Investment Shastra

Investing Style Apt for Individual Investor – The Peter Lynch Style!

“Go for a business that any idiot can run – because sooner or later, any idiot is probably going to run it.”

These are the interesting and popular words of Peter Lynch, a Wharton MBA graduate, a chameleon investor, and the man behind the 29% average annual returns that the Fidelity Magellan Fund made during 1977 – 1990, growing its assets from $20 million to $14 billion!!

About Peter Lynch . . .

After graduating in 1968, Peter Lynch started working for Fidelity Investments as an investment analyst in 1969; eventually becoming the firm’s director of research by 1974, a position he held till 1977. Lynch was named manager of the little known Magellan Fund in 1977 and achieved historic portfolio results in the ensuing years until his retirement in 1990.

His Investment Style

Peter Lynch’s investment style adapted to whatever worked at that time, with special emphasis on due diligence and stock research. He followed a bottom-up approach, concentrating on the company’s fundamentals. He only invested for the long run and paid little attention to short-term market fluctuations. His stock selection comprised more of growth and recovery stories.

He specialized in investing in fast growth companies with earnings growth of over 15% per annum. However, he took care that the Price/Earnings Growth ratio was less than 1.2, since he didn’t want to end up overpaying for growth. He loved companies that carry a lot of cash on the books, and hated those that carried large amounts of debt. He was amongst those, who didn’t pay heed to the macroeconomic conditions or where the interest rates were going. Lynch was a stout believer in investing in what you know, otherwise known as your circle of competence. He liked companies that were simple to understand, ones you could ask your neighbour about. He looked for companies with low market caps because he wanted to get in before others.

On the other hand, Lynch avoided stocks with certain characteristics that he found unfavourable, such as:

  • Popular stocks in popular industries
  • Small companies with big plans, not yet achieved
  • Profitable companies engaging in diversifying acquisitions
  • Companies with a single customer accounting for up to 25% to 50% of sales

Though Lynch’s investing style has been adaptive to whatever works, he did apply a set of 8 fundamental principles while stock picking:

fundamental principles while stock picking

Here, the key numbers to be looked into are:

  • P/E Ratio
  • Debt/Equity Ratio: should be low
  • Net Cash per Share: should be high
  • Dividend & Payout Ratio: should be adequate
  • Inventory levels: lower the better

While examining the P/E ratio Lynch believes that people tend to pay too much emphasis to Price.

Five ways in which a company can increases its earnings

However, it is actually the growth in Earnings that tends to impact the future stock price appreciation (or depreciation). If earnings growth turns out as expected, the market participants applaud it, and the stock price rises. Conversely, if they fail to deliver as per expectations, the price takes a dip. Lynch does not believe that investors can predict actual growth rates. The company’s plan to increase earnings and its ability to fulfil that plan are its “story,” and the more familiar you are with the firm or industry, the better edge you have in evaluating the company’s plan, abilities, and any potential pitfalls. Hence, stability & consistency of earnings is very important. An extremely high earnings growth rate should be checked for its sustainability.

Thus, the P/E ratio must be judged with respect to its historic average, industrial average, and the earnings growth rate over a period of time.

The Return on your (time) investment…

Peter Lynch strongly believes that individual investors have a distinct advantage over institutional and large money managers, when using his approach. Individual investors, he feels, have more flexibility in following this basic approach because they are unfettered by traditional rules and short-term performance concerns.

Hence you, the intelligent investor, stand to make the most of Peter Lynch’s investment philosophy.

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