How does Peter Lynch plan his investments?

By Altay Gursel | February 22, 2021
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About Peter Lynch

Peter Lynch is a world-renowned investor popularly known for his Fidelity Management and Research work, where he managed the Magellan fund. During his time at the company as their portfolio manager, the American, who has currently retired, pulled off an extraordinary feat that is still a marvel to the business world to date. He grew the assets of the Magellan funds from US$18 million to $14 billion from 1977 to 1990.

The fund was among the highest-ranking stock funds throughout his 13-year tenure at the helm of affairs, which has made the debate that the most significant investor of all time between him and Buffet is still a trending topic today.

Investment Strategy

Peter Lynch, after retirement, went on to mentor stock analysts at Fidelity and author bestsellers in investments and business. One of his favorite business mantras is “buy what you know.” He believes it can lead to greater returns because you have a piece of more personal knowledge about it than an outsider.

Lynch always believed that an average individual investor has a better advantage and can generate better returns than Wall Street and large institutions when using his strategy. In his famous best-selling book: “One Up on Wall Street: How to Use What You Already Know to Make Money in the Market,” he talks about how individual investors have more flexibility because they are unbothered by bureaucratic rules and short-term performance concerns.

He explains it a bit better in the book;

“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?”

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If you think about it, Wall Street and professionals have it harder than individual investors because they cannot afford to make a mistake and are always under pressure from their bosses, clients, and competition. On the other hand, individual investors are almost always overlooked and undervalued by Wall Street, and analysts often end up doing better in the market.

Peter Lynch’s Investing Philosophy (Invest in what you know)

Lynch believes that an investor’s best bet is investing in companies that you know or one which has easy-to-understand products. Lynch prefers investments in small and fast growing companies rather than the bigger names, hence his analogy that he would rather invest in motel chains than fiber optics.

Why invest in Nuclear energy when you know fashion? As simple as it seems, that is his philosophy. He advises that one should take a good look and investigate a company before investing. Otherwise, it’s just gambling.

He also believes that investors and consumers can make significant investments by monitoring and spotting market trends and activities that do not always show up in analysts’ numbers. For example, if a particular company begins to have more and more customers and interest from consumers, it could indicate that profits could go up.

A perfect example is bitcoin‘s rise, which has witnessed an astronomical rise since its creation in 2009. If you bought bitcoin then for as low as a dollar or less, you’d be a billionaire by now!

Lynch’s investment strategy also borders grouping companies into six categories to help investors make investment choices. These categories are; slow growers, stalwarts, fast growers, cyclical, turnarounds, and asset plays.

  • Slow growers:

These are usually the old but substantial companies aging due to many years in existence. They used to be fast growers that slowed down but are expected to grow faster than the country’s Gross National Product. They often pay higher and regular dividends. A good example is utility stocks. Lynch is not a fan of this category as it could be inconsistent.

Lynch advises you to check the dividend consistency and increases in case of economic issues.

  • Stalwarts:

Stalwarts are large companies, too; these companies are not precisely speedy climbers but are faster than the slow growers. Examples are Coca-Cola, Proctor, and Gambles, etc. They have an annual growth rate of 10% to 12%, but long-term growth and consistency are critical areas of interest for these companies.

Lynch predicts that if purchased at a reasonable price, the returns will be good with at least not more than 50% within a year or two. These firms cater for downside protection during recessions but must not be held forever.

  • Fast growers:

Fast grower companies hit an annual growth rate of 20% to 25%. They are the small and vibrant companies looking to carve their niche. Lynch prefers investments in these companies because they are fast and can generate the best returns, though they may pose more significant risks of extinction. Look out for fast growers that make a good profit, and their Price to Earnings ratio should be close to or below the growth rate.

  • Cyclical:

These are companies in which sales and profits tend to rise and fall based on economic cycles (recessions and market surge). These rises and falls can be most times predictable. Lynch warns investors to be wary enough to detect when the company will fall or rise because timing is key with these companies. Examples of such companies include; airlines, steel, chemicals, and the auto industries.

  • Turnarounds:

These companies were on the verge of a total shutdown and bankruptcy. However, they made a lively comeback due to various reasons, ranging from government bailouts, buyouts, or a strategic investment by another company.

Lynch advises considerations about how long these companies can operate with its debt structure if the company can survive a raid by its creditors and how long before they go bankrupt. It is a risky one, but some survive extinction and may end up being very rewarding. According to Lynch, some examples are Chrysler, Penn Central, and General Public Utilities.

  • Asset opportunities:

Asset plays are companies that could be sitting on a goldmine and have high chances of being a great and rewarding investment option. These are companies you know about but have somehow been unnoticed by Wall Street.

However, Lynch agrees that finding these companies can be really hard, but this is where personal knowledge and experience can be used as an advantage. Some companies in this category are TV stations, newspapers, real estate, etc.

One important thing to note is that none of these categories lasts forever for any company, a Cyclical can become a fast grower, and a Stalwart can become a Turnaround, and so on. So as an investor, you need to study and observe closely before buying and selling at every point in time.

However, Lynch advises investors to avoid companies that diversify into an unrelated business in their bid to expand. Investors must re-evaluate their interests in such companies.

