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."

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