An Investing Legend's Million-Dollar Insights: Part 2

This article is the second 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 in Fidelity's Magellan Fund. That stunning figure 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.

It's not easy to achieve such superb gains, of course, so this article series aims to uncover how Lynch applied 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 free 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.

How to invest in cyclicals
Peter Lynch found cyclical companies to be attractive investments. As sales and profits expand and contract over and over again in regular -- but nonetheless unpredictable -- fashion, catching the upswing in a share price could be profitable. For example, he talks about dazzling 17-fold and 50-fold price increases in vehicle manufacturer shares that he held through the 1980s.

But cyclical businesses tend to look attractive by conventional measures at precisely the wrong time. In contrast, they often look the most unattractive when we should be buying them.

According to Lynch, a low price-to-earnings ratio is a good thing for most shares, but not for cyclicals. When the P/E of a cyclical is low, it's usually a sign of the end of a prosperous period. Soon the company's earnings will decline quickly, and the share price will plummet.

For example, the recent financial record of InterContinental Hotels Group (LSE: IHG.L) illustrates its cyclicality:

Meanwhile, the share price plunged from around 1,400 pence in 2007 to about 450 pence in 2008. Since then, the price has recovered to 1,559 pence.

So when company earnings look the most tempting, the share price could be near its cyclical peak.

Lynch insight: Avoid, or sell, cyclicals when earnings are high and/or the P/E is low.

Conversely, a high P/E may be good for cyclical investing. It can mean that the company is already at its profit low-point, leaving greater scope for the business to improve.

Lynch insight: Buy cyclicals when earnings are low and the P/E is high.

Easier said than done
The problem for investors hoping to buy near cyclical bottoms is that a company's news flow usually trails the share-price reaction, making Lynch's advice hard to apply.

By the time InterContinental had released its worst financial results of the last recession during February 2010, the share price had already recovered more than 100% to around 1,000 pence as investors tried to anticipate the fact of the company's economic recovery. So the historical P/E was then very high, but the share price had already bolted!

To make the big returns, investors had to take a leap of faith and buy the plummeting shares with the extent of the financial carnage still unknown. Perplexingly, the P/E was 14 or so in 2007, too, so investors didn't see the credit crunch coming.

A game of anticipation
Lynch reckons that because playing cyclicals is a game of anticipation, it's hard to get right. But he did play the cyclicals and said his record was "moderately good."

Furthermore, he said the popular view that small growth shares were the major factor in his success was "wide of the mark." In fact, cyclical investing was a big part of what Peter Lynch did. Whenever there was a recession, he watched the cyclicals.

Lynch insight: Whenever there's a recession, pay attention to cyclical companies.

Be warned, though: Cyclical companies and sectors don't all move in lockstep. Lynch cautions that the key to successful cyclical investing is to know your industry cycle well. Right now, homebuilders such as Persimmon seem to be cycling up.

Commercial-property companies such as Capital Shopping Centres Group (LSE: CSCG.L), however, appear to be stuck, as the company's recent financial record shows:

As you can see, earnings are still flat.

Keep an eye on the exit
Just when it seems that things can't get any worse with cyclical companies, they begin to get better. But what goes around comes around, and the corollary is that just when it seems things can't get any better, they begin to get worse, according to Lynch. As soon as we buy a cyclical, we should be looking for signs that the cycle has peaked, such as high earnings and/or a low P/E; that's the time to get out.

Lynch cautions against unconditional loyalty to shares. He bought shares to sell them later, not to hold them indefinitely. Among the most frequently traded in his portfolio were those falling under the heading of "Cyclicals."

Lynch insight: Buy to sell later at a profit. Don't hold shares with unconditional loyalty.

In the next article, I'll look at how Peter Lynch turned one of his categories into a genuine moneymaking system.

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 "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, the report is free, so if you're an ambitious investor like me, you should download it today while it's still available.

You can read the third part of this series here.

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