He also advises that you invest in stocks with only the amount of money you can afford to lose and make long term investments.

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Peter Lynch in Retail investment

In his book “One up on Wall Street,” Lynch popularly says that “Big companies have small moves, and small companies have big moves.” It seems like an obvious statement at first, but he further states that people have no faith in these smaller businesses’ possible developments. He then claims that three things must happen before a small company is worth your investment:

  • The company must expand either through sales or store growth.
  • The company’s performance must perpetually improve. The performance is measured using the sales, earnings, and profit margins of the company.
  • The market must undervalue the stock of the company and the quality of the company goods.

That revelation is the foundation of his reputation as a genius in picking out the best stocks on the investment market.

Basic Investment Metrics

Lynch further explains in the book “One Up on Wall Street” that investors need to learn these metrics to guide them in making sound and informed investment decisions. He believes that the more stocks you evaluate using these metrics, the better your chances of finding the ones to invest in.

These analyses will expose any loopholes in the companies, and it does not require any solid background in mathematics to embark on.

  • Year by Year earnings:

Lynch admonishes investors to look at the tear to year earnings of companies to see if they possess stability and consistency. This is very important because the company’s profits and growth will eventually reflect in the stock price. All things being equal, the earnings should move up consistently.

  • Earnings growth:

Every company’s growth rate should be in tandem with its “story” or financial situation. For example, fast growers should have a higher growth rate than slow growers. Investors should be alert to spot high rates of earnings that are not consistent over the years, but if a continued and sustained growth rate is noticed, it may be factored into the price.

  • The Price to Earnings Ratio:

This is the most used valuation metric, mostly used to compare companies in the same field or industry with similar growth rates and financial conditions. The P/E ratio is calculated by halving a stock’s annual earnings by its current price.

Using the P/E ratio, an investor has a better idea of why Wall Street values companies the way they do. A mature company usually should have a lower P/E rate than a fast-growing one.

  • The Price to Earnings Ratio relative to its historical average:

By studying the patterns of earnings over time, investors gain insight into the company’s average trend and growth rate. This helps you know when and when not to buy and when to take profits in a stock you own.

  • The Price to Earnings Ratio relative to the Industry average:

This metric compares an undervalued company’s price-earnings ratio to that of the industry to ascertain if it’ll be a good investment. That enlightens you on why this company is priced differently and whether it’s a bad performer or just neglected.

  • The Price to Earnings Ratio relative to its Earnings growth rate:

A company’s price to earnings ratio that is half the historical earning growth level may tend to be a good bargain, while rates above 2.0 are generally unattractive. Lynch explains the system of this metric by stating that companies with higher prospects should sell with a higher price to earnings ratio. Still, the balance between both can either indicate a bargain or simply overvaluation.

  • The Ratio of Debt to Equity:

Investors should always check how much a company owes before investing in its stock. A company in debt may not survive long, especially if it experiences trouble. An ideal company should have more cash than obligations on its balance sheet. This gives it the financial stamina to grow as it wants and stand harsh economic situations.

  • Net Cash Per Share:

High levels of Net cash per share indicate a company’s financial strength and support for its stock price. This is calculated by adding the level of cash and its equivalent, subtracting long-term debts, and dividing the result by the outstanding number of shares.

  • Dividends and Payout Ratio:

Investors who prefer dividend-paying firms should check out firms that can pay dividends during the recession and have 20 to 30 years records of consistently doing so. Dividend-paying companies are usually large companies, so investors should buy from them.

  • Inventories:

Lynch warns that when inventories of retailers and manufacturers grow higher than sales, it is a bad sign. This is typical of cyclical companies.

There are a few things to note about Lynch’s investment methods, which he so aptly talked about in his book; one of them is Avoiding the Hottest Stock in the industry. He defines hot stocks as those that receive instant and rapid publicity once they hit the ground.

These companies experience massive growth and boom early on. Still, they may not be consistent with time because competitors may come with a copycat version of said products and deflate the original company’s stock value.

Other characteristics Lynch advises investors to avoid are;

  • Companies with big plans that are yet to be proven
  • Some profitable companies that tend to diversify into other things that are unrelated to their usual operations. Lynch terms these companies “diworsifications.”
  • Companies in which one customer is responsible for 25% to 50% of their sales

Lynch instead admonishes investors to look out for;

  • Ugly ducklings – Companies that are boring or operate in a less popular industry, such as waste management, funeral homes, etc. Lynch believes that such a company’s share prices will be reasonable in the market and often make for a sweet bargain.
  • Companies that offer products that are a necessity – products that people tend to buy for daily and regular use
  • Companies that its insiders buy the shares – it is a good indication that they believe in the company’s products. Hence it could make for a good bargain.

Lynch believes everyone can be a good investor with the right amount of research and knowledge of the market and companies before investing. Every investor must understand that there are grey areas and risks involved. He also advises investors to make long-term investments rather than short ones. Thus patience is vital.

Lynch is the author of many books on investment strategies, and you can get more from some of his books like; “Beating the Street,” “Learn to Earn,” the popular “One up on Wall Street,” and others.

Equipping yourself with these strategies will no doubt make you a better investor.