The Small-Cap Investing Handbook Part Five: Peter Lynch’s Rules

This is part five of a ten-part series on small-cap investing.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

 

For the other parts of this series please follow the links below:

So far in this series, I’ve looked at the academic research on small-cap investing but while academic research is always interesting, it’s no substitute for real-world experience. With that being the case, in the next few parts, I’m going to explore some tips, tricks, and experiences from the world’s most successful small-cap investors.

The Small-Cap Investing Handbook Part Five: Peter Lynch’s rules   

Peter Lynch is without a doubt the most successful small-cap investor to have ever lived. Anyone can generate 20%+ p.a. returns from small-caps for a few consecutive years but few have been able to establish a record similar to that of Lynch.

The Small-Cap Investing Handbook Part Five: Peter Lynch’s Rules

While managing the Fidelity Investments Magellen Fund, Lynch produced an average annual return for investors of 29.2% between 1977 and 1990, double the return of the S&P 500 over the same period, and catapulting the fund into the ranks of the best performing fund in the world. No doubt, if Lynch had continued to manage the fund throughout the 90s during the great dot-com bull run, the fund’s long term returns would be even more impressive.

As well as managing Magellen, Lynch also wrote several books on the topic of investing and these timeless investing books have really helped cement his reputation as one of history’s greatest investors. Within these books, Lynch made it extremely apparent that the average investor has what it takes to beat Wall Street at its own game and by following a few simple rules, investors could make money from small caps.

These 25 (26) Golden Rules Of Investing, are printed at the end of Lynch’s book, Beating the Street and no series on small-cap investing would be complete without them.

So, without further ado here are Peter Lynch’s 25 Golden Rules Of Investing:

  1. Investing is fun, exciting, and dangerous if you don’t do any work.
  1. Your investor’s edge is not something you get from Wall Street experts. It’s something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.
  1. Over the past three decades, the stock market has come to be dominated by a herd of professional investors. Contrary to popular belief, this makes it easier for the amateur investor. You can beat the market by ignoring the herd.
  1. Behind every stock is a company, find out what it’s doing.
  1. Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.
  1. You have to know what you own, and why you own it. “This baby is a cinch to go up!” doesn’t count.
  1. Long shots almost always miss the mark.
  1. Owning stocks is like having children – don’t get involved with more than you can handle. The part-time stock picker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don’t have to be more than 5 companies in the portfolio at any time.
  1. If you can’t find any companies that you think are attractive, put your money into the bank until you discover some.
  1. Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets. Always look at the balance sheet to see if a company is solvent before you risk your money on it.
  1. Avoid hot stocks in hot industries. Great companies in cold, no growth industries are consistent big winners.
  1. With small companies, you’re better off to wait until they turn a profit before you invest.
  1. If you’re thinking about investing in a troubled industry, buy the companies with staying power. Also, wait for the industry to show signs of revival. Buggy whips and radio tubes were troubled industries that never came back.
  1. If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over time if you’re patient. The average person can concentrate on a few good companies, while the fund manager is forced to diversify. By owning too many stocks, you lose this advantage of concentration. It only takes a handful of big winners to make a lifetime of investing worthwhile.
  1. In every industry and every region of the country, the observant amateur can find great growth companies long before the professionals have discovered them.
  1. A stock-market decline is as routine as a January blizzard in Colorado. If you’re prepared, it can’t hurt you. A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.
  1. Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether.
  1. There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.
  1. Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.
  1. If you study 10 companies, you’ll find 1 for which the story is better than expected. If you study 50, you’ll find 5. There are always pleasant surprises to be found in the stock market – companies whose achievements are being overlooked on Wall Street.
  1. If you don’t study any companies, you’ll have the same success buying stocks as you do in a poker game if you bet without looking at your cards.
  1. Time is on your side when you own shares of superior companies. You can afford to be patient – even if you missed Wal-Mart in the first five years, it was a great stock to own in the next five years. Time is against you when you own options.
  1. If you have the stomach for stocks, but neither the time nor the inclination to do the homework, invest in equity mutual funds. Here, it’s a good idea to diversify. You should own a few different kinds of funds, with managers who pursue different styles of investing: growth, value, small companies, large companies, etc. Investing in six of the same kind of fund is not diversification.
  1. The capital gains tax penalizes investors who do too much switching from one mutual fund to another. If you’ve invested in one fund or several funds that have done well, don’t abandon them capriciously. Stick with them.
  1. Among the major markets of the world, the U.S. market ranks eighth in total return over the past decade. You can take advantage of the faster-growing economies by investing some of your assets in an overseas fund with a good record.
  1. In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.

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