BackgroundMr. Lynch developed his investment philosophy at Fidelity and gained his considerable fame managing Fidelity's Magellan Fund. The fund was among the highest-ranking stock funds throughout Mr. Lynch's tenure, which began in 1977 at the fund's launching, and ended in 1990 when Mr. Lynch retired. His selection approach is strictly a bottom-up "buy what you know" one. He suggested focusing on companies familiar to the investor, applying fundamental analysis which emphasizes a thorough understanding of the company, its prospects, its competitive environment, and whether the stock can be purchased at a reasonable price. Lynch says he would rather invest in "pantyhose rather than communications satellites," and "motel chains rather than fiber optics".
He warns against diversification for diversification's sake, particularly if it means less familiarity with the firms. Instead, one should invest in whatever number of firms are large enough to allow you to fully research and understand each firm.
He suggests categorizing a company by "story" type, and he identifies six archetypes:
- Slow Growers: Large / aging companies growing only slightly faster than the economy as a whole, but often paying regular dividends.
- Stalwarts: Large companies that are still able to grow, with annual earnings growth rates of around 10% - 12% (e.g., Coca-Cola & Procter & Gamble).
- Fast-Growers: Small, aggressive new firms with annual earnings growth of 20% - 25% a year.
- Cyclicals: Companies in which sales and profits tend to rise and fall in somewhat predictable patterns based on the economic cycle (e.g., auto, airline and steel sector).
- Turnarounds: Companies that have either pulled themselves out of a serious slump, or got bailed by by the government
- Asset plays: Companies where the assets exceeds its market cap.
Does Lynch Investing Work?Peter Lynch was arguably the most successful mutual fund investor ever. During the 13 years that Lynch managed the Fidelity Magellan Fund (1977-1990), he racked up average annualized gains of close to +30%; nearly double the S&P 500’s +17.5% annualized performance over the same time period. At the time of Lynch’s retirement in 1990, the Magellan Fund was the largest mutual fund in the world (subsequently passed by Vanguard’s S&P 500 Index Fund). More recent AAII data suggests that, as at February 2011, the 10-year return for their sample Peter Lynch screen was 19.2% versus 0.7% for the S&P 500 (and 16.7% since inception vs. 2.4% for the S&P 500).
Calculation / DefinitionIt’s frankly impossible to come up with a screen that exactly replicates Lynch’s multi-faceted investing strategy. Nevertheless, the following approach seeks to emulate some of the key elements of his search for “fast growers”:
- Annual EPS Growth Rate >= 15% but<= 30%. Lynch felt that earnings growth was a primary driver of stock prices. However, he was wary of companies growing too quickly. Lynch’s view was that stocks growing earnings faster than 30% annually are risky bets. Those high growth rates aren’t sustainable, and such companies attract hordes of competitors wanting to get in on the action.
- Price-Earning Growth Ratio< 1.0: Lynch considers that the ratio of price-earnings divided by the sum of the historic earnings growth rate and dividend yield reveals bargains or overvaluations. Ratios above 1.0 are considered poor (or 2.0 if considering non-dividend paying stocks), while ratios below 0.5 are considered attractive.
- Institutional ownership<50%: Lynch was also wary of companies with too high a profile, arguing that one should look for undiscovered stories with a low institutional holding and few analysts.
- Total Debt / Total Equity< 25%. If debt levels are too high, then it often proves extremely difficult for managers to raise enough cash to keep expanding. And in the event of an economic slowdown, these firms should be in far better shape to weather any storms. Companies with high levels of net cash per share are particularly favored.
- Market cap less than $2 billion: Large, well-established companies can't offer truly superior returns for investors. Small companies should be favored as having more scope to become a 10-bagger.
- Operating Margin 5-Year Average >= 50% * Current Operating Margin. One should look for consistent profitability and should study the pattern of earnings, especially how they reacted during a recession.
- Price-Earnings: The price-earnings ratio is less than the industry’s median price-earnings ratio and less than the five-year average price-earnings ratio. Finding a good company is only half the battle in making a successful investment. Buying at a reasonable price is the other half.
- No Financials: Finally, Lynch mentions these rules do not apply to financial institutions, so those should not be included
Insider buying by a number of insiders is seen as a positive sign. If the company is buying back shares, this will support the stock price and probably indicates the company has been ignored, but that management is confident.
Geek StuffThe Price-Earnings Growth ratio above is not to be confused with the Price to Earnings to Growth (PEG) ratio which compares the P/E with forecasted future growth.
Watch out forOne micro-warning signal, particularly important for cyclicals (manufacturers & retailers) is if inventories that are building up. If they are growing faster than sales, that is seen as a red flag. On the other hand, if a company is depressed, the first evidence of a turnaround is when inventories start to be depleted.
In general, Lynch warns against:
- Hot stocks in hot industries.
- Companies (particularly small firms) with big plans that have not yet been proven.
- Profitable companies engaged in diversifying acquisitions. Lynch terms these "diworseifications."
- Companies in which one customer accounts for 25% to 50% of their sales.
From the Source:His strategy is detailed in his best-selling book "One Up on Wall Street” which provides individual investors with numerous guidelines for implementing his approach. His most recent book, "Beating the Street” is more anecdotal, providing examples of his approach to specific companies and industries in which he has invested.
- The Basics - How to invest like Peter Lynch
- Investing the Peter Lynch Way
- American Association of Individual Investors: Peter Lynch Screen
- The Peter Lynch Approach to Investing in "Understandable" Stocks
- Wikipedia on Peter Lynch