Take a Page from Peter Lynch's Book

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Peter Lynch, the legendary manager of the Fidelity Magellan fund, is one of the famous investors I try to emulate with my own investing.  One of my favorite books is his One Up on Wall Street.  I read it as an aspiring investor and I’ve taken many lessons from the book that have shaped my investing philosophy.  Lynch is certainly worthy of high praise:  from 1977 until 1990, the Magellan fund averaged a 29.2% return and as of 2003 had the best 20-year return of any mutual fund ever.   (For the sake of context, an investor who earns a 29 percent annual return on a $5,000 investment would become a millionaire in just 21 years).

One of the lessons from One Up on Wall Street I continue to practice is Lynch’s commentary on the subject of diversification.  His original thoughts pertained to companies that attempted to expand into too many business areas.  However, I prefer the concept also be applied to investors who buy too many stocks.  When an investor first starts out, they are constantly preached the merits of diversifying their portfolio.  In pursuit of constructing a well-diversified portfolio, for some it means buying dozens of stocks from a variety of industries in order to reduce volatility.  While diversification is certainly a merit of good investing, it’s important for investors to not over-do it.

Don’t De-Worsify

Peter Lynch coined the term “deworsification” as a clever way of warning businesses to not reach too far outside their core competencies.  I prefer to apply the term to an investor as well.  To illustrate, for the last several months I’ve been building a position in McDonald’s (NYSE: MCD).  I studied the quarterly and annual reports, analyzed the financial statements, and assessed the future outlook.  I came to the conclusion that McDonald’s is a fantastic company trading at a conservative valuation with a great dividend.  As a result, I bought shares.

Since then, I’ve noticed other companies in the fast food restaurant industry see share price declines and compressed valuation multiples.  For example, last year Yum! Brands (NYSE: YUM) saw its share price drop from almost $75 into the mid-sixties.  Concerns grew after the company warned that sales in its top market of China shrank more than expected in the fourth quarter at its KFC chain.  As a result of this issue, the stock declined, and its dividend yield exceeded 2 percent.  I began to talk myself into the merits of the company—that the KFC, Pizza Hut, and Taco Bell franchises were great businesses with huge growth potential in the emerging markets.  I especially wanted to invest in a company with significant operations in China, which was Yum's fastest growing geographical segment through the first nine months of 2012.

Although the merits of buying Yum! are true, since McDonald’s generates roughly 68 percent of its revenues from outside the United States, I'm already geographically diversified.  McDonald's has put huge efforts into developing its operations in China.  McDonald’s is executing on its plan to open 225 to 250 new restaurants every year until it reaches its stated goal of 2,000 restaurants in China by the end of 2013.

In addition to Yum! Brands, I was recently lured to the prospects of Wendy's (NASDAQ: WEN).  Wendy's pays a solid dividend of over 3%, and its stock is down about 10% from its 2012 high.  I am a big believer in the investment prospects of fast food restaurants, and in early 2012 Wendy's overtook Burger King as the number two selling fast food restaurant in the United States.  Wendy's has been extremely active in transitioning its locations to the franchise model, which has been a major contributor to McDonald's success.

However, despite Wendy's momentum, why should I invest in the number two company in an industry?  McDonald's has generated over $5.1 billion in operating cash flow and over $3 billion in free cash flow through the third quarter of 2012, and its dividend yield is higher than both Yum! and Wendy's.  For me, buying stock in one of the most valuable brands in the world is enough to satisfy my need for exposure to the restaurant industry.  The capital I would have allocated towards Yum! Brands or Wendy's can be better served towards stocks whose industries are not yet represented in my portfolio.


Robert Ciura owns shares of McDonald's. The Motley Fool recommends McDonald's. The Motley Fool owns shares of Darden Restaurants and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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