What is Peter Lynch's Strategy of Investing
Peter Lynch is a name that is looked up to in the investment milieu. One of the main reasons his sage has touched many-a-chords with investors across the globe is because he put a lot of power in the hands of retail investors.
He believed that individual investors are more empowered than large investors as they are not bound by bureaucracy, among other reasons.
He is also a great believer in investing in what you understand.
Read on to find out more about Peter Lynch and his investment mantras.
Peter Lynch Investment Strategy and Rules
Following are some of the prominent Peter Lynch investment strategy you can consider using-
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Story Investor
Peter Lynch himself was a 'story' investor. Through extensive research, he built stories around the company's growth path before investing. Lynch used actors such as what the company is doing, what it will do, what it is doing to achieve its goals, etc., to build stories.
Stories like slow/fast-growing companies, cyclical companies, reliable companies, and many others can be built after analyzing the company.
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Go Long
Lynch did not sell his holdings until the company's growth story had worsened. Instead, he has studied the power of compounding over the long run. He also did not believe in timing the market before making investment decisions.
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Invest In The Stocks You Know and Understand
"Invest in what you know." – Peter Lynch.
This is one of the key Peter Lynch investing rules. Peter Lynch strongly believes that the things that help us the most in investing are our eyes, ears, and common sense.
He believes that all humans can analyze things correctly, and we all do that daily, whether driving on the road safely, guessing what happens next in a TV show, or discussing new investment ideas.
Knowledge of the subject can help you decide whether to invest in the company. In addition, an informed decision keeps you prepared for unforeseen circumstances.
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Proper Research
This is another Peter Lynch strategy. This shouldn't be a surprise as we are discussing investing your money. So there must be adequate research done before making any move. One of the critical drivers of Peter Lynch's success is his extensive research.
Peter Lynch Formula
The Peter Lynch Formula is a well-known investment strategy created by Peter Lynch. The formula highlights the value of exploring potential investments and focuses on selecting stocks that can outperform the market.
The Peter Lynch Formula is divided into three parts-
- P/E Ratio: The P/E ratio, also known as the price-to-earnings ratio, compares the current stock price of a firm to its earnings per share. The lower the P/E ratio, the better the stock.
- Growth Rate: The growth rate of a stock estimates its potential. It is accomplishable by examining the company's past success and future growth possibilities.
- Potential: The final step in the Peter Lynch Formula is to analyze the stock's potential. It is achievable by studying the company's management, industry developments, and the broader economic climate.
The Peter Lynch Formula is an excellent tool for determining a stock's investing potential. However, investors can better grasp a stock's potential and make more educated selections by integrating the three parts of the formula.
The Rule of 20
The rule of 20 is an investing idea that applies to stock market valuation. It is a simple rule that examines the price-to-earnings (P/E) ratio and the inflation rate to determine the overall attractiveness of the stock market.
It states that the market's acceptable P/E ratio equals 20 minus the inflation rate. For example, if the current inflation rate is 2%, the market's golden P/E ratio would be 18. (20-2). The market is undervalued if the current P/E ratio exceeds the acceptable P/E ratio. If it is higher, the market is said to be overvalued.
The rule of 20 is a broad guideline that can assist investors in analyzing the stock market's overall attractiveness. It is not a precise calculation of market value.
It is crucial to note that the rule of 20 is only sometimes correct, as other factors can affect stock market value, such as changes in interest rates, economic indicators, and corporate earnings. Investors should use the rule of 20 as a starting point when making investing selections and performing additional study and analysis.
Selecting Stocks According to Lynch
Peter Lynch believed in picking stocks one by one after thorough research rather than expecting a speculative platform to throw open a list of 'good stocks.' Instead, take one stock at a time and get acquainted with the company and the industry.
He insists on knowing how the company plans to expand, cost pressures, pitfalls, and abilities.
Peter Lynch also kept the following points in mind when selecting stocks:
- First, you are investing in a predictable industry that sudden trends won't easily shake and won't attract much market competition.
- The company is growing convincingly.
- The company has a niche of happy and satisfied customers.
- The company is well-known but not to an extent where all the analysts talk about it.
- If the products are in demand.
- If the company is buying back shares because it shows that the company has a strong cash flow position.
- Over-diversification just for diversifying can land you trouble even more when you are not familiar with that many companies and industries.
Which Stocks to Avoid
Peter Lynch has one of the best books, One Up On Wall Street. In the book, he emphasizes that one should avoid hot stocks.
"If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favourable publicity, the one that every investor hears about in the carpool or on the commuter train – and succumbing to the social pressure, often buys."
This is quite true as the hot stocks might gain that initial publicity from some people, and social media and the internet can act as a catalyst to give them even more publicity. This results in the stock price touching the sky. But it can lose its value quickly once the investors realize that such hot stocks will not grow.
Summary
So that was all about peter Lynch's investing rules. As the manager of the Magellan Fund, Peter Lynch was responsible for creating the P/E ratio and popularizing the buy-what-you-know strategy. For over 13 years, he successfully managed the fund, which returned around 29% annually.
Throughout his career, Lynch has been a respected source of investments. He has attempted to provide a practical approach that retail investors could easily adapt.