Few investors have performed as well as Fidelity’s Peter Lynch. The average investor looking for key insights into the Peter Lynch investment strategy for success would have few better options than the great book from the man himself, entitled Beating the Street.
Inside this bestselling investing classic, Lynch shared what he called his “25 Golden Rules” as a summary to the major lessons and insights he had over his legendary 13 years managing Magellan.
Before we get into some of those, let’s review some quick highlights from Lynch’s illustrious stock picking career:
- $1,000 in the Magellan Fund in 1977 would be worth $28,000 by Peter Lynch’s retirement in 1990.
- In the first year of operation, Lynch’s portfolio had 41 stocks and a turnover rate of 343%.
- By 1983, the portfolio swelled to 900 stocks, though 90% of the portfolio was concentrated in 200 stocks.
- The number of stocks in the Magellan Fund reached as high as 1,400.
- The stock which made the fund the most money was Fannie Mae, a 5% position which quadrupled in 2 years.
- Lynch had many “10 baggers”, a term he coined to describe a stock which reached a 10x multiple of its original value.
Despite Lynch’s diabolic work ethic and massive trading activity, he stresses in Beating the Street that the average investor can do very well for themselves in the stock market, even just part-time, by sticking to a few well-known companies and managing a prudent investment strategy.
At the end of the book Lynch shares a chapter called “25 Golden Rules”; let’s look at a few with some additional comments on my end, which can hopefully point you in a direction to learn more and apply it to your own strategy.
- “Your investor’s edge is not something you get from Wall Street. 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.”
This is probably the most central thesis to Peter Lynch’s book. With all of the activity and attention to the thousands of businesses on Wall Street, there are bound to be a few where you might have a more intimate knowledge than the average investor.
Warren Buffett has famously referred to this as a circle of competence, and it can come from your own personal work experiences, your interests or passions, or the research you decide to embark on.
What’s great about the stock market is that anybody can play; you can make great returns on your investment whether you investigate stocks for a living or happen to observe a business that has all cylinders clicking.
By staying humble and sticking to what you know, you can do very well for yourself simply by avoiding mistakes of commission, or as Buffett’s partner Charlie Munger likes to put it,
It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.
- “Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.”
What is Wall Street’s loss can be the average investors gain, and the fact that investors are not bound to hit certain performance metrics by certain time periods can give that edge over the average active manager.
Though many people try, no one can reliably guess the direction of individual stocks or even the stock market as a whole.
The best that we can hope for is to partner up with great businesses and let the incredible power of compound interest do its work.
Outside of what’s maybe the common belief—what makes the stock market such a great place to build wealth is not that its prices swing so violently up and down, but that it provides a place for anyone to accumulate part ownership stakes in businesses, which are all working to grow and compound their own earnings.
It becomes most apparent when you zoom out and look at the long term, where stock prices eventually catch up with a company’s financial success (or keep pace with it all along).
Where you’ll see successful stocks over the long term you’ll see successful businesses, and it’s by owning these companies over the long term that you can increase your chances of steady and compounding returns as your wealth grows alongside them.
- “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.”
This is a key part of investing that even Lynch admits in his book that be an obstacle to average investors. Lynch says that if you don’t enjoy learning about businesses, and can’t stand to sift through financial statements like a balance sheet, then don’t even think about owning individual stocks (in which case we’d recommend buying something like an index fund).
Luckily for today’s investor, there are a myriad of resources out there which can teach you how to look at a balance sheet and what metrics and ratios to learn in order to determine if a company is solvent.
You might be surprised to find out that balance sheets and parts of accounting are not rocket science, but it does take some work to understand how they work.
Yes, you can go super deep into the (endless) weeds with accounting and financial data, but as an average investor looking to get nice, compounding returns—a superficial knowledge of how a balance sheet works and the simple definitions of assets, liabilities, and equity—should get you most of the way there, at least when it comes to understanding the financial stability of a company.
Note: For those of you who are more advanced I’d highly recommend learning about the contractual obligations table and how that relates to company solvency in addition to the standard solvency metrics.
- “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. The average person can concentrate on a few good companies, while the fund manager is forced to diversify. By owning too many stocks, you lose this advantage of concentration. It only takes a handful of big winners to make a lifetime of investing worthwhile.”
