The Peter Lynch Approach

07/27/2015 9:00 am EST

Focus: STOCKS

Christian DeHaemer

Investment Director and Editor, Crisis and Opportunity

In the 1993 movie Philadelphia, a trial attorney asks his clients to explain his situation “as if I were a six-year-old.” Peter Lynch took the same approach to investing, explains Christian DeHaemer, editor of Energy and Capital.

Have you ever noticed that Wall Street is chockablock full of jargon and obfuscation? It may seem like it's all shuck and jive...and that's because it is.

If a stock or a market sector can't be understood in a few minutes, your first thought should be that there is something wrong. You know, Chipotle Mexican Grill (CMG) sells burritos and Apple (AAPL) sells iPhones. It's not hard.

If I always wait in line for a burrito, see people buying phones, or keep buying the same toothpaste, it could be a profitable place to invest. You could do a heck of a lot worse than reinvesting your dividend in JNJ.

The flip side also works. Back when Enron was a market darling, there were many people covering the stock, but it was impossible to tell what exactly the company did. It turns out it ran scams.

In the 1980s, Peter Lynch became one of the most famous investors in the world. He took the Fidelity Magellan mutual fund from $20 million in assets in 1977 to the largest mutual fund in the world with a 13.4% annualized growth rate.

Peter Lynch had one simple theory: He said individual investors had inherent advantages over large institutions because the big guys either wouldn't or couldn't invest in smaller-cap companies that have yet to receive attention from analysts or mutual funds.

His three basic tenets were: 1) Buy only what you understand; 2) Always do your homework; and 3) Invest for the long run.

Lynch said he got his ideas from walking through the grocery store or talking to friends and family.

If you think back over what people you know were buying over the past five years, you can easily pick the winners.

I'm sure you bought Keurig Green Mountain (GMCR) when every office you know ditched the coffee pot in favor of those little individual containers.

The second step is to do your homework. Make sure the company you are buying has more than 5% of sales in the product you know.

If General Motors (GM) makes all its money from financing, it doesn't matter what the new Corvette is like.

Further, look at the PEG ratio (or price over earnings growth). As a rule of thumb, a PEG under 1.0 is a good buy.

In other words, if a company has a P/E of 100 (high) but it is growing earnings at 200% a year, next year the P/E will be 50 at today's entry price. It's okay to pay up for growth.

Lynch also likes companies with a lot of cash and below-average debt-to-equity ratios. A strong balance sheet is good.

His third rule is to buy for the long-term. Lynch thought a three-year investment horizon was a coin flip.

If you are like me, you have long-term assets and short-term trading assets. The vast majority of my investments are for 20 years.

If you are looking to buy this next dip for the long run, you might want to look at a Peter Lynch screen.

I ran one and the top four were companies that benefit from falling oil prices. One company is Carnival Corporation (CCL). The company just announced it was going to start running cultural cruises to Cuba.

It has a trailing P/E of 16 and a trailing growth rate of 126.5%, which equals a PEG of 0.12. CCL will benefit from falling oil prices and more jobs.

The next three are all airlines. I've made money on Hawaiian Holdings (HA) in the past. It flies people and cargo from the West Coast to Hawaii. The company is expected to grow earnings this year at 84% and it has a PEG of 0.3.

Other airlines that make the top of the Peter Lynch screen are JetBlue (JBLU) and Southwest (LUV).

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