13 tips from famous stock-picker Peter Lynch
Peter Lynch gave investors an in-depth look in his book A blow to Wall Street. Lynch was careful to warn her readers that it is important to analyze yourself first before spending time analyzing businesses. Lynch even provided in her bestselling book a list of the most important qualities for success:
- Common sense
- Pain tolerance
- Willingness to do independent research
- Willingness to admit mistakes
- Ability to ignore general panic
- Discipline to resist your human nature and instinct
You might be surprised that things like humility, pain tolerance, and common sense are on Lynch’s personality checklist, but not intelligence. Lynch felt that the behavior of actions is generally simple-minded and that real geniuses are too “enamored with theoretical thinking and are forever betrayed by the real behavior of actions.”
Lynch further noted that investors must accept that they will have to make decisions without complete or perfect information. You are rarely sure when making investment decisions, and if you fully understand what is going on, it is already too late to profit from it.
Lynch gained his fame as the portfolio manager of the Fidelity Magellan mutual fund, which he took control in 1977. During his 13-year tenure as a portfolio manager, he grew his assets from $ 20 million to $ 14 billion and has beaten the S&P 500 in 11 out of 13 years, with an average annual rate of return of 29.2%.
Lynch strongly believes that not only can individuals be successful in investing, but they also have a distinct advantage over Wall Street and professional fund managers by being able to identify trends early, by investing in what they know, by having the flexibility to invest in a wide range of businesses and not valued in the short term.
Short-term pain for long-term success
The volatility of the stock markets reminds us that long-term stock market success requires a certain detachment and tolerance for short-term pain. As Lynch pointed out, stocks will go up and down, and rather than panic when they go down, you need to have detachment to stay the course. Lynch warned investors that “when you sell out of desperation, you always sell low.”
AAII has developed a quantitative stock filter, or stock filter, with the aim of identifying stocks with the fundamental characteristics that Lynch looks for when selecting stocks. Fifteen Lynch-inspired leads are featured below. Our model shows impressive long-term performance, with an average annual gain since 1998 of 7.9%, compared to 6.5% for the S&P 500 index over the same period.
Stocks passing the Lynch screen (ranked according to the dividend-adjusted PEG ratio)
Lynch was a bottom-up stock picker looking for good companies selling at attractive prices. He did not focus on the direction of the market, the economy or interest rates. Lynch said, “If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.” It was not that he did not understand the importance of these big picture elements, he just did not believe that it was possible to reliably consistently predict them. Instead, he felt that it was better to spend your time researching top quality companies, doing basic research, and keeping a close eye on your fundamentals.
Analysis is at the heart of Lynch’s approach. In examining a business, he seeks to understand the business and outlook of the business, including competitive advantages, and assess potential pitfalls that might prevent the favorable “story” from occurring. In addition, an investor cannot make a profit if the stock was bought at too high a price. For this reason, it also seeks to determine a reasonable value. Here are some of the key figures Lynch suggests investors look at:
Sustainable profit growth
The rate of earnings growth should match the “story” of the business: Fast growing companies should have higher growth rates than slow growing companies. Extremely high levels of profit growth rates are not sustainable, but continued high growth can be factored into the price. A high level of growth for a company and industry will attract a lot of attention both from investors, who drive up the stock price, and from competitors, who provide a more difficult trading environment.
Lynch prefers to invest in companies whose profits are increasing at moderately fast rates (20 to 25%) in non-growth sectors. To avoid companies with unsustainable earnings growth over the long term, AAII’s Lynch-inspired strategy excludes companies with an average annual growth rate of earnings per share over the past five years greater than 50 %.
The earning potential of a business is a critical determinant of business value. Sometimes the market can get ahead and even overvalue a stock with a great outlook. The price-earnings ratio helps keep your perspective in check. The ratio compares the current price to the most recently published earnings. Stocks with a good outlook should sell with higher price-to-earnings ratios than stocks with a poor outlook.