I hope you don’t gloss over this statement, because it may be one of the most powerful ideas that you come across along your investment journey.
The simple math between the difference of -100% losses on the downside and (theoretically) unlimited gains on the upside makes for interesting dynamics in stock market returns.
What you’ll tend to see over time, which I touched on in my post about overdiversification, is a small group of stocks which contribute an overwhelming portion of the average returns from the stock market over different time periods.
When trying to “beat the street”, it could take just one or two of these outsized winners to propel your portfolio atop market averages, and it’s in these stock picks that you have to be vigilant in leaving them alone. Take a page from Peter Lynch’s book with this video on 10 baggers:
Peter Lynch has another saying, which Warren Buffett quoted in one of his annual letters, that selling your best stocks and selling your worst performing ones is like “pulling out the flowers and watering the weeds”, and it’s why you need to find a great winning business and just sit on it.
The overactivity on Wall Street tends to greatly hinder long term returns for the perpetrators who do it, and it all goes back to what we stated earlier—that the magic of the market is not outsmarting the tickers but rather being part owner of wonderful businesses that spit free cash flow as compounding machines.
- 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.
This is something I’ve written about before when I’ve said that the stock market cycles like the seasons, and that the greatest lessons during a bear market are that it is best to hold and that the storm will soon quickly pass.
If overactivity is the investor’s Achilles’ heel, then fear which causes selling overreactions is the thorn in the side of the heel.
Without a proper education on the true nature of markets, the average investor doesn’t stand a chance to earn the outsized returns that are available from long term stock holdings, which require patience and discipline in holding on during routine stock market declines, even though these tend to happen when the world seems to be on the verge of collapse.
While many investors try to time the market and believe they can sense when it’s time to stay out of the market, the reality is that a significant part of the gains in a bear-to-bull market come from single day rebounds. Missing even just one of these days could cause an investor to miss out on the entirety of returns that were similarly available to the investor that just held the entire time.
- “Time is on your side when you own shares of superior companies. You can afford to be patient—even if you missed Wal-Mart in the first five years, it was a great stock to own in the next give years. Time is against you when you own options.”
Keeping along the same lines of the theme of this post, it’s the combination of equity in a great business and the compounding effect over long periods of time which lead to the greatest returns for investors.
Basic principles like these can’t be ignored and must be respected.
What I love about this idea was that it wasn’t just Walmart who proved this concept out, but many other great businesses over the decades.
Probably the best example was Coca Cola, which Buffett bought in 1987. At the time the company was already the king of the United States, and was atop of the stock market for many decades even before Buffett purchased it.
The Coca Cola investment went on to be one of Buffett’s best performing stocks of all-time, paying his Berkshire Hathaway billions in dividends over the years.
It’s incredible how a great business can continue to capitalize on its outsized success and continue to compound capital and pay dividends for its shareholders for very long periods of time. This is particularly true when the company has a strong competitive moat, providing it a powerful franchise and/or pricing power to sustain growth with little reinvestment.
- “In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.”
If there’s one thing that investors of all stripes and styles can agree on, it’s the superiority of the stock market over bonds or money markets when looking at multi-decade time periods.
We can pore over countless statistics to confirm this point, but I really see it as the basics behind what each of those investment options represent.
Both money market and bonds deal with lending money, where the lender (investor) expects to receive interest (and principal) payments in the future in exchange for outlaying the money now.
Investors in stocks have a similar structure, but instead of guaranteed future payments the equity investor gets a part-ownership stake in a business, which represents a claim on the future profits of that business.
Since businesses in a free market economy have the power to grow in scale above the amount of money they borrow, the owners of businesses will outperform the lenders of monies, at least in the aggregate.
So if you have a diversified portfolio of stocks which have enough exposure to the growth of an economy as vibrant as the United States’, you’ll see those excess returns in your own portfolio.
Add in the compounding effect of those earnings, and you have a brilliant path to wealth which is accessible to anyone—which was the entire point of why the great book outlining Peter Lynch’s investment strategy was written by him in the first place.
For another in-depth breakdown of Peter Lynch’s strategy, with some of the specific metrics and stock picking filters he used in his decision making process, refer to this video: