Unwrapping Peter Lynch’s Investment Strategy: Peter Lynch was to the investing world what rockstars are to us. He is primarily known for his work at Fidelity Management and Research where he managed the Magellan Fund. This fund was launched in 1977 and ended when Mr. Lynch retired in 1990.
Even though 3 decades have passed since he retired, his work in Fidelity still astonishes investors as he grew the assets of the fund from $14 million in 1977 to $18 billion in 1990. With Lynch at its helm, the fund was among the highest-ranking stock funds throughout his 13 years tenure beating the S&P 500, its benchmark, in 11 of the 13 years.
Over the years there also have been debates on who was the ‘greatest investor of all time’ Buffet or Lynch? Clearly the 54 years Buffet spent at Berkshire Hathaway offering 20.9% annual return gives Buffet the greatest title. But Lynch achieving a 29% annual returns also provides solid arguments.
Just to put things in perspective a $10,000 investment that earned this return for 13 years would have grown to nearly $280,000. But it is not only this achievement that makes Lynch one of the greatest but also because he shares the strategy he used to achieve this in a simple manner gaining him considerable fame.
Peter Lynch’s Investment Strategy
Lynch was an institutional investor. Can his strategy be used for individual investors?
Lynch always believed that an average investor can generate better returns in comparison to professional or institutional investors like mutual fund managers, hedge funds, etc. This is because according to him individual investors hold a distinct advantage over Wall Street as they are not subject to the same bureaucratic rules.
Also, individual investors do not have to be bothered by short term performances. In comparison, professionals are answerable to their investors if a fund performs badly in a year. A justification saying “The assets are going through a phase and will perform better in the future” will not convince a fund’s clients.
Finally, individual investors also have the advantage of a smaller scale. It is easier to double $10,000 in the market than it is to double $10 billion.
Peter Lynch’s Investing philosophy
“Invest in what you know.” – Peter Lynch
Peter Lynch’s whole investing philosophy revolves around this. “Investing in what you already know about”. To support his argument he gives the example of a doctor. Say you are a cardiologist and are beginning your journey into the world of investing. Almost all of us have a fairly good idea of what companies like Mcdonalds and Nike do.
But would you have an edge by investing in these? Say, as required by your field you are made aware of a new heart pump being introduced. You being able to judge this will obviously be aware of the revolutionary effects the heart pump may have in saving human lives. Hence, in this case, your in-depth knowledge of the subject gives you an advantage while deciding if ever you could invest in the company or not.
Just like this, we may own experiences–for instance, within our own business or trade, or as consumers of products that provide us an edge to improve our investment judgment. Hence the quote “Buy what you know”. This is an advice that has also been advocated by Warren Buffet.
Sources that Peter Lynch Uses
The greatest stock research that we have at our disposal in order to identify superior stocks are our eyes, ears, and common sense. Also, Lynch does not believe that investors can predict actual growth rates, and he is skeptical of analysts’ earnings estimates.
Lynch was proud of the fact that many of his great stock ideas were discovered while walking through the grocery store or chatting casually with friends and family. Even when we are watching TV, reading the newspaper, driving down the street, or traveling on vacation just by noticing an investment opportunity we can do first-hand analysis over it.
Lynch is something of a ‘Story Investor’. Now that it is clear that Lynch advocates investing in what you know, and his initial research begins with his senses in the environment. The step that Lynch follows is that of finding a story behind the stock.
Often being engrossed in the investing world has led us to believe that stocks are nothing more than just a collection of blips on a screen or just numbers to be judged by ratios. But for Lynch, the stock is more than just that emphasis us to realize that behind the stock is a company with a story.
What is this ‘story’ Peter Lynch looked for?
According to Lynch a company’s plan to increase earnings and its ability to fulfill that plan is its “story,”. He lays down the 5 ways that a company can increase its earnings. Lynch points out five ways in which a company can increase earnings:
- It can reduce costs.
- Raise prices.
- Expand into new markets.
- Sell more in old markets.
- Revitalize, close, or sell a losing operation.
Hence this is where is the advice of ‘Investing in what you know’ falls into place. The only way you can have a better edge to judge a company’s plans to increase earnings is if you are familiar with the company or industry. This will increase your chances of finding a good story.
