The Investing Strategy Of Peter Lynch

by Jan Regenbogen
2 months ago
7 min

The New York Times once wrote about Peter Lynch: "Mr. Lynch's investment record puts him in a league by himself." For 13 years, from 1977 to 1990, Peter Lynch managed Fidelity's flagship fund, the Fidelity Magellan Fund, all the while constantly outperforming the market. In three books, among them the classic "One up on Wall Street", Lynch explains his investment philosophy. His straightforward approach to investing in the stock market is easy to understand and can be employed by each and every one. All the math you need in investing you get in the fourth grade, he says. A business education he even considers to be a negative as you would have to unlearn much of what you learned.

Professionals

"You'll never lose your job losing your client's money in IBM. If IBM goes bad and you bought it, the clients and the bosses will ask: What's wrong with that damn IBM lately? But if La Quinta Motor Inns goes bad, they'll ask: What's wrong with you?"

Peter Lynch in "One up on Wall Street"

Think about it. In some ways, "professionals" have it a lot harder than you. They are constantly under pressure from bosses, clients and the competition. They will think twice or thrice about buying a promising stock that nobody else in the industry owns because if it goes bad they are likely to be out of their job. You on the other hand have no one to answer to when it comes to your personal investments (except, perhaps, your spouse). This is were opportunities lie. Overlooked by Wall Street, too small, too "unsexy" a name or whatever the reason, according to Lynch these are the sort of companies that can potentially turn out to be "tenbaggers", meaning stocks that go up tenfold. But let us get to Lynch's investment strategy.

Stock Categories

Lynch classifies stocks in six categories each with its own criteria to watch:

Slow Growers

  • usually large and aging companies
  • often former fast growers that slowed down
  • e.g. utility stocks
  • earnings growth somewhat similar to GDP
  • as you buy slow growers mainly for the dividend, check the consistency of their dividend history
  • also check whether the payout ratio leaves room for dividend increases or buffer should an economic turndown occur
  • Lynch has only a few stocks from this category as there is not much excitement to expect from them

Stalwarts

  • not exactly agile climbers but faster than slow growers
  • big companies unlikely to go out of business
  • e.g. Coca-Cola, Procter & Gamble
  • earnings growth rates around 10-12 % per year
  • key consideration is price (low P/E-ratio)
  • check the company's long term growth rate, and whether it is able to keep up the momentum
  • Lynch tries to buy low and to sell with a 30-50 % gain after 1-2 years
  • as a long-term holder, check how the company did in the last recession
  • usually offer good protection during recessions and hard times

Fast Growers

  • small, aggressive new enterprises that grow 20-25 % per year
  • chosen wiseley these can end up being 10- to 40-baggers
  • fast growers are the big winners in the stock market (as long as they can keep up their growth)
  • look for fast growers with a solid balance sheet and making substantial profits
  • the P/E should be close to or below the growth rate
  • the trick is trying to figure out when they'll stop growing, and how much to pay for the growth
  • look whether the company still has room to grow respectively room for expansion
  • is the expansion heating up or slowing down?
  • be wary of companies growing at 50 % per year as they can usually not keep up with expectations

Cyclicals

  • companies whose sales and profits rise and fall in regular fashion
  • e.g. autos, airlines, steel, chemicals
  • coming out of a recession and into a vigorous economy, the cyclicals flourish
  • but going in the other direction, the cyclicals suffer, and so do the pocketbooks of the shareholders
  • timing is everything in cyclicals
  • try to anticipate early signs that a business is falling off or picking up and buy/sell accordingly
  • keep a close watch of inventories as large inventory build-ups are a sign of a worsening economic situation
  • the worse the slump, the better the recovery

Turnarounds

  • turnaround candidates have been battered and depressed
  • they are potential fatalities
  • can the company survive a raid by its creditors? cash vs debt?
  • how long can it operate in the red with its current debt structure without going bankrupt?
  • how is the company suppose to be turned around? has it rid itself of unprofitable divisions? is business coming back? are costs being cut?
  • stay away from tragedies where the outcome is unmeasurable
  • inspite many turnarounds getting wiped out, the occasional major success makes the turnaround business very exciting, and overall very rewarding
  • additional plus: their ups and downs are least related to the market

Asset Plays

  • a company that's sitting on something valuable that you know about, but the Wall Street crowd has overlooked
  • can be found in e.g. land, real estate, metals, oil, newspapers, tv stations, patented drugs or even company's losses that can be used to reduce taxes
  • a local edge can be a great advantage in these types of companies
  • how much debt is there to detract from these assets?
  • is the company taking on new debt, making the assets less valuable?
  • is there a raider in the wings to help shareholders reap the benefits of the asset (e.g. hedge fund)?

