Peter Lynch is a legendary investor who achieved a 29% CAGR during his 13-year tenure at Fidelity’s Magellan fund. He bought thousands of stocks, and eventually got a reputation for never having met a stock he didn’t like.
But in reality Lynch didn’t like a lot of stocks, and he had a set of rules he lived by. These rules kept him on the straight and narrow and made him one of the world’s best fund managers of all time.
Never invest in a idea that you can’t illustrate with a crayon
Peter Lynch believed, just like Warren Buffett, that nobody should be investing in things they don’t understand fully. And the only way you know you can understand it fully, according to Lynch, is if you can illustrate it with a crayon.
When we’re investing in companies with our hard earned cash, it’s of paramount importance that we know what we’re investing in, and we know how the company we’re investing in makes its money.
If we don’t, then we’re putting ourselves at risk. Naturally, if you’re a tech veteran, then you’re going to have an edge in understanding new technologies and their importance in the economy. And if you’re a retail buyer, your expertise is going to be in brands and fashion. By utilising our edge and being able to draw the investment case, we give ourselves higher chances of success.
Never invest in a company without understanding its finances
Cash flow is everything. How a company manages its cash is more important than profit. What does the balance sheet look like? Is it backed by strong and sturdy assets like cold hard cash, or is it riddled with intangible assets?
What does the liabilities section look like? Is there a large loan that needs paying off in current assets or is it bank debt that matures several years away?
The financial statements are the most important part of any investment decision, and if you don’t understand these at a basic level you are putting yourself at risk.
Long shots almost always miss the mark
There’s a reason a horse is marked as 100/1. It’s because it’s not expected to win. But every now and again, the outsider wins – enough to keep the punters dreaming and coming back to give away all of their gains.
Story stocks are usually big on dreams but fall short in reality. They talk a good game, but the proof is never in the pudding – or in the financial statements. Don’t listen to what the directors say – look at what they have done for the company.
Lynch may have retired nearly 30 years ago now, but his advice remains as timeless as ever. By avoiding mistakes we give ourselves the best chances of success to compound our capital over the long term.
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Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.