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$14 million to $18 billion.

Lynch went on to become 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.

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. If you're a follower of Lynch's work, you may already know that his famous mantra to "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.

But this is just one of many Peter Lynch quotes that can help hone your investing chops.

"Big Companies Have Small Moves; Small Companies Have Big Moves."

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. 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 often expand for years. They are also not heavily followed by analysts, so the chances of them being undervalued are 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 do start to scoop up the relatively small number of shares, the price of a small-cap retailer 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 solid 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 21.49 as of January 2020; it is overvalued compared to other retailers that specialize in building products, which have an average P/E of 14.08.

In other words, if Home Depot had more room to grow or a more reasonable valuation, it would make a fine 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.

"If I Could Avoid a Single Stock, It Would Be the Hottest Stock in the Hottest Industry."

Hot stocks in hot industries are defined by Lynch in One Up On Wall Street as those that receive 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. Also, competitors looking to cash in on the novelty of a hot product 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 easily lose all your profits.

The stock of Peloton, a popular exercise equipment company, is an example. Since everyone has to have one of the company's stationary bicycles, any miscue could send shares tumbling. Bulls may predict great things from new products and services that the company doesn't yet derive profit from today. It 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 with 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 20.62 as of January 2020.

As a result, it now has a niche, steady earnings, and a simple and predictable business model. While nobody would expect greatness from this stock, based on earnings per share (EPS), it grew by 11.50% over the year ending in December 2019, compared with 7.52% for the S&P 500. It is estimated to grow by 10.80% over the next five years.

At some point soon, Advance Auto Parts may reach the point of market saturation like the aforementioned 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 it.

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

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 greatest upside.

At the time this article was written, the author did not own shares of the companies mentioned and had no plans to buy them within the next three days.

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.