A Look Into Peter Lynch’s Investment Style – 5 Key Criteria – What Would He Buy Today?

by Begin To Invest on January 19, 2019

Every once in a while, I like to take a closer look at an event that comes up in our “This Day in History” archive, which gets posted daily on Facebook, Twitter, and is now available as an Amazon Flash Briefing.

Today we look into the life of Peter Lynch, whose birthday is this week, and who is one of the most successful mutual fund managers in history.

What did Peter Lynch look for in an investment, and what stocks would Peter Lynch buy today?

Lynch looked for 5 key criteria when selecting an investment:

Buy What You Know
Growth At A Reasonable Price
Avoid The Hot Stocks
Stay Small
Strong Balance Sheet

We’ll look at these in more detail below, and a list of companies that meet all of these criteria – but first a quick look at Lynch’s historic run as a mutual fund manager:

Peter Lynch – One of the Investing Greats

In case you haven’t seen, you can also follow www.begintoinvest.com with any month and date to go to that day in history page. For example; www.begintoinvest.com/january-19

The event for January 19^th was Peter Lynch’s birthday.

Peter Lynch was born on January 19^th, 1944 and would become one of the most successful mutual fund managers in history.

Lynch begin his investing career as an intern at Fidelity in 1966, and by 1974 was promoted to head of research for the company.

Lynch’s rise to stardom began in 1977, when we became the manager of Fidelity’s Magellan Fund. Lynch would remain in charge of the fund for 13 years, until 1990. Over those 13 years, Lynch would put up numbers that very few investors, let along mutual fund managers, have topped. From 1977 to 1990, Lynch’s fund produced an average annual return of 29.2%, and bested the S&P 500 in 11 out of those 13 years.

So what was his secret?

Thankfully for us, after his retirement, Lynch got busy writing. In total he has written three books about investing.

One Up On Wall Street: How To Use What You Already Know To Make Money In The Market

This was his first book, published in 1989. This book goes into some detail on specific criteria he looks for, a few examples, and the general “theory” behind his investment decisions. This is by far Lynch’s most popular work and has been revised and updated several times by now.

Beating the Street

His second book released in 1994, which goes into a little more detail about Lynch’s investment philosophy.

And, Learn to Earn: A Beginner’s Guide to the Basics of Investing and Business

This was Lynch’s third book released in 1996. It goes into more detail of his investment philosophy, and specific examples.

Best of all, since his books are old, you can get used copies of Peter Lynch’s books for just a couple bucks.

But I thought that the investment style of one of the best mutual fund managers in history deserves a little closer look. How did Peter Lynch invest? And what stocks would Peter Lynch buy today?

The Peter Lynch Investment Philosophy – 5 Key Investment Criteria

Here is a few of Peter Lynch’s required criteria for an investment, along with a quote on the topic from his book, One Up Wall Street:

Buy What You Know

“Know what you own, and know why you own it”

This is one of Peter Lynch’s most famous quotes. Lynch always spoke to the fact that “main street” Americans are able to spot trends well before those on Wall Street. Take a look around you. Which stores are busy? What new products do you see everywhere? What brands of clothes or toy is you child begging for?

Lynch believed in starting your search for the next great investment by looking at the companies around you.

One of my most successful investments was found this exact way.

At work in 2009, someone left my office, but forgot their pen on my desk. 30 minutes later, they returned asking for their pen back.

“Why did you come back for a stupid pen?” I asked. It was a relatively cheap ball point pen from a local area bank.

“I love my bank” he said.

The pen was one that he had received years ago after opening an account at Monarch Bank in Virginia Beach, Virginia.

Remember, this was 2009. The world was ending, and the most popular opinion to have was to hate banks (remember the “occupy wall street” protests?) So I looked a little deeper. This bank was obviously doing something right…

After looking through old financial statements and letters to shareholders it was obviously a gem. The bank was well run, still profitable (it never reported a loss through the financial crisis), and even in the depths of the great recession, paid a ~2% dividend and had a great history of increasing their dividend over time.

A couple shareholder meetings later I was sold. Monarch Bank has since been purchased, but much of management stayed on with the acquiring company, Towne Bank. To this day, this is my second largest position in my portfolio.

