Using the Peter Lynch Strategy for Retail Investing

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

A man sits in front of a computer thinking seriously about his investments
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U.S. investor Peter Lynch knows how to pick stocks. During his tenure at Fidelity between 1977 and 1990, Lynch pulled off a striking feat. He grew the assets of the Magellan Fund from $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 read by masses of readers who have a thirst for learning about money.

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

Stock Familiarity

If you follow Lynch's work, you may already know this famous mantra.

"Buy what you know."

Doing this can lead you to great retail stocks before Wall Street analysts catch on because you know about certain business niches 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 strategy to the masses through his relatable approach.

Company Size Matters

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

"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. 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 earnings, sales, and profit margins improve.
  • The market undervalues the stock, or its quality is not fully seen.

Great small retailers often fit two of these factors. They have a lot of organic growth potential. Patrons love them because of their personalization, so they can keep expanding for years. They are also not closely watched 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 small number of shares, a small-cap retailer's price can rise quickly.

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

This is not to say that you shouldn't buy large-cap retailers, but rather that you should not expect the same things from them. Home Depot, for example, is a stable company. With over 2,000 stores, its days of rapid growth are few if any.

Also, it has a trailing 12-month price-to-earnings (P/E) ratio of 23.44 as of the summer of 2021. It is overvalued compared to other building product retailers, 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 sense to invest in it. In this case, being richly valued but having limited growth potential is a bad mix.

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

Smaller retailers look good for 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 that get a lot of early publicity. They may see huge growth at the start 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 quite a bit. If you don't know when to sell, you could quickly lose all your profits.

The stock of Peloton, a famous exercise equipment company, is an example. Since so many people simply want to own a Peloton stationary bike, 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 common. Hot industries are always changing. Peloton stock may well soar, but looking at where it will be in the future requires a leap of faith.

If you don't like the idea of making that leap with your money, follow the Peter Lynch investing strategy and pick a stock if it has these things in common.

  • It's in a stable industry that won't change or attract rabid competition.
  • It is growing its earnings at a level that can be sustained (10%–25%). 
  • It has a niche and happy clients.
  • 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 car parts store. The firm flew under the radar of Wall Street analysts for years.

It's been in a sneaky growth industry. Many people in the U.S. drive older cars and have a need to buy parts to fix them up, so it leads that industry. This industry hasn't seen big headwinds, so earnings have been easier to predict. It has a trailing 12-month P/E of 25.70 as of mid-2021.

As a result, it now has a niche in the market. Advance Auto Parts reports steady earnings and has a stable and simple business model. While nobody would expect greatness from this stock based on earnings per share (EPS)—it grew by 10.97% from fall 2019 to fall 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 new stars of stocks.

Soon, Advance Auto Parts may reach the point of market saturation similar to Home Depot. Over time, 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.

Using Advice From the Legend

While you can't expect to match Peter Lynch's performance, you can improve your stock-picking abilities using his 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 through your investment time horizon. 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 largest 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.