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507-Great Investors: Peter Lynch
  Peter Lynch is one of the greatest money managers and most famous investors of
  all time. He drew acclaim for his success as the portfolio manager of Fidelity
  Magellan FMAGX, the mutual fund he ran from 1977 to 1990. When Lynch became
  Magellan's manager in 1977, the fund had $20 million in assets. Lynch's strong
  track record at Magellan drew investors at a rapid rate, and by 1983 the
  fund's assets topped $1 billion. During the 13 years Lynch ran the fund,
  Magellan outperformed the annual return of the S&P 500 stock index 11 years.
  Lynch achieved this performance even after Magellan was the nation's largest
  mutual fund with $13 billion in assets. The sheer size of Magellan was part of
  Lynch's aura. No one else had managed such a big fund with so much success.
  
  Despite his uncanny talent as a portfolio manager, Lynch's mantra is that
  average investors have an edge over Wall Street experts. He says that
  professional investors usually don't find a stock genuinely attractive until a
  number of large institutions have recognized its suitability and an equal
  number of respected Wall Street analysts have put it on the recommended list.
  This "Street lag" gives average investors many advantages, because they can
  find promising investments largely ahead of the professional investors. Lynch
  stated, "If you stay half-alert, you can pick the spectacular performers right
  from your place of business or out of the neighborhood shopping mall, and long
  before Wall Street discovers them." Therefore, individual investors can
  outperform the experts and the market in general by looking around for
  investment ideas in their everyday lives.
  
  Lynch's seminal book, One Up on Wall Street, articulates his investment
  philosophy. The Lynch stock-picking approach has several key principles:
  First, you should invest only in what you understand. Second, you should do
  your homework and research an investment thoroughly. Third, you should focus
  more on a company's fundamentals and not the market as a whole. Last, you
  should invest only for the long run and discard short-term market gyrations.
  If you adhere to the basic principles of this investment philosophy, Lynch
  believes that you will be well on your way to "beating the street."
  
  
  Stick to What You Know
  
  Investing in what you know about and understand is at the core of Lynch's
  stock-picking approach. This particular investment principle served Lynch very
  well in practice. Lynch invested only in industries he had a firm grasp on,
  such as the auto industry. That's what led him to Chrysler (today part of
  DaimlerChrysler DCX) back in the early 1980s. Chrysler was getting beat up by
  the competition and was near bankruptcy--it seemed the carmaker would never
  regain its footing. But after seeing prototypes of a new thing called a
  minivan, Lynch made Chrysler one of Magellan's top holdings. It paid off, and
  Chrysler more than tripled in price while Magellan owned it.
  
  Moreover, Lynch has pointed out that you will find your best investment ideas
  close to home. He claimed, "An amateur investor can pick tomorrow's big
  winners by paying attention to new developments at the workplace, the mall,
  the auto showrooms, the restaurants, or anywhere a promising new enterprise
  makes its debut." For example, Lynch said that after his wife raved over the
  fact that Hanes Co. (now owned by Sara Lee SLE) conveniently sold its L'eggs
  pantyhose in grocery stores, he figured the company was on to something good.
  His hunch was right. Hanes' stock rose sixfold while Magellan held it. Lynch's
  main point here is to look around you, because that's where you are most
  likely to find your winners.
  
  
  Do Your Research and Set Reasonable Expectations
  
  The second key principle in Lynch's investment philosophy is that you should
  do your homework and research the company thoroughly. Lynch remarked,
  "Investing without research is like playing stud poker and never looking at
  the cards." He recommends reading all prospectuses, quarterly reports (Form
  10-Q), and annual reports (Form 10-K) that companies are required to file with
  the Securities and Exchange Commission. If any pertinent information is
  unavailable in the annual report, Lynch says that you will be able to find it
  by asking your broker, calling the company, visiting the company, or doing
  some grassroots research, also known as "kicking the tires." After completing
  the research process, you should be familiar with the company's business and
  have developed some sense of its future potential.
  
  Once you have done your research on a company, Lynch believes that it is
  important to set some realistic expectations about each stock's potential. He
  usually ranks the companies by size and then places them into one of six
  categories: slow growers, stalwarts, fast growers, cyclicals, turnarounds, and
  asset plays.
  
  Slow Growers. Large and aging companies that are expected to grow slightly
  faster than the gross national product but generally pay a large and regular
  dividend. Lynch doesn't invest much in slow growers, because companies that
  aren't growing fast will not see rapid appreciation in their stock price.
  
  Stalwarts. Large companies that grow at a faster rate than slow growers, with
  annual earnings growth rates of about 10%-12%. Lynch believes that stalwarts
  offer sizable profits when you buy them cheap, but he doesn't expect to make
  more than a 30%-50% return on them.
  
  Fast Growers. Small, aggressive, new companies that grow at 20%-25% a year.
  These companies don't have to be in fast-growing industries per se, and Lynch
  favors those that are not. Lynch thinks that fast growers are the big winners
  in the stock market, but they also have a considerable amount of risk.
  
