In a previous article, I told you a little bit about investing legend Peter Lynch. I mentioned his amazing track record with Fidelity’s flagship Magellan Fund, how he coined phrases like “ten-bagger,” and that his approach to investing can be accessible to anyone.

I also promised to follow up with some actionable advice on how regular investors like you and me can emulate his approach. And that’s exactly what we’re going to do today…

But first, let me briefly refer to the end of my previous article. I summed up Lynch’s “keep it simple” philosophy like this:

Take a quick look at your portfolio and pick a random stock. Now ask yourself this question. Can you explain in simple terms to a 10-year-old why you own it in one minute or less?

That’s the litmus test.

If the business is too complicated and the bull argument too unwieldy, then you’re probably better off without it.

I’ll paraphrase an example he jokingly made about this at a business luncheon. Some people blindly invest in companies touting their newest one-megabit SRAM that comes with a floating I/O array processor, an optimizing compiler, 16 dual-port memory, four whetstone megaflop polysilicone emitters, and a UNIX operating system with asynchronous backward compatibility and peripheral bus architecture.

The layperson has zero idea what such gobbledygook means. Then they get blindsided when a Korean rival launches a competing product with more megaflops.

His core mantra was simple: invest in what you know and understand.

“Invest In What You Know…”

Even your own occupation can be a valuable source of insight into a specific corner of the market. After all, a doctor on Main Street is probably better equipped than an office dweller on Wall Street to weigh in on a new medical device IPO.

As we learned from the Dunkin Donuts example above, Lynch sourced more investment ideas from the world around him than by reading wonky economic reports and trade journals. You can learn a lot by seeing which cereal is most common in Wal-Mart grocery carts. Or by counting the number of vehicles in the Home Depot parking lot.

He scored massive gains simply by taking his daughters on frequent trips to the mall, using his keen powers of observation to observe teenagers in their natural habitat. Where did they eat? What clothes were fashionable? Which stores had the longest checkout lines?

Of course, the retail world looks a lot different these days. Good luck gleaning actionable intel from a group of kids staring at their phones.
In any case, that’s just the first step. Lynch was a firm believer in research and due diligence.

As he liked to say, “investing without research is like playing stud poker and never looking at the cards.”

He couldn’t understand why people consult Consumer Reports before buying a microwave and study travel guides ahead of a trip… but then blow half of their savings on a random stock tip without doing any homework.

So what did he look for? Well, that’s easy. As you might gather from all those ten-baggers, Lynch was fond of growth. Sluggish businesses don’t deliver 1,000% returns. But you can’t find success simply by screening for rapidly expanding sales and earnings – if only it were that easy.

The World According To GARP

As we know, these stocks often draw a crowd and get quickly overbid, leaving little additional upside. That’s precisely why Lynch generally avoided hyper-growth companies, especially those in “hot” industries. That’s usually the recipe for a correction. Without naming names, the spectacular blowups of many exorbitantly-priced Nasdaq highfliers this year is a good reminder of that principle.

Lynch relied quite a bit on old faithful: the P/E ratio. He liked to see stocks trading at a discount to industry peers and the stock’s own historical average. But all things equal, the faster a company can grow earnings, the more it is worth – and the more Lynch was willing to pay.

He was an early practitioner of what we know today as growth at a reasonable price (GARP). Is a P/E of 25 too expensive? Maybe for a business stuck in neutral. But not if the company is projected to grow earnings by 30% annually. In that case, the stock would have a Price-to-Earnings-to-Growth (PEG) of around 0.8.

Generally speaking, Lynch looked for stocks whose projected earnings growth rates matched or exceeded their P/E (PEG below 1.0). He made a slight adjustment for dividend payers, adding the yield to the growth rate in the denominator.

Putting that into practice, Best Buy (NYSE: BBY) would rank favorably on the Lynch GARP scale. As I write this, the electronics retailer is currently trading at 7 times this year’s expected earnings of $10 per share. By itself, that doesn’t mean too much. But consider that Best Buy has a yield of 5% and projected five-year earnings growth of 8% (for a total of 13%).

Comparing those figures gives us a PEG of 0.54 (7/13). Invert those two numbers (13/7), and you get 1.8, close to the threshold that Lynch considered a flashing buy signal.

To be sure, that’s just a simple valuation yardstick. But it’s an effective screening tool… and a good starting point from which to dig into the balance sheet, inventory levels, managerial efficiency, and other important factors.

10 More Lynch Tips

Here are ten more planks in the Lynch platform.

1. Look for attractive niche markets with recurring demand (like toothpaste and diapers) and high barriers to entry.
2. Give extra attention to spinoffs, hidden assets, and strong insider buying patterns.
3. Ugly ducklings can become swans. Seek out businesses considered boring, dreary, or simply distasteful (like funeral homes, waste haulers, etc.)
4. Don’t be afraid to let your winners run. Selling successful stocks too early is like cutting a flower before it blooms. The righter you are about one stock, the wronger you can be about others.
5. Beware of overhyped companies with unproven business models and leveraged firms with excessive debt/equity ratios.
6. Short-term market performance is a coin-flip. Be prepared to hold stocks for at least 10 years for their full value to be recognized.
7. Invest from the bottom up and evaluate business-specific fundamentals before weighing the larger industry outlook.
8. For every ten stocks analyzed, you might find one underpriced bargain. Whoever turns over the most rocks wins.
9. Neglected companies with few institutional holders and no analyst coverage are far more likely to be underpriced than those under a microscope. Stay away from glitter.
10. Excess cash flows lead to meaningful stock buybacks, the “simplest and best way a company can reward its investors.”

Closing Thoughts

You’ll notice these do’s and don’ts overlap in places with the tenets of another decent investor, Warren Buffett. The two pals disagree on a couple topics. Lynch (justifiably) prefers actively managed mutual funds, while Buffett is a staunch proponent of index funds. Buffett is also a big believer in a concentrated portfolio, while Lynch had more than 1,400 holdings at one point.

But on the bigger things – value, cash flows, managerial efficiency, competitive advantages, buy-and-hold — they see eye-to-eye. I think both also see the wisdom in investing in straightforward businesses whose stories are so simple you could illustrate them with a crayon. And these contrarians agree that sometimes the “smart money” is quite dumb.

One final pearl of wisdom. Lynch warns against the fruitless search for the next McDonald’s, the next Disney, or the next Intel (his examples not mine), arguing that there rarely is a next one. These leaders are unique and inimitable, making them great portfolio anchors.

I couldn’t agree more.

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