Learning From Peter Lynch
Posted on May 14, 2008 in the Investing category
.Peter Lynch is the legendary former investment manager of Fidelity’s Magellan fund. In today’s volatile investment climate, the investment philosophy of legends like Peter Lynch and Warren Buffet are suddenly back in vogue.
Peter Lynch’s core investment philosophy is that you should only buy what you understand, always do your homework and invest for the long run.
1. Only Buy What You Understand
Similar to Warren Buffet, Peter Lynch believes that the greatest stock research tools are our eyes, ears and common sense. 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. In other words, most of the stock market is in the business of serving you, the individual consumer - if something attracts you as a consumer, it should also pique your interest as an investment.
2. Always Do Your Homework
While first-hand observations and anecdotal evidence are a great start, but before you invest in a company you need to do your homework. Some of the fundamental values that Lynch looks at before deciding to invest are:
- Percentage of Sales: If there is a product or service that initially attracts you to the company, make sure that it comprises a high enough percentage of sales to be meaningful; a great product that only makes up 5% of sales isn’t going to have more than a marginal impact on a company’s bottom line.
- PEG Ratio: This ratio of valuation to earnings growth rate should be looked at to see how much expectation is built into the stock. You want to seek out companies with strong earnings growth and reasonable valuations - a strong grower with a PEG ratio of two or more has that earnings growth already built into the stock price, leaving little room for error.
- Favor companies with a strong cash position and below-average debt-to-equity ratios. Strong cash flows and prudent management of assets give the company options in all types of market environments.
3. Invest for the Long Run
Lynch has said that “absent a lot of surprises, stocks are relatively predictable over 10-20 years. As to whether they’re going to be higher or lower in two or three years, you might as well flip a coin to decide.” It may seem surprising to hear such words from a Wall Street legend, but it serves to highlight how fully he believed in his philosophies. Lynch believe that as long as the story hadn’t changed, there was no reason to sell.
In fact, Lynch once conducted a study to determine whether market timing was an effective strategy. According to the results of the study, if an investor had invested $1,000 a year on the absolute high day of the year for 30 years from 1965-1995, that investor would have earned a compounded return of 10.6% for the 30-year period. If another investor also invests $1,000 a year every year for the same period on the lowest day of the year, this investor would earn an 11.7% compounded return over the 30-year period.
Therefore, after 30 years of the worst possible market timing, the first investor only trailed in his returns by 1.1% per year! As a result, Lynch believes that trying to predict the short-term fluctuations of the market just isn’t worth the effort. If the company is strong, it will earn more and the stock will appreciate in value. By keeping it simple, Lynch allowed his focus to go to the most important task – finding great companies.
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