Peter Lynch: How to Find THE BEST Stocks to Buy

You shouldn't be intimidated. Everyone can do well in the stock market. You have the skills, you have the intelligence. It doesn't require any education; all you have to have is patience. Do a little research; you've got it. Don't worry about it; don't panic.

In 1990, Peter Lynch retired as manager of Fidelity Magellan, the nation's largest stock mutual fund and one of the most successful. In thirteen years, he drove Magellan to a twenty-eight hundred percent gain. Quite simply, Lynch has been recognized as one of the greatest money managers ever. He beat the stock market for so long, not by timing the market, but by picking the right stocks. Of course, no one can promise you Peter's record, but you can learn a lot from him, and you don't need a billion-dollar portfolio to follow his rules.

Hi, my name is Peter Lynch. For 13 years, I managed Fidelity Magellan Fund. Those are 13 amazing years. Nine times, the market declined by 10% or more, and I was very consistent. All nine times Magellan Fund fell 10% or more, I learned a lot of lessons. I think they're true now; I think they were true 20 years ago, and I think they'll be true 20 years from now. I think I can help you do a better job of investing.

You can't learn years of stock-picking experience in one night, but you have better stock-picking skills than you realize, and you have advantages that no one on Wall Street has. In Stock Shop, I'm here to help you find them and use them. You may be wondering why stocks are so important for a long-term investment program. The short answer: over time, stocks produce better returns than other investments.

In the past 60 years, stocks have returned about 10% a year, bonds have averaged 6% a year, and treasury bills or bank CDs around 3%. That doesn't seem like a big difference, does it? But the power of compounding makes an enormous difference over time. Suppose you invest fifty dollars a month and earn 6%. After thirty years, you have over fifty thousand dollars. Go ahead and play with the numbers yourself. If you clicked on the assumptions button on the previous interactive screens, you noticed that the worksheets do not take taxes into account.

When your investment is taxed, the government reduces your return every year. If you know you won't need the money until retirement, you should place as much of your investments as possible into tax-deferred accounts like IRAs, KEOGHs, 401(k), or 403(b) plans because you don't pay taxes on the money until it is withdrawn from the accounts. The power of compounding achieves the maximum effect, providing you the best return possible. The more time you have to let your earnings compound, the better results you'll get.

A 20-year-old who invests $200 a month and earns 10% on his money all along left $1.1 million by the time he was 60. A 35-year-old would have to invest $800 a month to have the same $1.1 million at age 60. You're going to have a tough time getting that 10% return without at least some stocks in your portfolio.

Before you start to invest, ask yourself one question: when will I need to use this money? The stock market is a long-term investment. If you need to use the money anytime soon, you should not invest in stocks. This is money you're willing to put in the market and leave it there for 5, 10, 20, 30 years. That's the kind of money you can do well with. If you're worried about it, don't invest it.

The stock market is volatile; individual stocks are volatile. The average range for stock in a year is 50% between its highest and lowest. Stocks go up and down; the market goes up and down. If you're investing with a one or two-year time horizon, you shouldn't be in individual stocks. You shouldn't be in equity mutual funds.

If you've been lucky enough to save up lots of money to send your children to college and they're starting school in two years, what are you going to do if the market goes down? In the long term, 10, 15, 20 years or more, stocks have beaten bonds and bank certificates of deposits, but in the short term, there's no telling what will happen.

In 1987, the S&P 500 fell 33% from its August top to its October bottom. If you had the stomach to ride through that drop, you would have found that the S&P performance from 1987 through 1992 still outperformed treasury bills and long-term government bonds despite that decline. If you want to double your money quickly and safely, fold it in half and put it in your wallet.

Any other way, you're simply gambling. A good stock can take two, three, even five years before it really pays off. It's not two or three weeks; it's not two or three months. My best stocks have been in my fifth, sixth, seventh year. Give your investments time to grow.

Many people ask me when is the right time to sell a stock. Selling stocks is a matter of comparing stories. If story A is better than story B, then sell B and buy more A. If you own eight companies, you're playing eight simultaneous games of poker. So only stay in the games where you have the best chance of success. But remember that stories rarely change overnight; it may take years for a good one to be recognized by the market.

Give your good stories the time to grow. Your advantage in picking stocks is your direct experience with companies as a consumer, on your job as a professional, or as a neighbor. Use those advantages as a place to start looking for good stocks. You have several things that you possess that will make you a good investor; they're inherent to your life. It's the field you work in; it's the area where you live. There may be some local company that's terrific.

You're a consumer; you see some products, you see some services that are terrific. We bought a Volvo. It was better than the American station wagons. It was safer; the price was right. I did a little bit of research; I found that Volvo, the stock Swedish company, was selling equal to its cash. You're paying almost nothing for the company. They had lots of other divisions that were doing terrific.

Buying that car turned out to be a great way to begin researching the stock. Sometimes people take things for granted. My feel was the mutual fund industry in the early 1970s. The industry grew slowly, but then it took off in the 80s. Money piled into money market funds, to equity funds. Like an idiot, I missed stocks like Dreyfus, Pioneer, T. Rowe Price, Strategic Investments, Franklin Resources—there are lots of companies that went up dramatically. These are my own field; all I had to do was buy these things.