By studying the model of price-earnings ratios over several years, you can develop an idea of the normal level of the business. This knowledge should help you avoid buying a stock if the price exceeds profits or alert you that it may be time to take profit on a stock you own. If a company is doing everything right, you might not be making money on inventory if you overpaid it.
The Lynch AAII approach specifies that the company’s current price-to-earnings ratio must be less than its own five-year average price-to-earnings ratio. This filter implicitly implies that a company must have five years of positive earnings and five years of price data.
Comparing a company’s price-earnings ratio to that of the industry can help determine if the company is a good deal. At a minimum, this leads one to wonder why the company is priced differently. Lynch’s Ideal Investment is a neglected niche company, one that controls a market segment in an unglamorous industry in which it would be difficult and time consuming for another company to compete. The Lynch AAII Screen requires the company to have a price-earnings ratio below the median for its respective industry.
Growth at a reasonable price
Firms with better prospects should sell with higher price-to-earnings ratios. A useful valuation technique is to compare the price-earnings ratio to earnings growth, known as the PEG ratio. A price-to-earnings ratio of half the level of historical earnings growth is considered attractive, while ratios above 2.0 are considered unattractive.
Lynch refines this metric by adding dividend yield to earnings growth. This adjustment recognizes the contribution of dividends to an investor’s return. The ratio is calculated by dividing the price / earnings ratio by the sum of the earnings growth rate and the dividend yield. With this modified technique, ratios greater than 1.0 are considered poor, while ratios less than 0.5 are considered attractive. The Lynch AAII screen uses this dividend-adjusted PEG ratio, with a ratio less than or equal to 0.5 specified as the threshold.
Solid balance sheet
A strong balance sheet provides leeway when the business grows or experiences problems. Lynch is particularly wary of bank debt, which can usually be called by the bank on demand. Small-cap stocks have a harder time raising capital in the bond market than larger-scale stocks and often look to banks for capital. A careful examination of the financial statements, particularly in the notes to the financial statements, should reveal the use of bank indebtedness.
The Lynch AAII approach ensures that the ratio of total liabilities to business assets is below the industry standard. The screen uses total liabilities because it takes into account all forms of debt. It compares the ratio of the company to industry levels, as acceptable levels vary from industry to industry. Normal debt levels are higher for industries with high capital needs and relatively stable profits, such as utilities.
In addition, the Lynch AAII screen excludes companies in the financial sector because their financial statements cannot be directly compared to those of other companies.
Lynch believes that the good deals are among the stocks overlooked by Wall Street. The lower the percentage of stocks held by institutions and the lower the number of analysts following the stock, the better. The AAII Lynch strategy requires a percentage of stocks held by institutions below the median of all stocks listed in the United States.
Portfolio constitution and monitoring
Lynch says investors should buy as many “exciting prospects” as they can find that pass all the research tests. However, there is no point in diversifying just to diversify. Lynch suggests investing in multiple classes of stocks to spread the downside risk.
Although Lynch is an advocate for maintaining a long-term commitment to the stock market, he says investors should review their holdings every few months, rechecking the “history” of the company to see if anything has gone wrong. changed with the unfolding of the story or with the course of action. The key to knowing when to sell, he says, is knowing “why you bought it in the first place.” Lynch says investors should sell if the story went as planned, and the price reflects that – for example, the price of a pillar has gone up as much as you might expect. Another reason to sell is if something in the story doesn’t go as planned, or if the story changes or if the fundamentals deteriorate – for example, stocks in a cycle begin to build up or a small business starts to build. enters a new phase of growth.
For Lynch, a price drop is an opportunity to buy more than one good lead at lower prices. It is much more difficult, he says, to stick with a winning stock once the price increases, especially with fast producers where the tendency is to sell too early rather than too late. With these businesses, he suggests holding on until the business enters a different phase of growth.
Rather than just selling a stock, Lynch suggests a “rotation,” meaning selling the company and replacing it with another company with a similar history, but better prospects. The rotation approach maintains the investor’s long-term commitment to the stock market and maintains the focus on fundamental value.
Stocks that meet the criteria for the approach do not represent a “recommended” or “buy” list. It is important to exercise due diligence.
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