Peter Lynch Strategy And Portfolio
Last Updated on April 18, 2023
Peter Lynch is a famous but retired money manager. Lynch managed the Magellan Fund of Fidelity from 1977 to 1990 with outstanding returns: more than double the S&P 500’s return. Lynch made 29.2% annual returns for his investors and retired at his peak in 1990.
He was a proponent of value investing, but is perhaps more famous for his slogans of “invest in what you know” and “ten baggers”. To better understand his investing philosophy, we recommend his book from 1989 called One Up On Wall Street.
In this article, we write about his childhood, education, strategy, investment philosophy, and what kind of companies he liked and disliked.
Let’s get going:
Peter Lynch’s childhood and early life
Peter Lynch was born on January 19, 1944, and spent his childhood in Boston and Massachusetts. His childhood years until 1960 were the greatest growth period for stocks in history, although most investors remained negatively related to the market because of the memories from the Great Depression.
Peter’s father died when he was 11, and his mother had to get a job. Wanting to help her somehow, Peter decided also to find a job. He became a caddy – the boy who carries balls and golf clubs. And this, in fact, was the starting point in his career. Peter got into the elite Brae Burn golf club, and his clients were the presidents and directors of large corporations: Gillette, Polaroid, and, most importantly, Fidelity Magellan. By helping George Sullivan find the golf balls and carrying his clubs, he was helping himself find a future job.
Peter was constantly surrounded by successful people and heard talk of market tactics and investment strategies. This period contributed to the early formation of his investment strategy.
The money Peter Lynch received at the golf club, he spent on college education, and in 1963, in his second year, he bought stocks for the first time – Flying Tiger Airlines for $7. Within two years, the stocks rose to $32, and Peter sold them and could pay part of his tuition at Wharton Business School.
His first successful steps in investing strengthened his faith in the stock market, and the next important step in Peter’s life was a summer internship at Fidelity Magellan in 1966. He was accepted, mainly thanks to the recommendations of George Sullivan.
How Peter Lynch managed the Magellan Fund
In 1969, after completing his military training and service, Peter Lynch returned to Fidelity Magellan as a staff member and securities analyst. His career developed rapidly: in June 1974, he was promoted and moved from assistant to analytical department director, and in May 1977 assumed leadership of the Fidelity Magellan Foundation.
At the time of taking office, the value of the assets of the Fidelity Magellan fund was a meager $20 million. The fund’s portfolio included stocks of only 40 companies. The fund’s philosophy was conservative – carefully picking a small number of undervalued stocks. Peter Lynch made the fund more flexible, expanded the geography of buying stocks and bonds, and did not focus on buying only American assets. During the 12 years that he managed the fund, the portfolio’s value increased more than 20 times. Growth drivers were little-known companies found and analyzed by Peter Lynch.
The fund has become one of the most efficient in America. During Peter’s career, he has only failed to outperform the S&P 500 twice. The average annual return of Fidelity Magellan reached 29%, which is 15 percentage points more than the return of the S&P 500. The dynamics of the fund’s return to the index can be seen on the chart:
Over his tenure, Peter Lynch increased the value of Fidelity Magellan to $14 billion. The fund included 1 200 companies when he retired in May 1990 at the age of 43.
Peter Lynch investment methods and strategy
Invest in what you understand.
This quote by Peter Lynch is at the heart of his investment strategy. He invested in companies whose business was clear to him. He never chased trends but looked for undervalued companies that large investors had not yet paid attention to.
Peter Lynch did not try to predict the movements of the markets, the state of the economy, and did not pay attention to short-term price fluctuations. For him, fundamental indicators of the company, companies with promising products and services, were always paramount.
At the same time, each person, having basic knowledge and investing methods, can find exciting companies at work, not far from home. Peter Lynch has always believed that amateur investors are more likely to beat the big investment companies and the markets in general. During his career, he formed an investment approach to how to pick stocks. Let’s talk about this in more detail.
How Peter Lynch making preliminary investment analysis
Investing without research is like playing stud poker without looking at the cards.
This Peter Lynch quotes is the cornerstone of his investment process. Of course, what investment strategy is complete without company analysis?
For Peter Lynch, the first step in analysis has always been to determine the company’s market share. He believed that the results an investor can get largely depend on the size of the companies. Large companies such as Walmart, Boeing, etc., will not give a rapid increase in capital and certainly will not double their value (unless you wait a long time).
