Peter Lynch: 3 Investment Principles to Live By

Focusing on your core strategy may enhance your returns

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It is tempting to lose sight of your investment principles when stock prices have risen rapidly in a bull market. For instance, you may become engrossed in exaggerated earnings growth forecasts, or in the prospect of rising valuations due to improving investor sentiment.

However, taking the time to revisit basic investment principles that form the core of your value investing strategy could be a productive use of your time.

One investor who has benefitted from having a solid set of investment principles is Peter Lynch. His long-term outlook and value focus could help to explain his consistent outperformance of the stock market.

A long-term focus

The recent rapid rise in stock prices may encourage investors to seek a quick return on their capital. For instance, they may buy a stock on a short-term view ahead of a major event, such as company results, in the hope of benefitting from an improvement in investor sentiment.

However, in my view, a short-term view is speculation rather than investment. I think it is not possible to gauge how a stock will perform over the short run. Therefore, the end result of speculation is likely to be largely based on luck.

A better approach is to maintain a long-term view of your portfolio. This may allow you to capitalize on the stock market's strong overall growth rate that has seen it produce compounded annual returns of 10% in the past 50 years. It may also be a less risky strategy than speculating on short-term stock market movements.

Lynch has always been a long-term investor. As he once said, "Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide."

Balance sheet strength

Rising earnings growth rates may sound impressive to bullish investors at the moment, but an uncertain economic outlook means that considering the balance sheet strength of a business may be of greater importance to value investors.

For instance, companies with high debt levels or weak cash flow may struggle to maintain a rapid rise in profitability during a period of weaker economic growth. This may cause their valuations to suffer heavily and could cause poor investment returns.

Allocating your capital to companies with solid financial positions may mean that you miss out on a number of growth opportunities. However, it will also reduce your risk of loss and could protect your portfolio against severe declines during a potentially uncertain economic and political period.

As Lynch once said, "Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets."

Value investing

Stocks that offer high earnings growth forecasts have become more popular as the stock market has rallied since its March low. However, their high valuations may mean there is a narrow margin of safety available, which could lead to disappointing investment returns.

Therefore, persisting with a value investing approach may be a means of efficiently allocating your capital. It may not necessarily produce quick returns, as investors may continue to favor growth opportunities over value stocks in the short run. However, buying quality companies when they have wide margins of safety has been a means of obtaining consistently high returns in the past.

As Lynch once said, "My system for over 30 years has been this: When stocks are attractive, you buy them. Sure, they can go lower. I've bought stocks at $12 that went to $2, but then they later went to $30."

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