  Cyclicals. Companies whose sales and profits rise and fall in a regular
  fashion. Lynch states that cyclicals are the most misunderstood stocks, and
  they are often confused for stalwarts by inexperienced investors. Investing in
  cyclicals requires a keen sense of timing and the ability to detect the early
  signs in a cycle.
  
  Turnarounds. Companies that have been battered and depressed, and are often
  close to bankruptcy. Lynch notes that such "no growers" can make up lost
  ground very quickly, and their upswings are generally tied to the overall
  market.
  
  Asset Plays. Companies with valuable assets that Wall Street analysts have
  missed. While Lynch says that asset opportunities are everywhere, he points
  out that you will need a working knowledge of the company and a healthy dose
  of patience.
  
  
  Know the Fundamentals
  
  
  The third main principle of Lynch's stock-picking approach is to focus only on
  the company's fundamentals and not the market as a whole. Lynch doesn't
  believe in predicting markets, but he believes in buying great
  companies--especially companies that are undervalued and/or underappreciated.
  One might say Lynch advocates looking at companies one at a time using a
  "bottom up" approach rather trying to make difficult macroeconomic calls using
  a "top down" approach.
  
  Lynch believes that investors can separate good companies from mediocre ones
  by sticking to the fundamentals and combing through financial statements to
  find profitable firms with solid business models. He suggests looking at some
  of the following famous numbers, which happen to be many of the same numbers
  that stock analysts at Morningstar look for.
  
  Percent of Sales. If your interest in a company stems from a specific product,
  be sure to find out if it represents a meaningful percent of sales. It doesn't
  make sense to remain interested if this number is inconsequential.
  
  Year-Over-Year Earnings. Look for stability and consistency in year-over-year
  earnings. In the long run, a stock's earnings and price will move in tandem,
  so look for companies with earnings that consistently go up.
  
  Earnings Growth. Make sure a company's earnings growth reflects its true
  prospects. High levels of earnings growth are rarely sustainable, but high
  growth could be factored into a stock's price.
  
  The P/E Ratio (Lynch's favorite metric). Think of the P/E ratio as the number
  of years it will take the company to earn back your initial investment
  (assuming constant earnings). Keep in mind that slow growers will have low P/E
  ratios and fast growers high ones. It is particularly useful to look at a
  company's P/E ratio relative to its earnings growth rate (PEG ratio).
  Generally speaking, a P/E ratio that's half the growth rate is very
  attractive, and one that's twice the growth rate is very unattractive. Avoid
  excessively high P/E ratios and remember that P/E ratios are not comparable
  across industries. However, comparing a company's current P/E ratio with
  benchmarks such as its historical P/E average, industry P/E average, and the
  market's P/E can help you determine if the stock is cheap, fully valued, or
  overpriced.

  The Cash Position. Look for a company's cash position on the balance sheet. A
  strong cash position affords a company financial stability and can represent a
  built-in discount for investors in the stock.
  
  The Debt Factor. Check to see if the company has significant long-term debt on
  its balance sheet. If it does, this could be a considerable disadvantage when
  business is good (can't grow) or bad (can't pay the interest expense).
  
  Dividends. If you are interested in dividend-paying firms, look for those that
  have the ability to pay out dividends during recessions and a long track
  record of regularly raising dividends.
  
  Book Value. Remember that the stated book value often bears little
  relationship to the actual worth of the company, because it often understates
  or overstates reality by a large margin.
  
  Cash Flow. Always look for companies that throw off lots of free cash flow,
  which is the cash that's left over after normal capital spending.
  
  Inventories. Make sure that inventories are growing in line with sales. If
  inventories are piling up and sales stagnating, this could be an important red
  flag. Inventories are particularly important numbers for cyclical firms.
  
  Pension Plans. If a company has a pension plan, make sure that plan assets
  exceed vested benefit liabilities.
  
  
  Ignoring Mr. Market
  
  The last key principle of Lynch's investment philosophy is that you should
  only invest for the long run and discard short-term market gyrations. Lynch
  has said, "Absent a lot of surprises, stocks are relatively predictable over
  ten to twenty years. As to whether they're going to be higher or lower in two
  or three years, you might as well flip a coin to decide." It might seem
  surprising to hear Lynch make this argument, because portfolio managers are
  typically evaluated based on short-term performance metrics. Nonetheless,
  Lynch sticks with his philosophy, adding: "When it comes to the market, the
  important skill here is not listening, it's snoring. The trick is not to learn
  to trust your gut feelings, but rather to discipline yourself to ignore them.
  Stand by your stocks as long as the fundamental story has not changed."
  
  
  The Bottom Line
  
  Lynch firmly believes that average investors can beat Wall Street
  professionals. He recommends investing only in what you understand and doing
  your research. By finding great companies with strong fundamentals at bargain
  prices, he argues that you will have the next big winners in hand before the
  professional investors. Lynch encapsulated this point well when he said, "The
  basic story remains simple and never-ending. Stocks aren't lottery tickets.
  There's a company attached to every share. Companies do better or they do
  worse. If a company does worse than before, its stock will fall. If a company
  does better, its stock will rise. If you own good companies that continue to
  increase their earnings, you'll do well."