“It’s always okay to own a stock of a good company for the long term that has a strong balance sheet, growing revenue and earnings, increasing free cash flow and efficient management.”
Peter Lynch based his success to investing principles on owning stocks of a good company. His overall strategy, based on a few core concepts, is surprisingly simple. A few of the most salient points are:
- Invest in what you know. Be very wary of complex investment stories and instead, prefer stocks that are readily understandable. With consumer spending driving two-thirds of the U.S. economy, products and services desired by most consumers would be good investments.
- Invest in companies with strong foundations. Companies with certain traits make them easier to buy and hold for the long run. On the business side, look for competitive advantages, such as high barriers to entry or efficient scale. Also, you should prefer stocks that have solid cash balances and conservative debt-to-equity ratios. “It’s hard to go backward if you have no debt,” Lynch once said.
- Focus on value. Invest in value stocks that trade at cheap valuations based on their price-to-earnings (P/E) ratio. But, also considered growth as part of the equation and thus don’t automatically reject a high-P/E stock at a reasonable price if it had a high growth rate. Covet strong companies that are undervalued because they operate in out-of-favor industries.
Lynch is famous for introducing price/earnings-to-growth (PEG), which factors growth into value. He also used a dividend-adjusted PEG ratio, since cash from dividends is part of the total-return equation.
Here are important financial ratios that are recommended that you utilize in your financial analysis of a company:
- Stock price
- Market cap
- Price to book value ratio
- Earnings per share
- Price to earnings ratio
- Net profit margin
- Debt to equity ratio
- Return on equity
- Dividend payout ratio
- Free cash flows
- Cash on hand balance
- Dividend yield
Lynch writes in his book, One Up on Wall Street: “In general, a P/E that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative.”
Furthermore, Peter Lynch liked:
- Strong players in out-of-favor industries and decent valuation
- Companies that generate recurring revenues and provide essential services;
- Businesses with a solid financial position and generate above-average profit margins.
- A solid, growing performer with relatively low net debt.
Research, patience and discipline
Overall, Lynch’s strategy looks for stocks trading at a reasonable price relative to earnings growth that also possess strong balance sheets. In short, nobody is born a great investor. Research, patience and discipline are what will eventually transform a novice investor into a seasoned stock picker.
References:
- https://www.kiplinger.com/slideshow/investing/t052-s001-10-stock-picks-with-peter-lynch-qualities/index.html
- https://www.fool.com/investing/2020/12/02/5-investing-tips-from-peter-lynch/