Due to the great financial crisis, most companies were undervalued based on their valuations. Based on backtesting results, the “Peter Lynch Growth with Lower Valuation” test portfolio took positions in Baxter International Inc. (BAX, Financial) and Abbott Laboratories (ABT, Financial), two medical companies that reached historically low price-earnings ratios. While these companies presented good value opportunities from 2007-2011, other medical companies provide better opportunities in 2016.
Brief introduction of Peter Lynch
Peter Lynch, manager of the Fidelity Magellan Fund, had a successful investing career. During the late 1900s, the Magellan Fund’s assets rose to about $14 billion, and Lynch realized an annual average return of 29%. The “greatest mutual fund manager of all time” realized these returns primarily by investing in companies that are undervalued based on its earnings. As discussed in the following webinar, Lynch categorized companies into six different groups, including fast growers, stalwarts and slow growers.
Backtesting Peter Lynch: an evaluation of various strategies
As discussed in the new feature announcement, backtesting allows you to compare which value strategies offer good portfolio returns. You can backtest the strategies with respect to five parameters, including rank by and rebalance frequency. Each of the parameters can affect the test portfolio and its performance relative to the Standard & Poor’s 500 index exchange-traded fund.
Based on the backtesting results, the growth with low valuation strategy slightly outperforms the stalwarts. On the other hand, fast growers generally offer weak returns: the fast grower strategy with no rebalancing severely underperforms the benchmark. Additionally, yearly rebalancing offers the strongest portfolio returns. As of Sept. 15, the backtesting resulted in the following portfolio returns.
| Strategy | Rebalance Frequency | Overall Performance | Rank | Ranked By |
| Growth with low valuation | Yearly | 238.57% | 1 | 10y Rev Growth ASC |
| Growth with low valuation | Semiannual | 145.82% | 3 | P/E ASC |
| Growth with low valuation | Quarterly | 123.73% | 6 | P/E DESC |
| Growth with low valuation | None | 117.42% | 7 | P/E DESC |
| Fast Growers | Yearly | 80.49% | 11 | N/A |
| Fast Growers | Semiannual | 111.25% | 9 | N/A |
| Fast Growers | Quarterly | 115.65% | 8 | N/A |
| Fast Growers | None | 17.51% | 12 | N/A |
| Stalwarts | Yearly | 164.84% | 2 | # of profit years DESC |
| Stalwarts | Semiannual | 128.26% | 5 | # of profit years DESC |
| Stalwarts | Quarterly | 141.79% | 4 | # of profit years DESC |
| Stalwarts | None | 81.85% | 10 | 10y Rev Growth DESC |
| S&P 500 Exchange-Traded Fund | 72.90% | Â | Â | |
The undervalued medical companies: then and now
The Peter Lynch Growth with lower valuation test portfolio bought Baxter in January 2012 and kept it throughout the past four years. The portfolio also held Abbott from 2006 to 2013, except for 2008. Both companies were undervalued based on their Peter Lynch earnings chart during this time period.
However, these two companies, especially Baxter, experienced weakening financial outlooks since 2013. As of September 2016, Baxter has several warning signs that suggest potential financial distress: contracting operating and gross margins, declining per share revenue, increasing debt and high price-to-sales ratios. The company’s current operating margin is near a 10-year low, and outperforms just 54% of companies in its industry. Additionally, Baxter’s three-year revenue growth and three-year EPS growth are -10.2% and -44%, respectively. The latter underperforms 92% of global medical instruments and supplies companies.
Although Abbott has expanding operating margins and high three-year EPS growth, the medical devices company is currently overvalued based on its Peter Lynch chart. The company’s per share revenue has decreased in the past five years: its current three-year revenue growth is near the industry median. As these companies experience declining profitability, gurus are trimming their positions: Daniel Loeb (Trades, Portfolio), who owns nearly 51.9 million shares, pared his Baxter position by 3.62%. Based on consensus picks data, 16 gurus have sold shares of Baxter during the past three months.
As of Sept. 16, the Peter Lynch growth with lower valuation screener listed 54 company stocks, including biotechnology company PDL BioPharma Inc. (PDLI, Financial) The company currently has a profitability rank of 9 out of 10, suggesting high growth potential. PDLI’s operating margin is 89.52%, which outperforms 99% of global biotech companies. The company’s operating margin sharply increased during 2006, and has ranged near 93% since 2012.
PDL BioPharma current stock price and price-to-book ratio are currently near a 10-year low, suggesting that the company stock has high value potential. The company is undervalued based on its Peter Lynch chart, its earnings power value and its Peter Lynch value. The margin of safety based on its earnings-based DCF valuation is 78.51%.
As the company has high upside potential, Jeremy Grantham (Trades, Portfolio) increased his PDL BioPharma position by 16.12% during the second quarter.
See Also
You can find good health care companies in at least two ways, one using the “screener method” and the other using the “guru idea method.” The All-in-One Screener allows you to find stocks using the former method, while Sector Picks and Consensus Picks allow you to find stocks using the latter method. GuruFocus also offers a Peter Lynch Screen that lists stocks that are undervalued based on their valuation ratios.
Disclosure: The author has no position in any of the stocks mentioned in this article.
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