For those who want to look at TowneBank in more detail, I have 2 articles on Seeking Alpha about the bank:

TowneBank: Best Bank in ‘Towne’ For a Flat Yield Curve

And, TowneBank: A True David vs Goliath Story

All because I “bought what I knew”. No New York City Wall Street analyst was going to give a $100 million market cap regional bank in eastern Virginia any time of day. No one was clued into what this bank was doing. It was an advantage that only an amateur investor who was paying attention to their surroundings would have – Just like Lynch said.

And this is a perfect example of what Lynch preaches. Look around you, be curious, and take advantage of your position.

Buy Growth at a Reasonable Price

“Carefully consider the price-earnings ratio. If the stock is grossly overpriced, even if everything else goes right, you won’t make any money.”

Lynch was a big believer in a simple P/E ratio to spot value. Lynch would start his search for companies with a P/E Ratio below the industry average.

But obviously, just a low P/E Ratio is hardly a reason to buy a stock. You need to dig deeper. Why is the stock priced low? Is it a poor performer? Or is it just neglected? Lynch loved to look for companies that were neglected, but who controlled their market.

Lynch would also factor in a company’s growth rate and dividend yield with the company’s P/E Ratio.

This is like a modified “PEG Ratio”. A basic PEG Ratio is calculated by taking the P/E ratio and dividing by the company’s growth rate. For example, a company with a P/E of 30, but a 30% growth rate would have a PEG ratio of 1. If that company’s growth rate accelerated to 60%, its PEG ratio would be 0.5.

Lynch also factored in the stock’s dividend yield to the growth rate. For example, if a company had a P/E ratio of 30, a growth rate of 28%, and a dividend yield of 2%, Lynch’s modified PEG ratio would be 1.

Lynch would look for companies with a modified PEG Ratio of under 0.5.

You can learn more about the CAPE Ratio (which is a 10-year averaged P/E ratio) and whether or not it predicts future stock market moves here:

What Can Shiller’s CAPE Ratio Teach Us About Future Stock Market Returns

Avoid What’s Hot

“If you find a stock with little or no institutional ownership, you’ve found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner…It frequently happens with banks, savings-and-loans, and insurance companies, since there are thousands of these and Wall Street only keeps up with fifty to one hundred.”

Lynch would look for growth, but not in the hot sectors followed by everyone else. Lynch would look for companies growing at 20% in industries that were typically low growth.

What industries are “in” today? FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google) come to mind. But instead of looking at today’s tech companies with large growth rates, like Facebook, Lynch would be looking elsewhere. Maybe a retail stock with double digit growth, an industrial with a new big contract, or an apparel company with a new hit line.

Lynch would also avoid stocks with large institutional holdings, regardless of the sector. If Wall Street was in, he wanted to be out. Which makes sense, if you want to outperform, you need to be doing something different.

Stay Small

“Big companies have small moves, small companies have big moves.”

Lynch believed that small firms had much more upside than larger firms. I think this is especially true today. Many investors today love Apple stock. But at a value of $900 billion, what is more likely, Apple becoming a $1.8 trillion company? Or a small bank growing from $10 million to $20 million?

Besides Lynch’s intuition, this size factor seems to have been proved by economics research as well. Most notably, Nobel Prize winner Eugene Fama, found size of companies to be one of the three original factors in his three factor model.

Want to find big wins in the stock market? Start small.

Strong Balance Sheet

“If you can’t understand the balance sheet, you probably shouldn’t own it.”

Lynch did not want to own companies with a lot of debt. As we will see in the next section, many of Lynch’s stock picks took years to play out. If a company is drowning in debt, it may not live to see a future where its product thrives.

Lynch warns specifically about avoiding companies with large amounts of bank debt, which should be noted in the company’s notes to the financial statements in their 10-Q or 10-K.

Lynch also looked at a company’s cash pile as support for the stock price. If a company has $16 in cash per share, the stock would not trade much lower than $16. Cash provides a margin of safety that made Lynch comfortable holding the position.

Read More Here: Evaluating a Company By Its Balance Sheet

Lastly, Patience

“The typical big winner in the Lynch portfolio (I continue to pick my share of losers, too!) generally takes three to ten years or more to play out.”

This is self explanatory, but serves as a reminder. Remember, you are investing for the long term, give your positions time to grow.