What is important to remember when categorizing companies into one of the six types is that they don't stay in the same category forever. Fast growers will eventually turn into stalwarts or slow growers. Fast growers like AMD or Texas Instruments are now considered to be cyclicals. McDonald's might be a future asset play as they own much of the restaurant real estate. Every few months you should recheck the company story.

Finding Attractive Investments

Where do you find attractive investments? Lynch gives some interesting suggestions:

  • the company name sounds dull or ridiculous (e.g. "Pep Boys - Manny, Moe, and Jack")
  • it does something dull (e.g. cans and bottle caps)
  • it does something disagreeable
  • it's a spinoff
  • the institutions don't own it, and the analysts don't follow it
  • the rumours abound: it's involved with toxic waste and/or the mafia
  • there's something depressing about it (e.g. SCI, which does burials)
  • it's a no growth industry (if it's on the other hand a hot industry, for every product there is a thousand MIT graduates trying to figure out how to make it cheaper in Taiwan)
  • it's got a niche
  • people have to keep buying it (e.g. cigarettes)
  • it's a user of technology
  • insiders are buying
  • the company is buying back shares

Understanding what you invest in and doing your Research

"Among amateur investors, for some reason it's not considered sophisticated practice to equate driving around town eating donuts with the initial phase of an investigation into equities. People seem more comfortable investing in something about which they are entirely ignorant. There seems to be an unwritten rule on Wall Street: If you don't understand it, then put your life savings into it."

Peter Lynch in "One up on Wall Street"

For Lynch, understanding what you invest in is critical. If you are a doctor for example, use your expertise to identify great stocks in the health sector that are thus far overlooked. Is there a drug which you prescribe more and more? Is there a new medical device that you and your doctor friends are installing in your practices? If you are a car mechanic, is there a new brand of tires that starts selling like crazy? Is there a new car radio all of your customers ask for? Your profession can give you a great edge at finding amazing companies that are - for now - still off-radar.

Always keep in mind: The discovery of a promising company itself is not a buy signal. Just because Dunkin' Donuts is always crowded doesn't mean it's a great investment. If you find a promising company, do your research: Test the product, visit one of their stores or offices, call or email the investor relations of that company and, of course, look at the balance sheet and earnings.

Looking at the Numbers

With regard to a great company that is grossly overpriced Lynch writes:

"If you had invested in a company with a P/E of 1,000 when King Arthur roamed England, and the earnings stayed constant, you'd just be breaking even today."

When looking at the balance sheet, see whether a company is socking away more and more cash - a sure sign of prosperity. However, if you see cash decreasing while debts are increasing this is a deteriorating balance sheet. In the most favorable situation, cash exceeds debt. It is very hard to go bankrupt if you don't have any debt. A normal corporate balance sheet should have about 75 % equity and 25 % debt. The debt factor is especially important when looking at turnarounds.

If inventories are piling up in the balance sheet, this could be a sign that business is bad at the moment. However, when a depressed company is beginning to deplete its inventory it might be a sign that things are turning around.

Another thing to look at is the number of shares outstanding. Lynch urges investors to look at a 10 year summary. Does the number of shares decrease as the company is buying back shares? Or does it dilute it's shares thereby decreasing its earnings per share?

For Lynch, if a company has a P/E-ratio of 15 you would expect it to grow about 15 % a year. If it trades for less than that you may have found a bargain. In general, a P/E-ratio of half the growth rate is very positive, while a P/E double the growth rate is very negative.

"And if you find a $20 stock with a sustainable $10-per-share cash flow, mortgage your house and buy all the shares you can find."

With regard to cash flow Lynch considers a $20 stock with a $2 annual cash flow per share to be normal. A $20 stock with a sustainable $4 cash flow on the other hand is terrific as it gives you a 20 % return on cash.

Summary

According to Lynch, everyone can be a successful investor. His track record speaks for itself. Lynch's approach is straight-forward and easy to understand. All you have to do is keep your eyes open and do thorough research. Be patient (watched stocks never boil) and when in doubt, tune in later. If you want to know more from Peter Lynch, have a look at the following lecture he gave in 1994: Link to Lecture by Peter Lynch (Youtube)


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