresenting its borrowing and revenue since February 2002.
Peter Lynch is undeniably an honorable man and a deservedly respected investor. He didn’t sell his stock and was completely surprised and suffered losses along with everyone else. According to Mr. Lynch, “Some of these work, some don’t. Just because I buy something doesn’t mean it’s going to work. People have to do their own homework.”