Peter Lynch’s Top 7 Tips for Investing in Small Cap Stocks

Small Cap StocksPeter Lynch and Small Cap Stocks 

To be the best, you have to learn from the best—or so the saying goes. Apply that to the stock market and it makes sense why people love to follow billionaire ace investors like Mark Cuban or Warren Buffett. Peter Lynch is one of those revered—if perhaps lesser known by the general public—investors who made a name for themselves as true visionaries on the stock market. The Peter Lynch net worth, after all, speaks for itself. And investing in small cap stocks are the perfect tickers on which to apply his philosophy.

Lynch is famous for a number of grand achievements in the investing world, which we’ll examine in this piece, but we’ll also tackle how we can apply that strategy towards investing in small cap companies.

Lynch made a name for himself when he ran the Fidelity Magellan Fund (MUTF:FMAGX) from 1977 to 1990. While he was managing the fund, Lynch came up with a 29.2% annual return, which was nearly twice that of the 15.8% return of the S&P 500 over the same time period. Just to show you the efficacy of the strategy used for Peter Lynch investments, if you had invested $10,000 in Magellan the day Lynch took over, you would have made $280,000 on the day he retired 13 years later. (Source: “Validea’s Guru Investor Blog,” Validea, September 18, 2009.)

While there are no longer any Peter Lynch investments directly made by the man himself, or at least not for clients, that doesn’t mean we can’t study his philosophy and figure out just what he might have invested in.

Peter Lynch Stock Tips 

You’ll hear a lot about who the greatest investor of all time is, and a lot of the same old names get bandied about. Warren Buffett vs Peter Lynch, for instance, is a fun match-up that finance geeks will debate over for a good long while. But the ironic thing is that they share some of the same fundamental thinking in their investment philosophies.

Invest in What You Know

The Peter Lynch strategy is, at its core, very simple. While he’s released a good number of tips and a couple of books on the ins and outs of stock market investing, one of his everlasting strategies is pretty much just common sense: invest in what you know.

The basic tenet here is that you should know what a company does before you give it money. After all, if a stranger on the street offered you a great way to see massive returns on an investment, you wouldn’t just hand over your money. Because no matter what the stranger says, you know nothing about him to justify lending him your hard-earned cash.

The same goes for investments. If you can’t understand a company or don’t know its balance sheet, stay away. For Peter Lynch stocks, the key is to find a company that you have a good bit of knowledge of, have researched, and if possible, one you like. Because, after all, if you like the product, there’s a good chance many other people do as well.

Invest in Growth 

Peter Lynch stocks are also ones that are high on growth.

Lynch is known for popularizing his P/E/Growth ratio. This equation divides a stock’s price-earnings ratio by its historical growth rate, giving you a number that shows how much you’re paying for growth. Essentially, the lower the PEG number, the better the value of the stock.

And that’s where small-cap stocks come in.

Remember that small cap stocks (usually defined as companies with market caps between $300.0 million and $2.0 billion) are usually prone to higher growth, and therefore perform well in the PEG equation.

But Avoid Unsustainable Growth Rates

There’s a limit to how high the growth should be for the best Peter Lynch investments. While 80% returns are fantastic, they are ultimately unsustainable. Which brings us to another another stock tip: Find companies that are profitable and have sustainable growth moving forward. This means companies that are showing 20%-50% returns, although closer to 25% is considered the sweet spot.

Building on the avoidance of enticing yet unstable growth rates, Lynch also advises not to be passive but instead be ready to shift investments around if need be.

Avoid Long Shots

While investors are constantly looking to get in on the ground floor of some industry or company about to hit it big, these are long shots that an investor is sometimes better off avoiding.

Like What You Buy 

The Peter Lynch strategy dictates that if you see a stock you like, get it. Sure, you can agonize over when the market will dip, when the correction will hit, or what the best time to buy is, but a core principle in this philosophy is that predicting a stock’s outlook for years using economic forecasts, market outlooks, or analyst predictions is an exercise in futility. Ultimately, you can tell if a good company will do well over the long term, barring unforeseen circumstances. But in the short term? It’s nearly impossible to know what’s going to happen in the next year or two.

Invest Long Term

This means that Peter Lynch stocks are generally meant to be held for the long haul.

Lynch is also not a fan of shorting, saying in an interview with Charlie Rose on Bloomberg, “When you’re short, you can only make 90%; when you’re long, you can make tenfold.” (Source: “Peter Lynch Journeys From Funds to Philanthropy,” Bloomberg, December 5, 2013.)
A more detailed look at the Peter Lynch strategy can be found in his books, One Up on Wall Street and Beating the Street.

Peter Lynch Stock Picks

Having established what Peter Lynch likes and doesn’t like about a stock, how can investors apply the Peter Lynch strategy to small cap stocks?

Well, it’s pretty simple: look for growth, balanced budgets, and simplicity.

One of my favorite quotes by the billionaire investor is also one of his most pithy.

Go for a business that any idiot can run – because sooner or later, any idiot is probably going to run it. (Source: “The Greatest Investors: Peter Lynch,” Investopedia, last accessed May 17, 2017.)

The through line in almost all the advice that Lynch dishes out is that you want something you understand, that shows growth, that is simple, and something that shows signs of a long-term and healthy company moving forward.

In small-cap stocks, that can be difficult at times to achieve. After all, there’s a reason these stocks are as small as they are. They can also be difficult to fit in with his buy-and-hold philosophy of finding sustainable growth rates without getting overtaken by hype and long shots.

But that doesn’t mean that an investor can’t take advantage of his advice. In fact, some of his most famous tips have to do with beating the market by investing in companies that Wall Street undervalues or overlooks. This last tip is one that applies especially to small stock companies.

The thinking here being that hedge fund managers and bigger investors are looking at many different companies. They are actually limited in investing in smaller stock companies and have to invest in different stocks as opposed to a single person.

As an individual, you can research several companies that you think have the ability to make have strong returns for years. You can look at the companies and know more about them than hedge fund managers can, because their job demands a different outlook on the market than you have.

It’s perfectly acceptable to have only a handful of companies in your portfolio, so long as you know them and you believe in them and their growth rate is strong.

Small cap stocks offer a great way for smaller investors to take advantage of the market and find ways around the billion-dollar competition that larger companies draw.

Creating the Peter Lynch Portfolio

Putting it all together, what’s the best strategy for applying the Peter Lynch strategy for investing in small cap stocks?

Much like the philosophy itself, it’s not all that complicated.

Do your research and due diligence. Find a company that is strong and stable. Find one that you expect to show growth rates in the 25% range for years to come, and one that the market has undervalued. Find a company in an industry that you like, and one that you figure will be prominent for years to come. And play for the future, not for the short-term gains. We’re not looking for Hail Mary 80-yard throws here—we’re instead more interested in five-yard rushes. Over the years, it will well outpace that long-bomb throw with far less risk.

Lynch’s accomplishments exist because he took his own advice and was able to create unparalleled sustained growth for years, a feat that most fund managers only dream of. That consistency is born out of a well-thought-out strategy that allowed him to take advantage of the oversights in the market as well not be handcuffed by projections and over-thinking.

In the end, the strategy is elegant in its simplicity. It’s what we all know instinctively about the market, but we let an overload of numbers and theories cloud our judgement. And what we know is this: There are good companies on the market and bad ones. Good ones will have strong stock growth for many years. Bad companies can have strong stock growth for a few years, but will always eventually crumble under the weight of their failings.

The key for investors here, then, would be to invest in the good companies—it’s that simple.