Peter Lynch Investing Screen: Searching For Undiscovered Growth Stories

In Brief

A “fast growers” screen which looks for consistently profitable, relatively unknown, low-debt, reasonably priced stocks with high, but not excessive, growth 

Background

Mr. 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 quot;buy what you knowquot; one. He suggested focusing on companies familiar to the investor, applying fundamental analysis which emphasises 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 quot;pantyhose rather than communications satellites,quot; and quot;motel chains rather than fibre opticsquot;.

He warns against diversification for diversification’s sake, particularly if it means less familiarity with the firms. Instead, one should to invest in whatever number of firms is large enough to allow you to fully research and understand each firm.

He suggests categorising a company by quot;storyquot; type, and he identifies six archetypes:

  • Slow Growers: Large / ageing 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 amp; Procter amp; 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.

The screen below focuses on the small, moderately fast-growing companies bought at a reasonable price, which Lynch tended to favour.

Does Lynch Investing Work?

Peter Lynch was arguably the most successful mutual fund investor ever. During the thirteen years that Lynch managed the Fidelity Magellan Fund (1977-1990), he racked up average annualized gains of close to +30%; nearly double the Samp;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 Samp;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 Samp;P 500 (and 16.7% since inception vs. 2.4% for the Samp;P 500).

Calculation / Definition

It’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 gt;= 15% but lt;= 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 lt; 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 lt;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 lt; 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 favoured.
  • Market cap less than $2 billion: Large, well-established companies can’t offer truly superior returns for investors. Small companies should be favoured as having more scope to become a 10-bagger.
  • Operating Margin 5-Year Average gt;= 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

Other factors: 

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 Stuff

The Price-Earnings Growth ratio above is not to be confused with the Price to Earnings to Growth (PEG) ratio which compares the PE with forecasted future growth.

Watch Out for

One micro-warning signal, particularly important for cyclicals (manufacturers amp; 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 quot;diworseifications.quot;
  • Companies in which one customer accounts for 25% to 50% of their sales.

In terms of knowing when to sell, he suggest reviewing holdings every few months, rechecking the company story to see if anything has changed. One should sell if the story has played out as expected or something in the story fails to unfold as expected or fundamentals deteriorate.

From the Source: 

His strategy is detailed in his best-selling book quot;One Up on Wall Street” which provides individual investors with numerous guidelines for implementing his approach. His most recent book, quot;Beating the Streetquot;” is more anecdotal, providing examples of his approach to specific companies and industries in which he has invested. 

Other Sources

  • 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 quot;Understandablequot; Stocks
  • Wikipedia on Peter Lynch

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