Next to investment legends such as Warren Buffett (Trades, Portfolio) and Carl Icahn (Trades, Portfolio), Peter Lynch falls by the wayside, but his influence on the investment world has inspired more change than possibly Buffett and Icahn put together.
Lynch is considered to be the greatest mutual fund manager of all time. The fund he managed, Fidelity Investment's Magellan Fund, produced an average annual return of 29.2% from 1977 until 1990, almost doubling the Standard & Poor's 500’s annual yearly return of 15.8%. During this period, Lynch pioneered the growth-at-a-reasonable-price style of investing. Lynch believed that the faster a company was growing, the more investors should be willing to pay for it, which makes a lot of sense today, but before Lynch’s success, the market tended to overlook growth and value together.
To come up with an easy way of evaluating stocks by assessing their value and growth potential, Lynch pioneered the PEG ratio. This measure of determining growth at a reasonable price divides a stock’s price-earnings (P/E) ratio by its historic growth rate to find growth stocks selling on the cheap. Estimated forward growth rates can also be used to give a more accurate reflection of the company’s growth potential rather than a backward-looking metric.
As well as his love of growth investing, Lynch liked to tell investors to “buy what they know,” following similar advice from Buffett. Unfortunately, this information is highly misused. Just because you like to eat in does not mean you should go out and buy the stock. Instead, this comment refers to research – you should only purchase a stock once you’ve done thorough research on the opportunity on offer. When you know and understand the opportunity, only then should you invest.
Plenty of research
For most investors, researching companies to the extent that Lynch was able to is completely impossible.
Over his career, Lynch invested in thousands of businesses and spent time studying all of them including visiting management. To be able to conduct this level of research you not only have to be a full-time investor, but you also need a whole team of analysts available to you.
How does the average investor replicate Peter Lynch’s strategy in an attempt to achieve similar returns? Clearly, research is the key starting point. You need to know and understand the companies that you own in your portfolio. The easiest way of doing this without having a team of Fidelity analysts at your disposal is to use a checklist and concentrate on one company at a time. Peter Lynch was all about growth investing, and growth companies tend to be multiyear investments. As a result, there’s no need to be doing new research every day. Once you’ve found a company that has all the qualities you desire, it’s easier to ride the gains for many years rather than trying to discover another opportunity.
But even if you know your target well, growth companies are notoriously speculative so it pays to have a well-diversified portfolio, cut losers and run winners.
Another strategy to help ensure that you avoid the losers and buy the winners is only to invest in those companies that have a significant insider ownership and cash balance. Most early stage growth companies will be heavy cash burners, which means they will be dependent on the charity of capital markets if they are not well funded.
Don't be afraid of valuation
A third tip that could help create a Lynch-like growth strategy is not to be afraid of a high valuation. Growth stocks tend to trade at high valuations due to the high expectations baked in to the stocks. These high valuations may put some investors off, but ultimately if a company is growing rapidly, there’s no reason why the valuation cannot be sustained. This is where Peter Lynch’s PEG ratio comes in handy. If the stock is trading at 50 times forward earnings but is expected to grow earnings at 100% next year, it will have a PEG ratio of 0.5 and on this basis still looks incredibly cheap.
Hopefully, these tips will help you build your own growth strategy and achieve Peter Lynch-style profits.
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