Peter Lynch’s Investing Bible

A summary of the insights from one of the greatest investors of all time.

If you don’t know who Peter Lynch is, he was the former manager of the Magellan Fund at Fidelity Investments, starting with a portfolio of 18 million in 1977 and growing it to over $14 billion upon retiring in 1990 and achieving an average annual return 29.2%. I think that in of itself demonstrates his credibility as an investing great, amongst Warren Buffett, Michael Burry, George Soros and others.

Rule #1 — Invest in what you know.

This is one of the insights that resonated most with me when looking into Peter Lynch’s personal investing style.

“People in the restaurant industry are buying biotechnology stocks. The people in the chemical industry are buying oil stocks. People don’t understand their natural advantage.”

Only invest in businesses that you understand inside and out, how their operations work, who their customer is, how they make their money, where they are going to be in ten years. Exploit your unfair advantages over the market in order to outperform the market. And most importantly, be weary of investing in stocks and businesses that you don’t understand. Because in doing so, you increase your risks significantly, and the likelihood of losing your money — or more realistically, failing to maximise your gains.

“People will do some research before they buy a dishwasher. People will invest in a stock they heard about on the bus”

You need to do some research before you buy a stock on its fundamentals, what makes the business great. Don’t act on a whim, act on the basis of deep understanding and deliberately.

Rule #2 — There is no such thing as a stock screener

Individuals should only invest in businesses that they understand and have had exposure to. For example, if you regularly use the google search engine, and have had extensive exposure to the google search engine, you would understand that google is a great business. They generate profit every time we search, and when companies pay google to list ads to rank higher on their search engine. They have an enormous competitive advantage over their rivals, including Bing and Yahoo. But you know this because you have used the google product. You have not applied a stock screener to identify google as a great business.

Rule #3 — There are 6 types of companies

Categorising companies into one of these six different types can be useful as a shareholder. Lynch recommends that you contain the majority of your portfolio from a select few of these six.

Slow growers. These businesses are reliable and grow just faster than US economy, paying consistent dividends to their shareholders. Lynch doesn’t recommend investing in these types of businesses significantly, as their growth rates are typically slower than other types of companies.

Stalwarts. These are the companies with earnings growth rates from 10–12% — usually in established industries but not always. They are not quite fast growers. It is recommended that you rotate these types of businesses in and out of your portfolio when moderate gains are reached.

Fast growers. These are the companies with earnings growth between 20–25% per year. Peter lynch holds a signficant proportion of his portfolio in these companies. However, these companies involve much higher risks than the Stalwarts or the slow growers.

Cyclicals. These are the businesses which fluctuate according to market conditions. Energy companies, mining companies, oil companies, agricultural companies. Valuation for these businesses is more difficult, and they can often by mistaken for Stalwarts.

Turnarounds- these are stocks that have taken severe beatdowns, but may have changing fortunes.

Asset opportunities — the businesses that Wall St have missed or overlooked. Those in which you have unique information not yet known or fully appreciated by the market. These are often the businesses in the industries that you have a deep understanding of. These will be the best opportunities, and your best opportunity to beat Wall St.

Rule #6 — Determining stock prices

Stocks must be purchased at a fair price with a good story (underlying company) — even if the story is good — if the price is too high you will not make money. As such, stocks should be purchased at prices below their ‘fair value’ and with a margin of safety.

Good Indicators of the Fair Value of a Stock.

• Historical earnings. You want to target business with an uptrend in earnings — as earnings will not deviate significantly from long term average. This means that theoretically, they should be producing more money for you as a shareholder the longer you hold the stock.
• The Price to Earnings Ratio is a staple of Lynch as an investor, as a great indicator of stock value. It effectively tells you how much the stock costs relative to how much money the business earns. Stocks which are expensive relative to how much the business earns are not likely to be good investments.
• The ratio of debt to equity is important
• Dividends — you want firms that have payed dividends regularly for 20–30 yrs and firms that have raised their dividend over time. Be wary of firms with volatile dividends, such as short term hikes in dividend yield. This behaviour may prove unsustainable, if the business is not able to grow their profits alongside the dividend.
• Earnings growth — too high is unsustainable — look for slow earnings growth over a long period of time

Rule #7 — What types of companies you should avoid

• Trending stocks in hot industries. These stocks have a tendency to be overvalued, even if they are great businesses. For example, Tesla and Amazon are both businesses that are ‘hot stocks’ in the hottest industry, the technology sector. Even if these business models are great, buying them at too high a price could mean that an investor will not generate a return, or will see losses on their invested capital
• Stocks with large plans that have not yet been proven. Buying businesses such as these means significantly increasing risk, as you are buying them under the assumption that they are able to execute their plan effectively.
• Stocks where one buyer accounts for 25–50% of sales. This is because if this buyer turns to a competitor, or were to stop buying for some other reason, sales would decrease hugely.
• Profitable companies engaged in diversifying acquisitions. Lynch terms this type of behaviour ‘diworsification’. Instead, seek out businesses which are doubling down on their strengths by reinvesting into the current business model, focusing their attention on an already proven, profitable method.

Rule #8 — Favourable stock characteristics

• Firms which produce goods with inelastic demand (alcohol, gambling, razor blades, food items. These firms are typically able to weather the economic downturns and are far less likely to collapse in the medium to long term
• Boring firms, firms in boring industries. These firms are more likely to be undervalued because they get less media attention, and attention from investors. These stocks also typically involve lower risks than with ‘hot stocks in hot industries’. Their business models have been proven to be a reliable method to generate returns for investors over time.
• Insiders are buying shares. If this is the case, is it a good indicator to external investors that the company is heading in a good direction, and will likely generate strong returns over the next
• The Company is buying shares back from current shareholders.
• The company is a spin off

Rule #9 — When to sell a stock

How to know when to sell a stock is vital for managing risk in the long term, by getting rid of underperforming stocks. When something fundamental about the business changes, or the ‘story’ of the business changes as Lynch likes to put it, you should sell the stock. For example, if a core part of why you were investing in a chewing gum company was their environmentally friendly formula, but they decide to switch to a more environmentally harmful production process to cut costs, you may decide to sell the stock. Secondly, you should sell the stock if the reason why you own the stock changes.

Rule #10 — You don’t need to be a Quant.

You don’t need to have attended Harvard. You don’t need a graduate degree in Statistics. In fact, according to Peter Lynch, you only need Year 5 or 6 primary school maths to succeed in the stock market. Lynch conducted an experiment where he got primary school students to analyze the balance sheets of companies in order to identify good opportunities in the market. These students were able to achieve returns of 69% in the market over two years whilst the market returned only 22%, demonstrating how advanced statistical understanding isn’t necessary to succeed.

Conclusion

If we can take anything away from Peter Lynch, it’s that you need to understand what you own.

“If you can’t explain to a ten year old, in two minutes, why you own a stock. You shouldn’t own it”

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