When it comes to true investing legends, Peter Lynch is in a league of his own.
The former head of Fidelity’s flagship Magellan Fund produced an annualized rate of return of 29.2% over his 13-year stint at the helm. This track record secured his place as the best mutual fund manager of all time.
So how did he do it? It’s not as complicated as you think.
In his best-selling book, “One Up On Wall Street,” Lynch revealed a powerful charting tool that greatly simplified his investment decisions.
Deemed the “Peter Lynch chart,” this simple graph plots the stock price against its “earnings line,” a theoretical price equal to 15 times the earnings per share.
When a stock traded well below it, he would buy. When it rose above it, he would sell.
Not exactly rocket science, is it?
The idea behind this technique is simple. Lynch (and most other successful money managers) believe that mature, stable companies are worth roughly 15 times their annual earnings. And over the last 135 years, this has proven to be the mean valuation of the S&P 500 index.
This is known as the P/E ratio. It is merely the price of the stock divided by its earnings per share. The resulting multiple represents how many times you are paying for last year’s earnings at today’s stock price.
All things being equal, the lower the number the better. Low P/E ratios mean that you are getting more earnings for your investment dollar. And since most large cap stocks eventually trade for at least 15 times earnings, you are more likely to see your shares appreciate as they return to the 15 P/E level.
This simple idea was the basis of Lynch’s investment approach and the reason he created his now famous chart.
The chart consists of only two lines. The first is the stock price. The second is the hypothetical stock price if it were to trade at a P/E of 15 (the earnings line). As Peter Lynch explained:
“A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies – such as Shoney’s, The Limited, or Marriott – when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well.”
Take Apple (AAPL) for example. The Peter Lynch chart below shows a 10-year history of the stock price and the earnings line.
(Image courtesy of GuruFocus, LLC)
Most investors who bought the stock when it was trading above its earnings line experienced very small gains or even short-term losses. However, buying Apple at any price below the earnings line led to sizable gains.
The same pattern can be found with almost any familiar U.S. stock. Oracle (ORCL) and Wal-Mart (WMT) are shown below:
(Image courtesy of GuruFocus, LLC)
(Image courtesy of GuruFocus, LLC)
Even Wal-Mart, thought to be one of the safest blue chips on the Street, suffered a severe correction after the stock price climbed too far past the Peter Lynch earnings line.
It is a well-known fact among investors that price follows earnings. Over multi-year periods, stock prices move in sync with changing company earnings.
But over the short term, stock prices are unpredictable. This creates valuable opportunities for savvy investors and makes the Peter Lynch chart a valuable resource. Using the chart on any of the stocks above would have produced some very impressive gains.
One of the reasons I like Lynch so much is that he did what very few top money managers have; he made a real effort to teach everyday investors the secrets to his success.
His simple approach to investing is refreshing in a world of trading algorithms and inside tips. In his other book, Beating the Street, Lynch shared what he called his “Golden Rules” for investing.
Peter Lynch’s Golden Rules for Investing:
- You have to know what you own, and why you own it.
- Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets. Always look at the balance sheet to see if a company is solvent before you risk your money on it.
- Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether.
- Your investor’s edge is not something you get from Wall Street experts. It’s something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.
- Over the past three decades, the stock market has come to be dominated by a herd of professional investors. Contrary to popular belief, this makes it easier for the amateur investor. You can beat the market by ignoring the herd.
- Often, there is no correlation between success of a company’s operations and the success of its stock over a few months or even years. In the long term, there is 100% correlation between the success of the company and the success of the stock. This disparity is the key to making money; it pays to be patient and to own successful companies.
- Long shots almost always miss the mark.
- Owning stock is like having children – don’t get involved with more than you can handle. The part-time stock picker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don’t have to be more than five companies in the portfolio at any one time.
- If you can’t find any companies that you think are attractive, put your money in the bank until you discover some.
- Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets.
- Avoid hot stocks in hot companies. Great companies in cold, non-growth industries are consistent big winners.
- With small companies, you’re better off to wait until they turn a profit before you invest.
- If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over time if you’re patient. You only need to find a few good stocks to make a lifetime of investing worthwhile.
- In every industry and every region, the observant amateur can find great growth companies long before the professionals have discovered them.
- A stock-market decline is as routine as a January blizzard in Colorado. If you’re prepared, it can’t hurt you. A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.
- There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.
- Nobody can predict the interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what‘s actually happening to the companies in which you’ve invested.
- If you study 10 companies, you’ll find one for which the story is better than expected. If you study 50, you’ll find five. There are always pleasant surprises to be found in the stock market – companies whose achievements are being overlooked on Wall Street.
- If you don’t study any companies, you have the same chance of success buying stocks as you do in a poker game if you bet without looking at your cards.
- Time is on your side when you own shares of superior companies. You can afford to be patient – even if you missed Walmart in the first five years, it was a great stock to own in the next five years. Time is against you when you own options.
So what else can you learn from Lynch?
If you like small caps and little-known growth stocks…a lot. Peter Lynch was the king of penny stocks.
He produced single stock gains of over 1,000% – dozens of times.
What made him different than the average at-home stock picker was his discipline. He applied strict value requirements even to small growth companies. He was sort of a growth/value hybrid, and he completely changed the game.
Lynch would have been an ideal manager to piggyback his ideas. Unfortunately, he retired 25 years ago. But his wisdom was passed on to the next generation, and top hedge fund managers continue to apply his tactics.
This is why I began publishing the 13F Insider Report – a monthly publication highlighting the top, high-conviction trades of investing icons like Warren Buffett, Carl Icahn and George Soros.
I like to think about it like this. Let’s say you’re at a fish camp with a ten-fish limit. You can’t throw anything back. The first ten fish you catch are all that you can keep.
The fishing guide gives you two options. The first is to fish from the camp’s large pond. The pond contains thousands of fish of all breeds and sizes. There are beautiful, 10-pound large mouth bass but also 8-ounce trash fish you wouldn’t feed to your dog. What you reel in is essentially luck of the draw.
Option two is to fish from a much smaller pond where the fish were hand-selected by top anglers. It only contains around a hundred fish, but each are though to be of the highest quality by local experts.
Unless you’re a sucker for a longshot, odds are you’re going to take option 2. This is the premise behind the 13F Insider Report. Why pick and choose from thousands of investment options when you can simply cherry pick your favorites from the portfolios of elite money managers?
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About the author
Ross is the chief analyst and writer for Wealth Empire. He advises subscribers on traditional and alternative wealth-building strategies. His service, the 13F Insider, tracks the trading activity of top hedge fund managers in order to find high-conviction investment opportunities. He is also a former broker, advisor and educator in the financial markets