STOCKS

Peter Lynch is certainly one of the legends in the investment business, and if you look for stocks like him, you come up with some very interesting names observes John Reese in Validea.

Choosing the greatest fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff—a number of investors have put up the types of long-term track records that make it difficult to pick just one who was "The Greatest."

If you were to rank Peter Lynch at the top of the list, however, you'd probably find few would disagree with you. During his 13-year tenure as the head of Fidelity Investments' Magellan Fund, Lynch produced a 29.2% average annual return—nearly twice the 15.8% return that the S&P 500 posted during the same period. According to Barron's, over the last five years of Lynch's tenure, Magellan beat 99.5% of all other funds. If those numbers aren't impressive enough, try this one: If you'd invested $10,000 in Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.

Just like investors who entrusted him with their money, I, too, owe a special debt of gratitude to Lynch. When I was trying to find my way in the stock market many years ago, Lynch's book One Up On Wall Street was a big part of what put me on the right track. Lynch didn't use complicated schemes or highbrow financial language in giving investment advice; he focused on the basics, and his common sense approach and layman-friendly writing style resonated not only with me but with amateur and professional investors all over, as evidenced by its best-seller status. The wisdom of Lynch's approach so impressed me that I decided to try to computerize the method, the first step I took toward developing my Guru Strategy computer models.

One Size Doesn't Fit All

One aspect of Lynch's approach that makes it different from those of other gurus I follow is his practice of evaluating different categories of stocks with different variables. His favorite category, as I noted, was "fast-growers". These companies were growing earnings at a rate of 20 to 50% per year. (Lynch didn't want growth rates above 50%, because it was unlikely companies could sustain such high growth rates over the long term).

The other two main categories of stocks Lynch examined in his writings were "stalwarts" and "slow-growers". Stalwarts are large, steady firms that have multi-billion-dollar sales and moderate growth rates (between 10 and 20%). These are usually firms you know well—Wal-Mart and IBM are current examples of "stalwarts" based on that definition. Their size and stability usually make them good stocks to have if the market hits a downturn, so Lynch typically kept some of them in his portfolio.

"Slow-growers", meanwhile, are firms with higher sales that are growing EPS at an annual rate below 10%. These are the types of stocks you invest in primarily for their high dividend yields.

One way Lynch treated slow-growers and stalwarts differently from fast-growers involved the PEG ratio. Because slow-growers and stalwarts tend to offer strong dividend yields, Lynch adjusted their PEG calculations to include dividend yield. For example, consider a stock that is selling for $30, and has a P/E ratio of 10, EPS growth of 12%, and a 3% yield. To find the PEG, you'd divide the P/E (10) by the total of the growth rate and yield (12+3=15). That gives you 10/15=0.67, which, being under 1.0, indicates that the stock is indeed a good value.

Another difference: For slow-growers, Lynch wanted a high yield, and the model I base on his approach requires dividend yield to be higher than the S&P average and greater than 3%.

A Market-Beater

Over the long term my Lynch-inspired model has had its ups and downs, but if you've stuck with it, it's paid off. Since I started tracking it in July 2003, my Lynch-based 10-stock portfolio has averaged annualized returns of 6.2%, easily beating the 3.6% annualized return for the S&P 500 (all performance figures are through Dec. 30). The 20-stock Lynch-inspired portfolio I track has been one of my best performers, gaining 13.0% annualized over that period.

Here's a look at five stocks that currently make up my 10-stock Lynch-based portfolio:

Capella Education Company (CPLA)
Bridgepoint Education Inc. (BPI)
HomeStreet Inc. (HMST)
Finish Line Inc. (FINL)
AutoNavi Holdings Limited (AMAP)

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Tickers Mentioned: Tickers: CPLA, BPI, HMST, FINL, AMAP

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