An Investing Legend's Million-Dollar Insights: Part 5

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This article is the fifth in a five-part series that documents the share-picking strategies of Peter Lynch, the Fidelity fund manager who enjoyed average annual returns of 29% for 13 years. Click here to see the series introduction, complete with links to the other articles in the series.

LONDON -- Between 1977 and 1990, Peter Lynch produced a 2,700% gain for investors in Fidelity's Magellan Fund. That stunning rate of return equates to a compound annual growth rate of around 29%. If you could replicate it, you'd need just 37,000 pounds to reach 1 million pounds in 13 years.

But such returns are not easy to achieve, of course, so this article series aims to uncover how Lynch applied the theory from his two books, One Up On Wall Street and Beating The Street, to crush the performance of his peers.


By the way, I also recommend reading this special Motley Fool report, "10 Steps To Making A Million In The Market," which outlines the types of shares that could really compound your portfolio. It has certainly inspired me to act! Best of all, the report is 100% free.

Betting on recovery
A great deal of Peter Lynch's success came from his categories of "Turnarounds" and "Asset Plays."

To Lynch, a potential turnaround company would be on its knees and in danger of going bust before it looked interesting. Such companies are no-growers and can crash-land from any of Lynch's other categories.

Lynch insight: Turnaround opportunities can crash-land from any category.

So why take the risk of investing in broken companies? Lynch reckoned that if you get your judgement right, turnaround shares can make up lost ground quickly. He cited the example of Chrysler, from which he enjoyed multibagging returns as it recovered from almost certain extinction in the 1980s.

I've enjoyed success with BP (ISE: BP.L) as it recovered from the Gulf of Mexico rig disaster and its shares moved from 300 pence to 500 pence. Since then, BP's shares have fallen back, and I think they still offer value.

At today's share price of around 430 pence, the firm trades on a forward P/E of about seven for 2013. Meanwhile, the forward dividend yield looks attractive at 5.4%.

Currently, many investors are hoping for a turnaround in some of London's banking shares. These are cyclicals that fell too hard, but some of the numbers are starting to look attractive.

For example, with its share price around 30 pence, Lloyds Banking (ISE: LLOY.L) trades on a forward P/E of 7.6 for 2013, thanks to an anticipated 91% resurgence in earnings. The forward dividend yield is expected to be 2.3%, and the value case is enhanced by an almost 50% discount to net tangible assets.

Lynch insight: Turnarounds can make up lost ground quickly.

In absolute dollars, Lynch made his greatest profits from large turnaround companies, so the category was a significant contributor to his outperformance. Yet despite his success, he offers a wealth warning: Many of his turnaround investments failed! It's a risky business for sure, but he reckoned that "the occasional major success makes the turnaround business exciting, and rewarding overall."

Lynch insight: Turnarounds don't always turn!

Underpinning assets
Finally, asset plays are companies with overlooked or undervalued assets such as cash, property, or equity. Depressed share prices tend to move asset values into focus, perhaps arising due to poor trading or other operational problems. Often, the best turnarounds are asset plays as well.

Lynch insight: Asset-backed turnarounds are attractive.

I've had success with Densitron Technologies.

When I bought some of its shares in December 2006 for 5.9 pence each, the group's net tangible asset value was about 9.7 pence per share. Yet even that figure looked understated due to undervalued property assets and investments owned by the company. The electronic-equipment firm had been unprofitable, but trading losses were decreasing. So Densitron became a combined turnaround and asset play.

Now the share price is about 10 pence, and the company returned 5 pence per share to investors when it sold its stake in a Taiwanese manufacturer, thus realizing value in some of its "hidden" assets. I'm currently showing a 154% capital profit plus an ordinary annual dividend yield of about 10% on the purchase price. These days, investors are attracted to Densitron for its growth.

The firm's financial record tells the story:

 

2007

2008

2009

2010

2011

Revenue (millions of pounds)

115

134

155

188

210

Earnings per Share (pence)

8.48

10.86

13.81

17.36

19.48

But the share price didn't get moving until 2010. As Peter Lynch points out, turnarounds and asset plays require patience.

Lynch insight: Turnarounds and asset plays require patience.

Fluid categories
Companies change categories, cautions Lynch. Densitron went from a turnaround/asset play to a fast grower. The trick is to monitor the company's progress so that buy, sell, and hold decisions remain timely.

Companies can change categories. Buy, sell, and hold accordingly.

There's also overlap between categories. I recently ran a share screen that looked for average earnings growth between 2% and 25%, embracing slow growers, stalwarts, fast growers, and everything in between. There were 357 companies on the list from the London stock market. So category definitions become blurred, and a strategy that works for one category may work for shares falling outside it.

What to do with losers
Finally, Peter Lynch said he had more losing shares than 10-baggers. He handled those by selling as soon as he realized his analysis was wrong -- even at a big loss -- and by never adding to a position with deteriorating fundamentals.

Never hold or add to a share with deteriorating fundamentals.

Fool on
That's the end of this five-part series aimed at uncovering how Peter Lynch's pragmatic and tested insights led to his peer-crushing outperformance in the stock market. I hope you've enjoyed reading it.

His strategy in investing his way to compound 29% returns have motivated me to use his insights -- and this report, "10 Steps To Making A Million In The Market" -- to propel my own portfolio to the magic seven-digit milestone! Just click here to start reading the report while it's still free and available. I'm convinced it won't disappoint you.

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The article An Investing Legend's Million-Dollar Insights: Part 5 originally appeared on Fool.com.

Kevin owns shares in BP and Densitron Technologies. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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