Peter Lynch makes "Value Investing" a household word.

By Nancy Zambell, Contributing Editor

Last week, I wrote about the resurgence of "Value Investing" and discussed Warren Buffett's additions to Benjamin Graham's original thesis. This week, I would like to continue with Peter Lynch's expansion of the notion of value investing.

Peter Lynch — the longtime Fidelity Magellan fund manager — 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 Graham's and 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.

With his homespun stories of paying attention to your neighborhood and investigating the stocks of companies that you like and that seem to be doing well in your community — the Home Depots, the Wal-Marts, the Limiteds — Lynch enticed millions with the thought that individual investors could bring home what he likes to call "ten-baggers," or those stocks that return 10 times your investment. Then, he really took the wind out of the "quants" on Wall Street when he told investors that they learned all of the math they needed to make money in the stock market in the 4th grade!

Like Graham and Buffett, he also 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: iff 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. Or the rumors abound: "It's involved with toxic waste and/or the Mafia." Or, there's something depressing about it. Face it, not one of us wants to think about dying, but for years, funeral home companies made out like bandits in the stock market. Lynch's thinking was "bring it on." Those are often just the sort of companies that were his "ten baggers".

It's the undiscovered stock, or the company that is undercovered by Wall Street. In other words, the institutions don't own it and the analysts don't follow it. Most likely, the reason it's 'undiscovered' is that the company just doesn't need Wall Street's capital and is not yet an underwriting client for the big brokerage firms. And if that's the case, analysts usually don't bother with it. Yet, investors can make a killing, since often these are just the types of businesses that competitors buy at a premium price.

Sometimes Wall Street may not consider it because it's in a no-growth industry. Again, that may be the case, or it may operate in an industry that's not growing due to cyclical economic matters. At any rate, the company may be hidden from Wall Street but is ripe to be snapped up by a competitor, or just waiting on the next boom cycle to come into its own.

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 can be superior picks. 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.

And although in the last few years, spinoffs of solid companies haven't fared too well, Lynch was extremely successful investing in them. Once the market resumes a steady bullish pattern, they may again offer tremendous potential.

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 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. For more on this topic please see my article last week in Big Idea Investor.

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?

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


Disclaimer & Important Information

Financially Fit is owned and published by Business Financial Publishing, LLC of Washington D.C.  Business Financial Publishing is neither a registered investment adviser nor a broker/dealer.  Readers are advised that this electronic publication is issued solely for information purposes and should not to be construed as an offer to sell or the solicitation of an offer to buy any security.

The views expressed herein are based upon our analysis of the issuer's public disclosures, and assumes both their accuracy and completeness.

The opinions and statements included herein are based on sources (including the companies discussed and public sources) believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness. We have not independently verified the information contained herein. This information is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. We encourage you to consult with independent financial advisors with respect to any investment in the securities mentioned herein. You should review a complete information package on all companies, which should include, but not be limited to, the Company's annual report, quarterly reports, press releases and all regulatory filings. All information contained in Financially Fit should be independently verified with the subject company. The foregoing discussion contains  statements which are based on current expectations, estimates and projections, and differences from such expectations, estimates and projections can be expected.

Financially Fit is intended only for residents of the United States. Financially Fit is not for residents of the United Kingdom and is not an approved publication by the Financial Services Authority in the UK.

The information contained in this newsletter is not intended to be a complete discussion of information regarding all of the current and/or intended business activities of the covered companies. Any opinions expressed in Financially Fit are statements of judgment as of the date of publication, are subject to change without further notice, and may not necessarily be reprinted in future publications or elsewhere.

Business Financial Publishing and its members, managers, writers and employees do not accept compensation from the companies discussed within Financially Fit, nor any of our individual newsletter publications (Growth Report, Rising Star Stocks, Supernova Stocks).

Business Financial Publishing and its members, managers, writers and employees, and their families from time to time positions in the securities of the companies discussed within Financially Fit.  These positions are subject to change at any time without notice.