Peter Lynch Strategy That Will Make You a Better Investor

Lynch's strategy is well suited for retail investors.

Peter Lynch
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Through his bestselling books One up On Wall Street and Learn to Earn, Peter Lynch taught his investment strategy to the masses. You already know that Lynch's "buy what you know" philosophy can lead you to great retail stocks before Wall Street catches on. But "buy what you know" is just "step one;" it will lead you to the stocks that warrant further research. You still must analyze the stock from there.

 

Here are two other pearls of wisdom from Peter Lynch that will help you pick great retail stocks

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

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 companies performance (earnings, sales, profit margins, etc.) improves.
  • The market has badly undervalued the stock, or its quality is not fully appreciated. 

Great, small, retailers often fit two of these categories. If they can grow organically and customers love them, they will expand for years. They are also not heavily followed by analysts, so the chances of them being under appreciated are high.

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

I'm not saying you shouldn't buy large-cap retailers; I'm simply saying you should have different expectations for them.

Take Home Depot for example. It's a terrific company, but with over 2,000 stores its days of rapid growth are likely over. Which would be fine but it currently has a price to earnings (P/E) 22, which means it is priced for growth.

In other words, if Home Depot had more room to grow or a more reasonable valuation, it could make a fine investment. However, being richly valued with limited growth opportunities is a bad combination. You have to know what category your stocks fall into (value plays, dividend payers, fast growers, etc.) so that you can know what to expect out of them, and so you know when their valuation is "too rich."

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

Hot stocks, in hot industries, are often too hot to handle. Valuing a stock like Amazon.com is nearly impossible. Since everyone has to have it, perfection is priced into its current valuation. Any miscue could send shares tumbling. Part of the reason shares haven't tumbled yet, is because bulls are predicting great things from new products and services (cloud, streaming, etc.) that don't generate much profit today. This is not uncommon; hot industries are always changing.

Amazon.com may very well continue to soar, but analyzing where it will be in the future takes a leap of faith. 

If you don't feel comfortable making that leap, you may prefer a stock with these "Lynch approved" characteristics.

  • It's in a dull, predictable, industry that won't change or draw in rabid competition.
  • It is growing earnings at a sustainable level (15-25%). 
  • It has a niche and delighted customers.
  • It is off the radar. You won't hear many analyst bragging about recommending it, and no one at a cocktail party is going to tell you it's their hot stock pick. 

A great example of this type of stock is Advance Auto Parts.

It has a niche, steady earnings, and a simple and predictable business model. While nobody would expect greatness from this stock, its earnings rose about 20% annually over a five year. Steady earnings, lead to exceptional results; the stock went up over 200% in the five years (vs. 78% for the S&P 500). 

At some point soon, Advance may reach the point of market saturation like the aforementioned Home Depot. Eventually both stocks P/E's will slide and they will be on my radar as value plays. Every retailer is at a different point in its growth cycle, and each one could be a good investment at the right price.

The best winners will be the next Advance Auto Parts. Luckily, if you remember these rules, you can find them. Advance flew under Wall Streets radar for years. Along the way, it always had room to grow, steady earnings, and a great niche. It's been in a sneaky growth industry, American's are driving older cars and fixing them up, and it has dominated that industry. Most importantly, its industry has never been under significant headwinds or changes, so earnings have been easier to predict.

Learn from the Legend

While you can't expect to match Peter Lynch's performance, he accumulated a 29.2% annual return for 13 years, you can learn from his strategy. The wisdom behind these quotes can help you pick great retail stocks for years to come. 

Disclosure: I do not own any of the stocks mentioned in this article and have no plans to buy shares in the next 72 hours. Never buy any of the stocks mentioned here (or anywhere else) without doing your own research.