For this reason, Lynch is a strong advocate of investing in companies with which one is familiar, or whose products or services are relatively easy to understand. Thus, Lynch says he would rather invest in “pantyhose rather than communications satellites,” and “motel chains rather than fiber optics.”.
How Peter Lynch Categorized Companies?
We may have come across several companies that may grab our interests after first-hand research. Peter Lynch suggests that in order to be able to judge their story potential better it is best that we categorize then by size. This will help us form reasonable expectations from the company.
This is because if the company is categorized by size we can then judge their ability to increase their value and hence their story. Large companies cannot be expected to grow as quickly as smaller companies. This will further help us decided if the expectations are what we would like to receive in our portfolio. According to him, the categorization can be done in the following 6 ways:
- Slow Growers
Large and aging companies expected to grow only slightly faster than the economy as a whole. These generally make up for their growth by paying large regular dividends.
- Stalwarts
These include large companies that are still able to grow, with annual earnings growth rates of around 10% to 12%. If purchased at a good price, Lynch says he expects good but not enormous returns–certainly no more than 50% in two years and possibly less.
- Fast-Growers
Small, aggressive new firms with annual earnings growth of 20% to 25% a year. These do not have to be in fast-growing industries. Fast-growers are among Lynch’s favorites, and he says that an investor’s biggest gains will come from this type of stock. However, they also carry considerable risk.
- Cyclicals
Companies in which sales and profits tend to rise and fall in somewhat predictable patterns based on the economic cycle; examples include companies in the auto industry, airlines, and steel. Lynch warns that these firms can be mistaken for stalwarts by inexperienced investors, but share prices of cyclical can drop dramatically during hard times. Thus, timing is crucial when investing in these firms, and Lynch says that investors must learn to detect the early signs that business is starting to turn down.
- Turnarounds
Turnarounds are companies that were on the verge of bankruptcy but have been revived. This could be because the government bailed them out or another company made a strategic investment in them. Lynch calls these “no-growers”.The best example of such a company is Satyam. The stocks of successful turnarounds can move back up quickly, and Lynch points out that of all the categories, these upturns are least related to the general market.
- Asset opportunities
Finding these hidden assets requires a real working knowledge of the company that owns the assets, and Lynch points out that within this category, the “local” edge–your own knowledge and experience–can be used to greatest advantage.
(Lynch would pick a David over Goliath company on any day)
The category an investor prefers for his/her portfolio may vary as per investor preference. But Lynch always preferred Fast Growers, this, however, came with considerable risk. To be more precise Fast Growers that are not from fast-growing industries.
This is because in contrast every stock in a fast-growing industry would be growing as well but not specifically because of the company. This growth is only because of investors Fear Of Missing Out due to a short hype in the industry. Over time, however, the high growth industry will also attract significant competitors. This will eventually lead to a drop in growth.
Lynch also coined in the term “Tenbagger” and these companies will clearly be found to be among the fast growers. Tenbaggers are stocks that go up in value tenfold or 1000%. These are the kind of stocks that Lynch looked out for when he was running the Magellan Fund.
The first rule that he set for the Magellan stock is that if one was identified to have the potential, then the investor must not sell the stock when it goes up 40% or 100%. Peter Lynch felt that this amounted to “pulling the flowers and watering the weeds.”
Evaluation and Selection of stocks
The simplicity of the strategy that we have gone through so far may lead us to believe that it is easy. But we are only halfway through the strategy. After classifying the stocks, we now come to its evaluation. Lynch was extremely dedicated when it came to researching. He always believed that the more he researched the greater were his odds of finding the best ones to invest in.
Peter Lynch follows what is called the ‘Bottoms-up’ approach. According to this every stock picked must be thoroughly investigated. Such analysis will expose any pitfalls in the story of the company. Also, it is important to note that if the stock was purchased at a too high of a price then the chances of making a profit will be reduced or wiped off. Hence it is important that the stocks are diligently researched and evaluated.
