When was the last time you bought a stock that gained over 1,000%?
Peter Lynch bought more than a hundred of them during his 13-year stint as head of Fidelity’s Magellan fund.
He called them “ten baggers” – stocks that increased in price more than tenfold. Some of his best picks include Fannie Mae, Ford Motor, Philip Morris, Taco Bell, Dunkin’ Donuts and General Electric to name a few.
Combining Growth and Value
Peter Lynch is best described as a growth/value investor. And his 29.2% annualized return over 13 years at Fidelity makes him the greatest mutual fund manager of all time. But what made him a true legend?
After stepping down from the Magellan throne, Lynch shared his secrets with retail investors.
His best-selling books, One Up On Wall Street and Beating the Street, laid out his investment process in clear and concise detail. Through these works, he taught small investors how to achieve market-beating success by using knowledge they already possessed.
His famous investment philosophy is simply, “Invest in what you know.” Since most people tend to become experts in a particular field, Lynch believed this basic principal could help individual investors find good undervalued stocks.
What separates him from other growth stock investors is his discipline to buy only at reasonable prices. This combination of growth and value made him a legendary stock picker.
Price Follows Earnings
Peter Lynch’s primary focus was on earnings, knowing that stock prices follow earnings over a large time frame. By buying shares when the price was temporarily depressed in relation to their earnings, he was able to profit from both the correction in price and the hopeful continuation of growth.
Avoid Hot Stocks
Lynch also avoided “hot” stocks and sectors. This included an avoidance of technology producers and seldom exposure to the energy markets. Even though he missed the boat on Apple and a few other tech giants, Lynch assures us that the losses from investing in these sectors would have far outweighed any potential gains.
Peter Lynch’s Investment Formula
He instead looked for simple companies with better-than-industry numbers and demonstrating the following investment metrics:
P/E Ratio
His now-famous “Peter Lynch chart” plotted a stock’s price against its historical earnings line – a theoretical price at 15 times earnings. He stated, “A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies – such as Shoney’s, The Limited, or Marriott – when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well.”
PEG Ratio
Lynch was a firm believer that investors should only buy stocks when the P/E ratio was below the company’s historical growth rate. This equates to a PEG ratio below 1 and ensures that investors do not overpay for stocks. We should be willing to “pay up” for fast growing companies, but not to absurd levels that will inhibit future returns.
Debt to Equity
The primary cause of business failures is an unsustainable debt load. Mr. Lynch maintained that companies should carry as little debt as possible and remain below the corporate average of 35%.
Inventory to Sales
For producers of physical goods, one of the early warning signs of diminishing returns is a buildup of excess inventory. By monitoring the inventory to sales ratio’s change on a year to year basis, investors have a better chance of identifying enterprises suffering a deterioration of their supply/demand curve.
Net Cash Position
Companies holding large cash reserves offer a greater margin of safety during economic hardships. Calculated by subtracting total liabilities from cash and equivalents, Lynch viewed the net cash position as a bonus. While not a necessity for favorable results, it adds an additional level of security to any common stock investment.
Charlie Tian, Ph.D.
Founder, GuruFocus.com
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