An Investing Legend's Million-Dollar Insights: Part 3

This article is the third 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% return for investors holding Fidelity's Magellan Fund. The performance equated to a compound annual growth rate of around 29%. If you could replicate those returns, you'd need just 37,000 pounds to reach 1 million pounds in 13 years.

It's not easy to achieve such superb gains, of course, so this article series aims to uncover how Lynch applied his tactics 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's certainly inspired me to act! Best of all, the report is 100% free.)

Steady companies
Peter Lynch said it was "wide of the mark" to think that small growth shares were the major factor in his success. So where did he make his money?

In the last two articles in this series, I examined how important cyclical companies were to his capital returns. But there was another category that featured highly in his portfolio, and that's the one he labeled "stalwarts." He defined a stalwart as a company with an average 10% to 12% annual growth in earnings.

So, in today's stock market, we are talking about companies such as accounting software supplier Sage (ISE: SGE.L) , which has averaged 11.8% earnings-per-share growth over the last four years. At the current 285 pence share price, you can pick up this stalwart on a forward P/E of 13 based on expected earnings growth of 11% for 2013.

Another is cigarette producer Imperial Tobacco (ISE: IMT.L) , with an average 11.3% earnings growth rate. This firm expects earnings growth of 7% in 2013, making the forward P/E 12 at the current share price of 2,509 pence.

Lynch's money-making system for stalwarts
According to Lynch, such stalwarts come with a wealth warning.

Although growing faster than slow-growing companies, stalwarts do not produce rocket-like share-price charts as fast-growers might. You're in the foothills with stalwarts, he reckons, and it can take a long time to double your money. In fact, it can take so long that the risk of ownership does not result in an advantage to the owner, who could have grown his money in safer ways.

There can be long periods when the share prices of stalwarts either decline or remain flat. Given that, Lynch reckons that if you are sitting on a 20% to 50% gain after a year or two, it could be time to think about selling. And that's exactly what he did in the Magellan fund, over and over again.

Buying undervalued stalwarts and selling them after a share-price gain of 20% to 50% became a money-making system for Lynch.

Lynch insight: Sellstalwarts to take profits on 20% to 50% gains.

There was no buy-and-hold forever philosophy in Lynch's approach to stalwarts.

When he bought a company's shares, he had an exit plan in mind right from the start. Lynch was buying the shares of stalwarts when value had emerged but before the share-price movement had acknowledged that value. Essentially, he was trying to catch an accelerating spurt when a share price caught up with the fundamentals.

If Lynch had continued to hold stalwarts over many years, his holding period would have included all the times when the share price stagnated, or declined, or moved up at a pedestrian pace, and that would have held back his annual returns.

Instead, Lynch was looking for compressed periods of accelerated share-price growth so he traded the shares. Peter Lynch traded shares with great regularity when it came to stalwarts.

Lynch insight: Trade stalwarts regularly according to their valuation.

Stalwart investing in action
Right now, I'm hoping for an uplift in supermarket chain Tesco's (ISE: TSCO.L) shares, which I bought when a profit warning knocked the price at the beginning of the year. The company's recent trading record looks like this:

Although average earnings growth of around 7.5% falls below Lynch's 10% indication for a stalwart, if Tesco gets its U.K. earnings back on track the share price could recover from the current 320 pence back to around 400 pence. If that happens, I'll sell.

When it came to the category of "slow growers," Lynch reckoned that the only reason for holding them would be for the dividend. As Magellan was a capital appreciation fund, he didn't hold many slow growers. Those that he did hold were for 20% to 50% capital gains, as for stalwarts.

In practice, that suggests that he applied his money-making system to any undervalued company growing earnings from, roughly, 2% through to 12% and beyond.

Peter Lynch knew that two or three gains like these on stalwarts and others had the same effect on his portfolio as doubling his money on just one share -- and he took full advantage of that fact.

In the next article, I'll look at the way Peter Lynch managed investments within the category for which his success is most well-known: the fast growers.

For now, though, let me just tell you that I'm 100% sold on how Peter Lynch invested his way to compound 29% returns. Indeed, I'm using his lessons -- plus the free "10 Steps To Making A Million In The Market" report that I mentioned earlier -- to help take my own portfolio to the magic seven-digit milestone!

As I say this report is free -- so if you're an ambitious investor like me, you should download it today while it's still available.

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The article An Investing Legend's Million-Dollar Insights: Part 3 originally appeared on Fool.com.

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