Using the Peter Lynch Strategy for Retail Investing

Pick retail stocks like a pro with these quotes from the investing guru.

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If anyone knows how to pick stocks, it's American investor Peter Lynch. During his tenure at Fidelity between 1977 and 1990, Lynch pulled off an astonishing feat. He grew the assets of the Magellan Fund from US$18 million to $14 billion.

Lynch became an icon of investing, both as a mentor to stock analysts at Fidelity and as an author of investment guide books consumed by masses of money-minded readers.

Here are some of the more famous lines from his writings.

Stock Familiarity

If you're a follower of Lynch's work, you may already know this famous mantra.

"Buy what you know."

It can lead you to great retail stocks before Wall Street analysts catch on because you have more intimate knowledge of the business niche than an outsider.

Through his bestselling books One Up On Wall Street: How to Use What You Already Know to Make Money in the Market and Learn to Earn, Peter Lynch taught his successful investing strategy to the masses through his characteristically accessible approach.

Company Size Matters

Peter Lynch's quote from One Up On Wall Street stipulates that small retailers are generally better stock picks than large ones because they have more to gain. Each stock you own represents a share of ownership in a real business.

"Big companies have small moves; small companies have big moves."

The market has already deemed what that company is worth via its current stock price. Therefore, if you expect the company to rise in value, one of three things must happen:

  • The company expands—for retailers, this is preferably done through organic sales and store growth.
  • The company's performance (earnings, sales, and profit margins, for example) improves.
  • The market undervalues the stock, or its quality is not fully appreciated. 

Great small retailers often fit two of these criteria. They have a lot of organic growth potential, and customers love them because of their personalization, so they can continually expand for years. They are also not heavily followed by analysts, so the chance of undervaluation is high.

Institutional investors often avoid small-cap stocks for years because they can't buy enough shares to impact their bottom line. When they finally start to scoop up the relatively small number of shares, a small-cap retailer's price can rise suddenly.

Following this Peter Lynch investing strategy, it may be worthwhile to pick the "Davids" over the "Goliaths" of retail.

It is not to say that you shouldn't buy large-cap retailers, but rather that you should have different expectations for them. Home Depot, for example, is a dependable company, but with over 2,000 stores, its days of rapid growth are likely numbered.

Also, it has a trailing 12-month price-to-earnings (P/E) ratio of 23.28 as of January 2021. It is overvalued compared to other retailers specializing in building products, which have an average P/E of 18.52 for 2021.

In other words, if Home Depot had more room to grow or a more reasonable valuation, it would make a good investment. However, being richly valued but possessing limited growth potential is a bad combination.

You have to know what category your stocks fall into (value plays, dividend payers, or fast growers, for example) so that you know what to expect from them and can recognize when their valuation is "too rich."​

Smaller retailers are appealing stock buys because of their unseen growth potential.

On Avoiding a Stock

Hot stocks in hot industries are defined by Lynch in One Up On Wall Street as those receiving a lot of early publicity. They may experience explosive growth initially but burn out quickly as investors realize that they do not have the earnings, profits, or growth potential to back the buzz.

"If I could avoid a single stock, it would be the hottest stock in the hottest industry."

Also, competitors looking to cash in on a hot product's novelty will eventually enter the market with a copycat version and deflate the original company's stock value. When the price falls, it can often fall dramatically, so if you don't have the experience to sell, you could quickly lose all your profits.

The stock of Peloton, a popular exercise equipment company, is an example. Since everyone simply has to have one of the company's stationary bicycles, any mistake on its part could send shares tumbling.

Bulls (investors with a positive outlook on a stock) may predict great things from new products and services that the company doesn't yet derive profit from today.

This is not uncommon; hot industries are always changing. Peloton stock may well soar, but analyzing where it will be in the future requires a leap of faith.

If you don't feel comfortable making that leap with your money, follow the Peter Lynch investing strategy and pick a stock provided it has these characteristics:

  • It's in a predictable industry that won't change or attract rabid competition.
  • It is growing its earnings at a sustainable level (10%–25%). 
  • It has a niche and delighted customers.
  • It is under the radar. You won't hear many analysts bragging about it.

A great example of a stock that fits the bill is Advance Auto Parts, an aftermarket automotive parts provider. The firm flew under the radar of Wall Street analysts for years.

It's been in a sneaky growth industry, as many Americans drive older cars and have a need to buy parts to fix them up, so it has dominated that industry. Most importantly, its industry hasn't experienced significant headwinds, so earnings have been easier to predict. It has a trailing 12-month P/E of 24.76 as of January 2021.

As a result, it now has a niche in the market. Advance Auto Parts experiences steady earnings and has a predictable and straightforward business model. While nobody would expect greatness from this stock—based on earnings per share (EPS)—it grew by 10.97% from September 2019 to September 2020. Compare this with negative growth in the EPS for the S&P 500 over the same time frame to see the difference.

Predictable stocks with stellar financials often win out over the unproven superstars of stocks.

Soon, Advance Auto Parts may reach the point of market saturation similar to Home Depot. Eventually, both stock's P/E ratios will slide. Every retailer is at a different point in its growth cycle, and each one could be a good investment at the right price. The winners will be the next Advance Auto Parts; if you remember these rules, you can find them.

Applying Advice From the Legend

While you can't expect to match Peter Lynch's performance, you can improve your stock-picking abilities using his investment strategies. The wisdom behind Peter Lynch's quotes can help you pick great retail stocks that could be from small or predictable companies ignored by Wall Street analysts but may well reward you throughout your investment time horizon. But you still have to do your research and factor in both the financials and your instinct to choose the stocks that you think have the most significant upside.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.