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Peter Lynch is widely regarded as one of the most successful mutual fund managers in US history. He ran Fidelity’s Magellan Fund from 1977 to 1990, delivering a 29.2% CAGR—more than double the S&P 500 benchmark. By the time he retired at 46, the fund’s assets had grown from a modest $18 million to $14 billion.

Lynch is also the author of the classic investing book One Up on Wall Street. A value investor at heart, he is credited with developing the GARP (Growth at a Reasonable Price) strategy and popularising the term “multibagger.”

Here are his six rules for spotting multi-bagger stocks, and how they can be applied in India.

Lynch was famous as a growth investor, but he never overpaid for growth. A PE of 40 was often too high for him. He mostly stuck to stocks with a trailing PE under 25.

If the market offered stories to justify high valuations, Lynch demanded evidence. Without it, he wouldn’t buy the stock—no matter how fast the company was growing in the short term.

Lesson for Indian investors: Dalal Street is full of high-growth stories, but not all are worth chasing. Always ask: How much am I paying for this growth? What is the stock’s PE?

While the trailing PE is a great tool, it’s calculated using the last 12 months earnings. But investors make money in the future.

So a valuation tool than accounts for expected growth is useful.

This is where the forward PE comes in. It’s the same thing as the regular PE ratio (stock price divided by the earnings per share) but here the earnings are the expected earnings over the next 12 months.

As long as your expectations of earnings growth are reasonable (neither too aggressive nor conservative) the forward PE can be a good guidepost for investors.

Lynch himself mostly bought stocks with a forward PE less than 15. This is because he did not want to overpay for expected growth.

High debt can kill any growth story. Lynch understood this well. He knew that every dollar that went to repaying debt was one less dollar that was reported as earnings. Higher the debt, greater is the pressure on the bottomline.

Lynch wasn’t anti-debt. He didn’t mind a company taking on debt to fund assets as long as those assets would generate revenues and profits in the future.

But he was cautious about evaluating such companies. He would critically analyse the expected growth in earnings to be delivered by the assets created by the debt.

How fast would the asset be created? How fast would the revenues scale up? How much profit could be reasonably expected? Would it move the needle meaningfully compared to the current profits?

And most importantly, what was the management’s plan to repay the debt?

If you incorporate these questions into your analysis, it will make you a much better investor.

Among the top metrics you consider before making an investment decision, the EPS growth percentage should be high on your list.

At the end of the day, a company’s share price follows the trend of the company’s profits. Thus, the profit (i.e. earnings) attributable to each share is perhaps the most critical thing investors look at.

And the growth of the earnings per share (EPS) on a yearly basis is at the heart of a good growth investing strategy.

For Peter Lynch, this percentage was a reasonable 15%. This is not a low number. In the short term, companies can deliver very high growth (40%+) but in the long term, it’s very difficult for any company to maintain a 15%+ growth rate.

If earnings growth is at the heart of growth investing, then is there a way to compare this growth rate to the stock’s valuations?

Yes, there is. It’s called the price to earnings growth (PEG) ratio. The PEG ratio divides the PE ratio with the company’s expected growth rate.

Keep growth expectations reasonable. Otherwise the PEG ratio won’t be reliable.

Peter Lynch typically invested in stocks with a PEG less than 1.2. He preferred a PEG less than 1. According to him a PEG less than 1 was ideal because he was paying only for an increase in the company’s growth rate and not the current growth rate.

This can be modified in the Indian context based on an investor’s comfort level.

The idea here is to invest only in established companies. These are companies that have overcome the early growth phase and are likely to be in a sustainable growth phase.

These companies are neither large-caps nor micro-caps. Lynch bought many stocks in the mid-cap and small-cap categories.

This allowed him to outperform the market even though his portfolio was massively diversified with over 100 stocks. Most retail investors won’t be able to track 100 stocks but they can implement this lesson, nonetheless.

Stick to stocks of a certain size. Don’t be tempted by microcaps just because they offer higher growth potent compared to bigger market-cap stocks.

Lynch consistently emphasized the paramount importance of thorough research and analysis before committing to any investment decisions.

Peter Lynch's investing strategy is unique, with a lot of common sense behind it. He believes in 'investing in what you know'.

In his book, One Up on Wall Street, he expounds on his investment philosophy, offering valuable guidance to retail investors on how they can effectively leverage their personal experiences and knowledge to make astute investment choices.

According to him, investors should invest in only those companies in which they understand the business model and fundamentals. They should closely scrutinise companies, their products or services, and their potential for growth.

You can get started with the Peter Lynch style of investing with the Equitymaster screener for the same - Peter Lynch Stocks in India.

Happy investing.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com

Disclaimer: This article is for educational purposes only. It is not a recommendation and should not be treated as such. Learn more about our recommendation services here...

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