Let’s look at the market value of Walmart stocks. Stocks are up 97.68% from 2013 to 2023, while the S&P 500 is up 217.95%:
Yes, at specific points in a market decline, you can buy stocks at reasonable prices, but you should not expect them to grow tenfold, or become a ten-bagger, as Peter Lynch would say. His strategy was looking for small companies with quality products that were undervalued by the market and could show significant growth in the long run.
Apple is a prime example of such a company. Initially, a small company that was a niche computer company, it has shown an impressive share appreciation of 852.82% over the past ten years. And such growth is more interesting, isn’t it?
How Peter Lynch categorized companies
The next step in Peter Lynch’s analysis of a company is to assign it to one of six categories:
- Slowly growing;
- Moderately growing;
- Fast growing;
- Cyclical company;
- Coming out of the crisis;
- Having undervalued assets.
Let’s take a closer look at each of these groups.
A striking example of such a company is, for example, Coca-Cola and Walmart. The soft drinks and retail trade market is divided and mature, there is not much growth, and the share price of such companies and revenues are growing slowly.
Such companies are in every industry. Typically, the growth dynamics of a particular industry coincide with the growth dynamics of such companies. These companies earn stable incomes and pay regular and generous dividends to their investors. Essentially, you are purchasing a fixed-payment bond.
This group includes multi-billion dollar companies with stable growth. They are more flexible, constantly looking for product development, and are not yet at their peak in the industry.
An example is Mcdonald’s (MCD). They bring in a steady income. Peter Lynch has always kept these companies in Fidelity Magellan’s portfolio because they provide good protection during downturns and economic hardships.
The companies in this group have always been Peter Lynch’s target: small caps with excellent products, sound balance sheets, and good profit margins.
A rapidly growing company does not necessarily belong to a fast-growing industry. It can also appear in a slow-growing industry. Examples of such companies (for Peter Lynch) were Taco Bells in the fast food sector, Walmart in the department store sector, and Gap in the clothing retail sector (remember, this was in the 1980s). Thanks to their business models, these companies have shown explosive growth in their share price.
However, in addition to all the advantages, fast-growing companies have many risks, especially young companies, such as the risk of “unproven” business model, the risk of management mistakes, and, as a result, a loss of investor interest.
For such companies, financial indicators rise and fall depending on the market phase. When the economy is emerging from a recession and recovering, cyclical companies appreciate quickly, and their share prices rise much faster than moderately growing companies. This is understandable since, in a strong economy, demand for these companies’ products is increasing. When the market falls, cyclical stocks fall with it.
Cyclical companies might include General Motors, US Steel, oil stocks, etc.
Coming out of the crisis
Companies that have experienced strong shocks and might be declining are the riskiest of all investment options.
Forming an in-depth analysis of such companies is essential because you can lose a lot if you get it wrong. Investing in them at the recovery stage means that such companies will catch up very quickly if management manages to turn around the company. Chrysler, Ford, Penn Central, General Public Utilities, and many others are examples.
The most pleasant thing about investing in stocks of companies that have successfully overcome a crisis is that their ups and downs are the least dependent on the general market conditions. Peter Lynch saw the potential in Chrysler’s bankruptcy and began buying in early 1982 at $6. Subsequently, in less than two years, they increased fivefold and fifteenfold in five years.
Having undervalued assets
This category includes companies with a potential value that is unknown to the market or the market doesn’t understand the potential. These are essentially nuggets, uncut diamonds. Often these companies are traded over-the-counter markets (OTC), small companies that no one has heard of, but with large land plots or patents for interesting inventions or scientific discoveries. Burlington Santa Fe (BNSF) is such an example when Berkshire Hathaway bought it.
Which companies does Peter Lynch like?
Peter Lynch has always liked simple companies with clear business models and products – businesses that anyone can understand. He formed the following signs of a good company:
- Boring name. In his opinion, companies with boring, simple names are great. An example of such a company is Bob Evans Farms Inc (BOBE) in the translation “Bob Evans Restaurants”, an American restaurant chain. Very often, such companies are overlooked only due to their name.
- Boring activities. Boring and simple activities ensure that most investors will not notice this company despite its strong business model (or growing profits). It will be bought up when the company becomes fashionable and shows good results.
