Primer | How to invest like Peter Lynch

Peter Lynch is a legend in the world of investing not only because of his performance as a fund manager but more so for his easy-to-understand method of investing.

Having funded his education in the Wharton School of Management with an investment that grew ten times, Lynch has a unique investing style that can be easily adapted. As a fund manager of Fidelity Magellan Fund from 1977 to 1990, Lynch recorded an annualised compounded return of 29 percent over this period.

While Warren Buffett also gave phenomenal returns during this time, his fund mainly consisted of a small group of investors. Lynch managed an open-ended fund which grew from $20 million in assets when he started to $13 billion by the time he quit.

Managing an open-ended fund is a high-pressure job because of the number of pestering clients, redemption pressure on account of non-performance and the fund being open to public scrutiny. Yet Lynch was able to beat 99.5 percent of other fund managers in the US markets.

Lynch’s three books on investing – One up on Wall Street, Beating the Street, and Learn to Earn have all been bestsellers and talk about his unique investing style.

Lynch’s approach to investing was like a consumer rather than a fund manager. He compared a company’s product, brand recall, and market leadership apart from the usual fundamentals to pick up stock. By the time he hung up his boots, Lynch had 1,000 stocks in his portfolio.

Here are few of Lynch’s basic rules for investing.

Know what you are buying

“Know what you own, and know why you own it” – Peter Lynch in ‘One Up on Wall Street’.

For retail investors, this tenet is perhaps the most important. While fund managers are expected to know all sectors and pick winners from these, a retail investor is restricted in terms of knowledge about various sectors. Rather than investing in companies where the nature of the business is complex, for example the pharmaceutical industry, an investor would be better off sticking to sectors that he is comfortable with or one where he is working.

For instance, a software engineer would naturally be able to analyse an IT company better than a refinery. There are certain sectors like consumables which everyone can understand but the trickier ones should be left to the experts.

In any case, Lynch says that there are only a few stocks that will outperform in your portfolio, it is therefore important to bet big on your most convincing idea. Lynch points out that you only need a few good stocks in your lifetime. Many stocks will give mediocre gains, some may give above average returns but only 2-3 stocks will be multi-baggers.

Portfolios of outstanding investors in India such as Rakesh Jhunjhunwala confirms this thesis. Around five stocks account for more than 80 percent of his wealth. The Pareto principle of 80 – 20 is applicable to investing. Around 80 percent of your return will come from 20 percent of your stock.

Successful investors know this fact, the unsuccessful ones expect every stock of theirs to be a multi-bagger.

While knowing what you know is important, so is researching for new companies. Lynch says the person that turns over the most rocks wins the game. If one goes by the Pareto principle you will get one good investment after looking at ten ideas. Continuous research is the only way of picking good companies.

Watch them grow

Lynch was one of the first who said that a retail investor was at an advantage compared to a fund manager in picking up stocks. A mutual fund is restricted by size and cannot invest in small capitalization stocks. For a retail investor, there are no such restrictions. In fact, smaller companies, because of a lower base, grow faster. As Lynch says “Big companies have small moves, small companies have big moves.”

However, a retail investor is scared by the movement in the market and sells at the first sign of weakness in the hope of buying the stock back at a lower price. It is important to look at the business fundamentals of the company rather than its share price. According to Lynch “The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.”

In his book ‘One Up on Wall Street’ Lynch pointed out examples of stocks giving multi-fold returns only after years of holding. Examples include the Lukens stock which went up six-fold in the fifteenth year, American Greetings was a six-bagger in six years, Angelica a seven-bagger in four, Brunswick a six-bagger in five, and SmithKline a three-bagger in two.

Indian markets too have seen similar returns. Graphite electrodes companies shot up by nearly 12 times in one year after stagnating in a narrow range for nearly a decade. Similarly, sugar stocks shot up by five times in a year in 2016-17 after being range-bound for five years. Frontline stock Maruti Suzuki was range-bound for four years and gave a seven fold return in the next four.

Invest after you investigate

Just because a product sells more does not make that company investment worthy. A little bit of background research and a look at the basic financials can do the job.

Researching a company is not rocket science. Lynch says ‘Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it.’

One does not need to have complex excel sheets but a basic understanding of the health of the company should do for a start.

Lynch says “If you can follow only one bit of data, follow the earnings—assuming the company in question has earnings. I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow, or next week is only a distraction.”

Focused research on your potential buy is more important than having a macro view of the globe, which most investors consider in the hope of timing their investment. ‘Don’t look at economics to predict the future. If you spend 13 minutes a year on economics, you’ve wasted 10 minutes. Focus on your companies. If you own auto stocks, you should be very interested in used car prices’ says Lynch.

One of the often talked about ratio by Lynch is the PEG or price to earnings growth ratio. Here is his simple interpretation of it from One Up on Wall Street. “If the P/E of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year…and a P/E ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a P/E ratio of 12 is an unattractive prospect and headed for a comedown…In general, a P/E ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative.”

One cannot get a simpler formula than that in valuing companies. If two companies have the same PE ratio, one with higher growth rate is preferable.

Conclusion

Peter Lynch does not believe in timing the market. His research on buying companies at the top price of the year as compared to the bottom price of the year resulted in a small difference over the long run. Neither is Lynch a huge fan of corporate governance, rather he prefers betting on companies with strong business fundamentals. As Lynch says ‘Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.’

[“source=moneycontrol”]