Who is Peter Lynch?

Peter Lynch is one of the greatest mutual fund managers of all time. He ran the Magellan Mutual Fund of Fidelity Investments, it is now the most successful mutual fund in history. When he took over the fund he averaged a 29.3% annual increase rate and expanded the fund from 18 million dollars to an enormous 14 billion.

How Does He Do It?

Lynch largely uses common sense to make his stock picks. He would investigate a company he was interested in extensively before coming to a decision about the company. He warns us not to invest in hot industries or hot stocks because they are unpredictable and most likely inflated. His favorite companies are small, aggressive companies that grow at an average of 20% per year. He says that if you can find the right kind of company like this, you can find a ‘ten bagger,’ which is a company that increases tenfold. Like Buffett, he steers clear of businesses he does not understand and supports holding companies for the long-term.

Lynch’s Method

Lynch relies heavily on historical performance. He has little need for future forecasts and predictions. He compares most of his picks to its past performance before buying them. He advocates having a plan and sticking to it. You should not be influenced by short term fluctuations of the market.

Stock Categories

Lynch put stocks into one of six categories: slow growers, stalwarts, fast-growers, cyclicals, turnarounds and asset opportunities. He is most well known for popularizing the fast-grower category.

1. Slow-Growers – Companies that are past their prime and quite large. They are expected to grow around the same rate as the economy. He avoids these stocks.

2. Stalwarts – Blue chip companies that are large but still have room to grow. They have an average growth rate of around 10-12%. (Example is Proctor and Gamble or Coca Cola)

3. Fast-Growers – Small, aggressive companies that grow around 20 – 25% per year. These are Lynches favorite stocks.

4. Cyclicals – Companies that rise and fall with the economy. He recommends that investors learn to pick up on signs that a company is going to fall in price. (Clothing Companies)

5. Turnarounds – Companies that have been devastated that turnaround and become successful.
These companies are least related to the overall economic cycle. (Example is Chrysler)

6. Asset Opportunities – Companies that own overlooked assets. This can be difficult to determine and Lynch recommends that investors use their own personal knowledge of industries they know best to determine this category.

Steps to Finding Great Stocks

1. Fast Growing Stocks (EPS Growth Rate)

Lynch loves companies with a consistent growth rate that is around 20%. He is wary of companies that grow too fast, though. Anything above 30% may be too risky because it is an unsustainable growth rate. Finding companies that consistently grow at 20% will significantly narrow down your investment options.

2. Consistency (profit margin/ 5-year profit margin)

One way Lynch calculates the consistency of a company is comparing the most recent pre-tax profit margin to its historical pre-tax profit margin. He recommends avoiding stocks that are inconsistent and volatile.

3. Be wary of debt (total liabilities/ total equity)

One of Lynch’s greatest pieces of advice is that a debt free company cannot go bankrupt. He believes that the debt/equity ration should be around .33 on average. He advocates that the lower the ratio the better.

4. Price to Earnings Ratio (P/E) to Growth Ratio – (P/E divided by Growth Rate)

Lynch uses the p/e ratio to determined if a stock price is high or low. He compares a companies p/e ratio to its historical earnings growth. He thinks that a company with a p/e ratio of 10x should have an annual growth rate of 10% which is a p/e to growth ratio of 1. This is where he can find a good price for a company. If a company has a p/e ratio of 10x but has growth rate of 20% then it is a huge bargain (p/e to growth ratio of 2). Conversely, a company with a p/e ration of 10x and an annual growth rate of 5% should be avoided like the plague. Although he does warn that too high of a P/E to growth ratio of above 2 is dangerous.

5. Institutional Ownership

Lynch likes stocks that have little Institutional Ownership. Institutional Ownership is defined as how many outstanding shares of a company are owned by mutual funds, pension plans or any institution that invests in stock. The average for most recognizable companies is 40%.

6. Inventory

This concept makes a lot of sense. If a companies inventory is growing faster than its sales, that is a bad sign. This is called Inventory Turnover. If inventory turnover is dropping then inventory is rising faster than sales. Any company with a dropping inventory turnover should be avoided.

7. Seek Out the Boring and Overlooked

Avoid hot stocks and stay away from the glamour. If a company has a boring history it is probably a good company if it is consistent.

8. Save

Lynch advocates living under your means in order to save money for investment. If you don’t save your money, you won’t have any to put aside for investing.

Picking the Stock

Lynch often credits walking through malls and grocery stores with giving him the best investment ideas. He was a common sense investor in the purest form. He even credits his Wife’s love of Hanes panty hoes with his investment in the company which gave him enormous profits.
He also recommends that you spend an hour each week researching stock, including those you already own. If the stock market seems confusing and too much risk for you, Lynch recommends investing in a low expense mutual fund with no loads. (Vanguard and Fidelity are great choices)