- “Crazy” activities. At the time, an example of such a company was Safety-Kleen. They offered car repair installations for washing dirty parts, and few people wanted to get involved in this business. But despite this, the company’s profits and share price grew and developed in other directions.
- A spin-off business. A spin-off usually has a strong balance sheet and can operate better as an independent company. Independence frees up management resources, which further can cut costs and increase innovation and ways to increase profits, both in the short and long term. Read here for why spin-offs outperform.
- Lack of interest from major investors and analysts. If such companies have excellent earnings, sales performance, and growth potential, it might indicate they are overlooked if institutional ownership is low (and the share price is not overbought). Many of these can be bought at reasonable prices.
- Not a growing industry. Peter Lynch was a conservative investor. When choosing between a rapidly growing industry and a non-growing one, he chose the latter and found companies that optimized their costs, increased market share, and, as a result, showed growth.
- Companies with their “own” niche. Such companies might have an absence of competitors. They specialize in niche markets and have patents for unique products.
- A product that is constantly bought. Unlike those that produce durable products, companies that produce consumer products have stable growth and development. For example, the automotive industry is more subject to fluctuations than meat producers.
- Technology users. Peter Lynch believed that instead of investing in computer companies struggling to survive an endless price war, it is better to invest in a company that benefits from a price war, such as Automatic Data Processing. The company had the advantage of low equipment prices for its activities, thus earning more profit.
- Companies that insiders buy. According to Peter Lynch, there is no better evidence of a company’s prospects than the money that employees of the company invest in them.
- Repurchase of shares (buyback). This is the easiest and best way to reward investors. Buybacks reduce the number of shares outstanding, and with the company’s earnings unchanged, earnings per share increase, and as a result, their share price grows.
Which companies Peter Lynch dislikes
In addition to the criteria for good companies, Peter Lynch formed the criteria for companies that he passed. These are:
- Popular stocks (today “meme” stocks?), often with a rapid increase in the share price without any fundamental reason.
- Companies that call themselves “second”. For example, the second IBM, the second McDonald’s, etc.
- Companies that rush into diversification, spending money on pointless lines of business.
- Companies going up due to rumors and anticipations.
- Companies that focus on one or more customers.
- Companies with catchy names.
How Peter Lynch does fundamental analysis of companies
The next step is to analyze the company’s fundamental indicators. How did he read and analyze the company’s financial statements? Peter Lynch proposed to explore the following set of fundamental indicators:
- P/E ratio (price/earnings). This ratio characterizes the relationship between the stock price and the company’s profit. It helps to understand if a stock is overvalued or undervalued relative to the company’s earnings. This coefficient also shows how long the initial investment will pay off, provided that the profit does not change, i.e. if the P/E is 15, then your investment will pay off in 15 years.
- PEG ratio. Of no minor importance, Peter Lynch compared the P/E ratio with the growth rate of the company’s profit. This ratio is calculated as the P/E ratio to the average actual profit of the company over the past 5 years. Its optimal value is below 1. For example, a company with a P/E of 15 should grow by an average of 15% per year. If the P/E is below the company’s growth rate, then its stock is a good find for an investor. Thus, a company with an average growth rate of 12% per year and a P/E of 6 is a very attractive investment. Conversely, a company with an average growth rate of 6% per annum and a P/E of 12 is unattractive and might be on the verge of decline.
- Company sales structure. This indicator helps to understand where the company’s revenue comes from. At the same time, it is essential to know what percentage is occupied by promising or growing businesses of the company. Also, the revenue structure helps the investor to understand how diversified the company’s sales are. For example, AstraZeneca plc operates in seven areas of medicine and has a wide range of medicines. Sales diversification reduces the company’s risks in crises or recessions. With a decrease in revenue in one of the areas, the company can compensate for it in others.
- Cash on the company’s balance sheet indicates its ability to pay off short-term debts, i.e., characterize the company’s liquidity. The more cash on the company’s accounts in relation to short-term debt, the more liquid the company is.
- The leverage ratio. What are the leverage and borrowings, and how much equity does it have? Debt versus equity. For Peter Lynch, the optimal ratio was 75% equity and 25% debt. With such a balance sheet, the company is less dependent on creditors and more stable during crises or recessions.
- Dividends. Peter Lynch most often preferred companies that do not pay dividends because such companies reinvest their profits in the company’s development, thus increasing the company’s value. Lynch was always looking for companies with aggressive growth policies, not boring, and consistently paying dividends. Please read why dividends do nothing for shareholders.