It was really dumb. Back in the 1950s, a fireman from New England noticed the factory in his town seemed to be hiring, expanding all of the time. This person didn't have a great computer, and he wasn't a professional investor. He was just an observant neighbor. He decided to put two thousand dollars per year into Tam Brands, then called Tam Pax. By 1972, the fireman was a millionaire just from using his local edge.

Investing is a personal thing—you have to do it by yourself. You don't do it with a committee. You have to be able to have the emotional strength to stand the volatility of the market in general and stocks in general. If the key organ here is not the brain, it's the stomach. Give the stomach for this; do you have the patience for it? You should be able to look in the mirror and say to myself, "What am I going to do if the market goes down?"

If you know something that will drive a company's earnings higher, you know something that will drive the company's stock higher sooner or later. But you can't just guess at it; you have to have some reasons, such as costs are coming down or a new product is going to be a big hit. Research is developing a company's story, an idea of why earnings should go up or down. It doesn't mean sitting in the library for hours reading SEC filings or fiddling with a calculator.

Research is exciting; it's very little math. When I owned Chrysler, it was the biggest position in my fund. When I was at a movie theater or at a sports event, I'd run into somebody driving a minivan. I'd ask them, "What do you think of the minivan? Would you buy another one? What do you like about it?" Some people would say, "Well, it's a little underpowered. They only have a four-cylinder engine."

I knew they were already working on a six-cylinder engine, so this is research. Research starts with the things you know—your edge. If you're a mechanic, look at the tools you use: which are the best, which are the best value? Or if you're a doctor, see what new technology saves the insurer money or software systems that reduce costs at hospitals. You probably already know a few companies quite thoroughly.

The amateur investor probably can follow between five and eight companies. They could lecture in these five or eight companies; they know them very well. There are ten to fifteen thousand public companies in the United States; there's lots more overseas. So you don't have to be experts on lots of companies; you just have to know a few very well. It's a lot of fun; it only takes a few hours a month. It's not a full-time job.

I owned Dunkin' Donuts for 12 years. I think I might have talked to them once every year. The story didn't change a lot. You don't have to worry about low-cost imports coming from Korea when you own a donut company. You don't have to worry about the economy; you don't have to worry about someone inventing a new computer chip. The story doesn't change that much.

McDonald's earnings have gone up, I think, more than 80-fold over the last 30 years. The stock's gone up 100-fold. What made McDonald's earnings continue to grow? If they just stuck with a cheap cheeseburger and a cheap hamburger at lunch, they probably would have run into earnings problems 10, 15 years ago. But they expanded their menu; they kept their costs low; they added breakfast; they went overseas.

Every day they add two or three more restaurants. People thought there was no room for more McDonald's 5, 10, 15 years ago; they were wrong. If they had done the research, they would have said, "Well, there's a couple hundred countries out there. There's lots of places to grow." Actual bad economic news, rising interest rates, wars, elections—any of these can push the market down.

If you're one of those people that pour over graphs, economic statistics, or astrology charts trying to figure out what the stock market is going to do next, you are wasting your time. No one can predict the market. You have to understand the market goes down. There's been 95 years this century; we've had 50 declines of over 10%.

Of those 50 declines, 15 have been 25% or more. So about once every two years, the market falls 10%. About once every six years, it falls 25%. These are big drops; you have to understand that that's the nature of the market. In 1990, Saddam Hussein went into Kuwait; the banking system was in trouble; we had a recession.

You had all this background noise; lots of good companies had nothing to do with wars, nothing to do with banking—they all went down. In 1990, the market fell from 3,000; it fell over 20%. This gave you a great opportunity to buy terrific companies at very good prices. Behind every stock is a company. If the company does terrific over a long period of time, the stock will do terrific. If the company does lousy, the stock's going to do lousy. That's all you're betting on.

This is a company that's had 35 years of double-digit earnings growth. Every single quarter, we've had changes in the Supreme Court, we've had the stock market go up and down, we've had changes in presidents, we've had recessions, we've had wars. All those things had no effect on Automatic Data Processing. So every time the market went down, it gave you a chance to buy it.

You're saying I believe strongly this company is going to do well. If you start to see symptoms that that's not going to happen, the stock's going to very rapidly respond to that. If the company runs out of steam, the stock's going to run out of steam. Look at Fannie Mae. From July through October 1990, the Standard Poor's 500 fell 21%. Fannie Mae fell from about $42 a share to about $26, even though earnings were still increasing.

This was a terrific time to buy Fannie Mae. The company was doing well; management was still great; the story was solid, and they had a very good business. But you got to buy the stock at a 38% discount. If you start by looking at the entire universe of stocks—more than 3,000 stocks on the New York Stock Exchange alone and over 13,000 public companies in total—you'll blow a gasket.

So I break stocks into categories, partly to make the job of researching more manageable. Putting stocks into categories is the first step in developing the story; at least you'll know what kind of story it's supposed to be. The category tells you what questions you should be asking about a company. You simply can't expect all stocks to behave the same.

Basing a strategy on general maxims like "sell when you double your money" or "sell when the price falls 10%" is absolute folly. No formula will apply to all stocks. Different stocks behave differently, so they require different approaches, different expectations, and different kinds of stories. Suppose you've made a 50% gain on two companies. One is a fast grower with a long way to go; the other is a big, lumbering, slow-growth company that has already saturated 95% of its market, and that market itself is growing slowly.

The 50% return is fantastic for the slow grower; the chances are it's time to sell it. The same 50% return could be just the tip of the iceberg for the fast grower.