How Peter Lynch Finds the Perfect Company

Peter Lynch -- perhaps the greatest mutual fund manager of all-time -- brought the concept of Value Investing to the masses with his books One Up On Wall Street and Beating the Street.

He wholeheartedly bought into Benjamin Graham's and Warren Buffett's strategy of value investing, and then further enhanced it by taking much of the mystery and formality out of investing and making regular people feel like they weren't too stupid to commandeer their own investing plan.

Like Graham and Buffett, he shunned both market timing and investing in companies that are difficult to understand. And Lynch placed tremendous emphasis on the importance of research in making the right buy-and-sell decisions. Bottom line: if you don't do your homework, you are not going to do well.

Lynch went on to give investors real tips for separating the winners from the losers by defining the "perfect" company:

It sounds dull - or, even better, ridiculous. In my career, I have made money on some of the most boring stocks you can imagine, and so did Lynch: Trucking, banks, REITs, paint manufacturers, even a lawn mower company. Or it may do something dull, or disagreeable. Maybe it cleans out septic systems, or disposes of biomedical wastes. Lynch's thinking was "bring it on." Those are often just the sort of companies that were his "ten baggers".

It's got a niche. I personally like to buy companies that are number 2-4 in market share in a specific, limited market.  At the same time, I like companies with room to grow by taking market share from competitors. Along those same lines, I like businesses with long legs, or products that people continue to have to buy. After all, we would all have a hard time doing without dish detergent, razor blades, and prescription drugs - all industries that have made fortunes for their investors.

It's a user of technology. Companies that maximize cutting-edge technology to make their organizations and products more efficient will always win out over those that refuse to get their heads out of the sand. Wal-Mart WMT was one of the perennial favorites of individual investors just for this reason. The company jumped leaps and bounds over its competitors when it forged ahead with its RFID inventory tracking system - before most of its peers had even heard of it!

The insiders are buyers - especially if they are buying consistently, and in large volume.

Lastly, Peter Lynch felt if the company was buying back shares, it may prove an interesting and profitable investment. Of course, for years now, many companies have used share repurchases as a ploy to increase their stock prices and drive EPS growth by reducing the share count, so investors must be careful in analyzing the underlying reasons for share buybacks.

Next, Lynch gave investors great advice on his stocks to avoid - at all costs:

The hottest stock in the hottest industry. If you are ever tempted, just remember the tech wreck at the turn of the millennium. He lumped the following topics into this same warning:

Beware the next something. See above.

Beware the whisper stock. See above.

Beware the stock with the exciting name. See above.

Avoid diworsefications (his word, not mine) . Lynch felt that too much diversification could just worsen your portfolio returns. And I agree. I once analyzed a portfolio for a customer who had 22 mutual funds, 12 of which invested in very similar industries and stocks. He was unwittingly paying fees on 8 too many funds, offsetting a lot of the gains he had made.

Beware the middleman -- those companies whose business depends largely on just a few customers. If they lose a big customer, it may send them into bankruptcy.

And, finally, Lynch told investors what so few financial advisors do: How to know when you should sell a company. His advice:

Sell if its fundamentals have deteriorated, if its price-earnings ratio goes too far beyond the normal range for the company (in either direction) , toward the end of the cycle with a cyclical stock, after a turnaround has been completed, at the end of the second phase of rapid growth, or (if you hold a stock you bought as an asset play) just wait for a raider to come in and pay you a premium.

Lynch retired early to spend more time with his family, but he left behind a reputation as the nation's #1 money manager and a track record of turning a $1,000 investment in 1977 in Magellan fund into $28,000 by 1990. Not bad for a guy who invests in dull, boring stocks, huh?