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3 Essential Investment Rules from one of the Best Investors of All Time

David Goodboy

A long time ago, before the dawning of the big-mouth hedge fund kings and the popularity of self-directed investing, a quiet stock-picking genius was making millions for himself, his employer and his investors.

The former golf caddy was first hired by Fidelity Investments as an intern, but he quickly worked his way up the ranks. He would go on to manage a fund that exploded from $18 million to $14 billion with more than 1,000 different stock positions.

It grew to become one of the most popular mutual funds of all time, averaging an annual return of more than 29% from 1977 to 1990.

Fortunately, this fund manager was very open with his stock-picking maxims and opinions, authoring two books.

Who am I talking about? Peter Lynch. The wonder-fund was Magellan Fund (MUTF:FMAGX), and his books are "One Up On Wall Street" and "Beating The Street."

Although he retired in 1990 in pursuit of philanthropy, his investment wisdom remains relevant. I have distilled his wisdom to three easy-to-follow rules:

Only invest in what you understand
In his writings, Lynch credits his observations and conversations with friends and family for his stock-picking success. He believes that if you like a product, service or store, then it stands to reason that others will also, thus creating a successful business. Always look for strong needs in the marketplace and then find companies that fill the needs for investment. Every time you leave your home, keep your eyes open for new opportunities.

Research is essential
Investing in what you know and understand is only the first step in finding lucrative stocks. Understanding the fundamentals of a company is key. If the numbers don't make sense to you, Lynch says, don't invest. Here are the metrics he believes are most critical.

Percentage of sales
Be certain the item or service that first attracted you to the company makes up a significant portion of its sales. If it's a small percentage, be certain the other products and services of the company attract your interest as unique, new or different.

Price/earnings to growth
Peter Lynch is credited with popularizing this fundamental ratio. Also known as the PEG ratio, it measures whether a stock is overpriced based on its growth and forecasts.

If the PEG ratio is greater than one, then it suggests market expectations of growth are higher than the consensus estimate. It can also mean the stock is overvalued due to heightened demand for shares. If the PEG ratio is less than one, it means the market is underestimating growth and the stock is undervalued or the analyst's consensus estimates are set too low. When the PEG hits two or higher, it may mean future growth is already built into the stock price. It's important to note that the PEG ratio is best suited for non-dividend paying stocks, since it does not take dividend returns into consideration.

Strong cash position, little debt
If you are a Retirement Savings Stock investor or follow Carla Pasternak's High-Yield Investing, you already know the critical importance of a company having a strong cash position and little debt when it comes to being a consistent dividend payer. These same criteria are also a crucial part of Lynch's stock-picking toolkit.

Invest for the long haul
Lynch isn't a day trader or short-term investor. In fact, he is opposed to short-term thinking when it comes to the stock market. His famous quote: "Absent a lot of surprises, stocks are relatively predictable over 10-20 years, as to whether they are going to be higher or lower in two or three years, you might as well flip a coin to decide." When Lynch says long term, he means it.

Here's a stock that fits Lynch's stock-picking criteria:

Alliant Energy Corporation
Alliant Energy operates the Whispering Willow Wind Farm in Franklin County, Iowa. Alliant Energy Corporation (LNT) is a Wisconsin-based utility company serves a little less than 500,000 natural-gas customers and about 1 million electric customers. Most homeowners should be familiar with how this company works, satisfying Lynch's rule number one of investing in what you know.

A dividend-adjusted PEG ratio of 0.90 means it's undervalued. A 14% long-term growth rate, a price-to-earnings (P/E) ratio of 16.3 and a strong cash position make this stock perfect for a Peter Lynch-inspired portfolio. Include the added bonus of a nearly 4% dividend yield and the stock shines as a potential investment.

Risks to Consider: The stock market is full of unknowns. Even if a company fits the Peter Lynch criteria perfectly, there's no guarantee of profits. Anything can happen. Always position size properly and use stops when investing.

Action to Take --> Building a long-term portfolio based on Lynch's ideas is a time-proven investment method. I like Alliant Energy right now for a long-term, dividend-producing investment built on solid investment wisdom.

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