- Cash flow is the amount of money a company receives from its activities. It is essential to use free cash flow in calculations. Free cash flow is funds that remain after subtracting all costs and outlays, and Peter Lynch often used this indicator to value companies. For example, a $20 stock with an annual cash flow of $2 per share has a ratio of 10 to 1. This 10% cash flow return corresponds to the minimum expected return on stocks over the long term. For example, $20 stocks with $4 cash flow per share deliver an impressive 20% return.
- Inventories. When analyzing a company, it is imperative to look at the dynamics of inventories. Growth of the inventory in manufacturing or retail companies is usually a bad sign. If a company reports a 10% increase in sales but a 30% increase in inventory, this might indicate a problem. Later, it might need to shed prices to get rid of the increased inventory. Otherwise, the company will face problems next year, even more so the year after. The new products will compete with the old ones, and as a result, inventory will grow so much that the company will have to reduce prices drastically, hence profits. On the other hand, if a company’s inventory in crisis begins to decline, this is the first sign of recovery.
- Growth rate. According to Peter Lynch, the key to the success of every company lies in the ability to increase profits by reducing costs and raising prices. The most important indicator for him was the profit and its growth rate. A company with a 20% earnings growth rate and a P/E of 20 is a much better acquisition than a 10% earnings growth rate and a P/E of 10. See how the gap widens between these 20% and 10% growth companies with initial earnings of 1 dollar per share:
|Year||Company A||Company B|
Even if Company A’s P/E ratio fell from 20 to 15 due to investors’ doubts about its ability to maintain a high growth rate, it would still trade above
Company B. After ten years, Company A has a share price of 77.4 with a P/E of 15, and Company B is at 23.6 with a P/E of 10. Even if Company B has a P/E of 15, it’s still only worth 35.4.
How Peter Lynch formed his investment portfolio
How many stocks should you hold in a portfolio?
Peter Lynch owned all the major stock categories listed earlier in the article. However, he mainly focused on growth stocks, which accounted for 30% to 40% of the fund’s assets, while the rest of the holdings were distributed among stocks of other categories: 10-20% of moderately growing companies (to increase the stability of the portfolio), 10-20% in cyclical companies, and the rest in companies emerging from “crisis” (turnarounds).
Very importantly, 1% of the funds were always invested in 500 minor (potential) companies. Peter Lynch constantly monitored each stock in the portfolio to find the best moment to increase or decrease the number of shares.
Even though Lynch was a supporter of long-term investment, and market and price fluctuations were not important indicators for him, all companies in the fund’s portfolio were reviewed every three months. Earnings reports were analyzed, and studies were carried out on the future prospects of the companies.
If necessary, the portfolio was rebalanced, while Peter never left cash in the portfolio. He was not a market timer, and going into cash meant “leaving the stock market”. He aimed to always stay in the market and adjust the portfolio’s allocations depending on fundamental indicators.
When did Peter Lynch sell a stock?
He always relied on the relationship between price movement and fundamentals when selling companies. If the share price of a moderately growing company soared by 40% while nothing fundamentally changed, then Lynch sold or reduced the allocation and replaced it with another moderately growing company.
He kept fast-growing companies as long as their profits increased, they continued to expand, or he saw no immediate threats to their business. If a stock grew by 50%, but the fundamentals became questionable, he sold it. The same principle was applied to cyclical companies and companies emerging from a crisis (turnarounds).
If the share price of strong companies fell while the fundamental indicators were typical or grew, Peter Lynch always increased their share in the portfolio.
If you don’t convince yourself that “a 25% drop is a buy signal” and get rid of the pernicious idea that “a 25% drop is a sell signal,” then you will never make a decent profit from stocks.
Peter Lynch strategy and portfolio – Conclusion
Peter Lynch’s strategy was extremely effective for the Magellan Fund and proven via its spectacular performance. He never tried to predict the market movements; he believed in promising companies that had shown growth and were not overpriced.
All the methods described above help us to understand how to find such companies. Even better, by reading about Lynch, we get to understand the mindset of one of the most outstanding investors of all times.
However, we also have to take into account that Peter Lynch had at his disposal access to vast analytical resources at Fidelity and the ability to communicate directly with the management of companies he researched.
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