Here are some of the key numbers Lynch suggests investors examine:
— Year-by-year earnings
While looking at the company’s earning over the years one should try and assess if the earnings are stable and consistent. Ideally, the earnings should keep moving up consistently. Assessing the earnings over the years is important because this trend will eventually be reflected in the stock price revealing the stability and strength of the company.
— Earnings growth
It is also necessary that not only for the earnings to keep moving upwards consistently but also to match the company’s story. This means that if a company has the story of a fast grower its growth rate must be higher than those of slow growth rates. One must also keep an eye out for extremely high levels of earnings that are not consistent over the years.
This will also help us identify stocks that are overvalued as a result of attracting attention in that extremely high growth period. Investors here bid up the price. But if a continued growth rate is noticed then it may be factored into the price
— The price-earnings ratio
At times the market may get ahead of itself and overprice a stock even when there is no significant change in the earnings. The price-earnings ratio helps you keep your perspective, by comparing the current price to most recently reported earnings. Stocks with good prospects should sell with higher price-earnings ratios than stocks with poor prospects.
— The price-earnings ratio relative to its historical average
Studying the pattern of price-earnings ratios over a period of several years should reveal a level that is “normal” for the company. This should help you avoid buying into a stock if the price gets ahead of the earnings, or sends an early warning that it may be time to take some profits in a stock you own.
— The price-earnings ratio relative to the industry average
At this point, we may come across stocks that are undervalued in an industry. By comparing its P/E ratio with the rest of the industry we can figure out if it is because it is a bad performer or if the stock has simply been overlooked
— The price-earnings ratio relative to its earnings growth rate
Companies with better prospects should sell with higher price-earnings ratios, but the ratio between the two can reveal bargains or overvaluations. A price-earnings ratio of half the level of historical earnings growth is considered attractive, while relative ratios above 2.0 are unattractive.
For dividend-paying stocks, Lynch refines this measure by adding the dividend yield to the earnings growth [in other words, the price-earnings ratio divided by the sum of the earnings growth rate and dividend yield]. With this modified technique, ratios above 1.0 are considered poor, while ratios below 0.5 are considered attractive.
— The ratio of debt to equity
Lynch is especially wary of bank debt, which can usually be called in by the bank on demand. This is because a Balance sheet that does not have debt or minima debt will come in handy when the company chooses to expand or faces financial difficulty
— Net cash per share
Net cash per share is calculated by adding the level of cash and cash equivalents, subtracting long-term debt, and dividing the result by the number of shares outstanding. High levels provide support for the stock price and indicate financial strength.
— Dividends & payout ratio
Dividends are usually paid by larger companies, and Lynch tends to prefer smaller growth firms. However, Lynch suggests that investors who prefer dividend-paying firms should seek firms with the ability to pay during recessions (indicated by a low percentage of earnings paid out as dividends), and companies that have a 20-year or 30-year record of regularly providing dividends.
— Inventories
This is a particularly important figure for cyclical businesses. When it comes to manufacturers or retailers, an inventory buildup is a bad sign, and a red flag is waving when inventories grow faster than sales. On the other hand, if a company is depressed, the first evidence of a turnaround is when inventories start to be depleted.
Other Characteristics Peter Lynch finds favorable
- Lynch keeps an eye out for ugly ducklings. These are companies that have a boring name or those that function in boring industries. He also considers companies that are in depressing and disagreeable industries. Examples being Funeral homes that are depressing or Waste Management which is disagreeable. Most investors invest in interesting companies like Tesla where cars are launched into space etc. But Lynch is aware that it is these ugly ducklings where their nature is reflected in the share price. This offers up good bargains
- Spin-Offs. This is because investors are skeptical of spin-offs and hence receive lesser attention in comparison to the parent company.
- Companies that operate in industries with multiple entry barriers. A niche firm controlling a market segment would be attractive
- Companies that offer products that are a necessity. These companies provide stability as people tend to buy their products regardless. eg razor blades.
- Companies that take advantage of technological advances in their industry but are not directly producing technology say like Google and Apple. This is because companies that produce technology are stock prices that are valued highly.
- Companies with low analyst coverage as they are generally not priced too high.
