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Invest like the best – how Peter Lynch beat the city

Peter Lynch was a legendary fund manager. We look at his key principles, and how you can apply them to picking investments.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Peter Lynch, American fund manager and author of “One Up on Wall Street”, rose to fame while managing the Fidelity Magellan Fund between 1977 and 1990.

13 years might sound impressive, but it doesn’t scratch the surface of some of the longer-standing managers – Warren Buffett bought his first shares more than 75 years ago.

So what made Lynch stand out? His approach to picking companies and their performance.

While managing the Fidelity Magellan Fund during the period 1977 to 1990, Lynch’s average annual return was over 29%. He managed to grow an initial investment of $1,000 to more than $28,000 without charges. Returns of this nature are exceptional and past performance is not a guide to the future.

Finding “Tenbaggers”

Lynch dubbed the term “tenbagger” for companies that grew their share price ten times over. And those were exactly the kind of hidden gems he was looking for.

Something that separated Lynch from Buffett and Ben Graham was his hunting ground. Lynch was particularly fond of higher-risk but potentially faster-growing smaller companies.

To find companies capable of such massive growth, the tenbaggers, Lynch needed companies that could grow profits quickly. But that alone wouldn’t guarantee success.

Lots of popular companies, those covered by an army of city analysts, are already priced for future growth. That means their share prices already take in to account how quickly everyone thinks they’ll grow. We tend to say these companies have “growth baked in”, or they’re “priced for perfection”. They often don’t have much of a margin of safety, covered in our last article.

Instead, Lynch looked for companies that flew under the radar. Companies with boring names that made money doing boring things. In his book, he mentions one of his favourite investments was a company that simply made womens’ leggings. As a general rule of thumb he avoided any company where the name started with an “X” – they were attention grabbers, not ‘tenbaggers’.

Pink sheets and penny stocks?

While Lynch preferred companies that were smaller and generally growing quickly, he also looked for quality. One of our favourite Lynch quotes is “Time is on your side when you invest in superior companies”.

Remember when you’re buying shares, you’re buying ownership in a business. Lynch said if you can’t explain why you own a company in two minutes or less to a 10-year old, you shouldn’t own it. In contrast, his biggest gripe was when investors would tell him they own something because “the sucker just keeps going up”. We agree.

There’ll be winners and losers

In contrast to how most think about investing, Lynch said he didn’t need to be right more than five times out of 10.

The most you can lose, Lynch said, was 100% of an investment – something he became quite familiar with in his career.

Brilliant companies have the potential to make investors multiple times their initial investment which could help offset any losses if they arise.

The moral here is to invest in a wide range of companies and to run your winners. That is, as long as they still fit with your objectives and attitude to risk.

If we own a mixture of great businesses that cover each other’s weaknesses we can help maximise our chances of investing success, although of course there are no guarantees.

Growth versus value

One of Lynch’s favourite metrics was the PEG ratio. A ratio that takes the normal price-to-earnings ratio and divides it by how quickly the company’s profits are growing. He argues it’s a good sense check on how highly rated a company is – something “priced for perfection” will have a much higher rating. He liked companies trading under 1. Though remember ratios only tell part of the story so should not be looked at in isolation.

Benjamin Graham, on the other hand, was looking for investment bargains, generally based on the assets a company owned. Buffett, Graham and Lynch are all successful investors in their own right, but each of them have a distinct management style.

Lynch acknowledges six main types of investing, or six categories of companies – slow growers, stalwarts, fast growers, cyclicals, turnarounds and asset plays. We think this is a good way to think about diversification.

Take Warren Buffett, arguably the most impressive of the three. Despite owning a wide mix of companies, Buffett’s Berkshire Hathaway has seen its value fall by more than 30% six times between 1979 and 2019. In early 2000 Berkshire lost 44%.

Investing in lots of companies in a similar category can only give you so much insulation when that style goes out of favour. We think one of the best ways of diversifying a portfolio is by investing with the best fund managers, investing differently, in different parts of the world. Remember that all investments fall as well as rise in value, so you could get back less than you invest.

Remember there’s no charge to buy funds with HL. The fund managers choose the underlying investments and do the hard work for you at no extra cost. The HL platform fee (a maximum of 0.45% per annum) and the managers’ ongoing charges apply.

Find out more about how to build your portfolio of expert managers

This article is not personal advice. If you’re unsure if an investment or course of action is right for you, please seek advice. Past performance is not a guide to the future.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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