- The company is buying back shares. Buybacks are announced once companies start to mature and have cash flow that exceeds their capital needs. The buyback will help to support the stock price and is usually performed when management feels share price is favorable.
Characteristics Lynch finds unfavorable are:
- “If I Could Avoid a Single Stock, It Would Be the Hottest Stock in the Hottest Industry.”
Hot stocks in hot industries are those that attract a lot of attention in the initial stages due to its explosive growth. This growth, however, burns away as the growth achieved does not match the increase in price due to the added publicity. Over time it becomes clear that the company does not have the earnings, profits, or growth potential to back the buzz. Also as soon as a company with such hot stocks exist copy cats start to appear in the industry deflating the company’s stock value. - Companies that diversify into unrelated businesses. Lynch suggests staying away from such companies. Lynch calls this ‘Diworsefication’.
- Companies in which one customer accounts for 25% to 50% of their sales.
Advice for new investors
Lynch suggests that for an investor who is just stepping into the stock market it is best that he starts off with a paper portfolio. And pick 5 companies to buy. Then he investor should ask himself why he is buying these stocks. Answers like “the sucker’s going up.” arent good enough of a reason.
And if the stock performs better for a period then he should again question himself. Why did it go up? Noticing the changes that occurred during this period is also what research is all about. One must also then notice what kind of stock is one good at picking. A person may have a better eye for cyclical while another may be good at selecting fast growers.
Lynch also lets us know that in the stock market it is not the brain that is the most important but the stomach. This is mainly because one must remain invested in stocks that are selected for the long term. There may be ups and downs on a daily basis and the waves of information made available to us do not help in this aspect. Hence being able to hear the news and still have faith in the stock for 10-30 years is necessary. Market falls occur regularly hence it one should have a significant tolerance for pain. Most people do really well because they just hang in there.
Even when it comes to professionals it is not necessary that those will grow multifold. Some may even make a loss.
“In this business, if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.”
A stock may lose 100% of its value but even one great investment that grows at 1000% of its value will not only make up for the losses also change your life. This shows that you don’t have to be perfect as an investor as a handful of multi-baggers can help you create all the wealth you need.
When is the right time to invest?
Lynch conducted a study to determine whether market timing was an effective strategy. Here he took two sets of investors one that would’ve invested on an absolute high day from 1965-1995. And another who would invest the same amount but on the lowest days of the year.
According to the results of the study, the investor who invested on the absolute high day would have earned a compounded return of 10.6% for the 30-year period. The other investor who invests on the lowest day of the year would earn an 11.7% compounded return over the 30-year period. According to this study, the investor who invested in the worst market timings trailed only by 1.1% per year.
This led Lynch to believe that it wasn’t worth it to run around figuring the right time to invest. This time would be better invested in focussing on what was important i.e. finding great companies.
When to sell your investments?
Despite Lynch being an advocate of long term commitment and not favoring market timing, he does not believe that investors should hold one stock forever. According to Lynch investors should keep an eye on their investments and review their holdings once every 6 months. One may not expect it but just like the buys the sales also depend on the story on the company. An investor should sell his stock if he feels that the stock has played out according to the story and its performance is reflected in the price.
Another reason would be that the story itself is changed by the company or the stock fundamentally deteriorates. Or else as long as the story is as expected a price drop would only mean an opportunity to buy more. Therefore you have to define when a company is getting close to maturity, and that’s when you exit. Or the story deteriorates. If the story’s intact, you hold on.
“A good stock can take several years before it really pays off. Give your investment time to grow. No one can tell you when the right time is to sell a stock. You need to have patience. If you are averse to risk, the stock market is not for you,”
Lynch also advocates for rotation selling. According to him once a stock’s story is played and the expected returns achieved the investor should sell the shares and replace them with those of another company with similar prospects
Closing Thoughts
Peter Lynch’s performance and stock-picking ability have set him, leagues, apart from most of his peers at Wall Street. The strategies that he has provided us with not only provide us with a fresh perspective towards the investing world. One which is generally considered to be simply mundane snd a game of numbers.
His last lesson, however, can be noted in his walking away from the mutual fund industry at the pinnacle of his career. Where he chose to use his wealth to live life to the fullest instead of simply chasing money.
