Peter's Principles: Lynch-Style Investing

04/13/2015 10:00 am EST

Focus: STOCKS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

John Reese is an investment expert focused on analyzing the strategies of stock market legends. Here, the editor of Validea turns his attention to famed fund manager Peter Lynch, discussing both Lynch's strategy and some favorite stocks that currently meet Lynch's investing criteria.

Steven Halpern:  Our special guest today is John Reese, editor of the leading investment newsletter, Validea.  How are you doing today, John?

John Reese: Very good, thanks, Steven.

Steven Halpern:  Well, thanks for joining us. To adjust stocks and develop a variety of portfolios, you analyze the strategies of many of the market’s most legendary investors, such as Warren Buffet and Ben Graff, and today we’re going to discuss your latest guru spotlight, which happened to be Peter Lynch.  For our listeners, could you provide us with background on Peter Lynch?

John Reese:  Well, choosing the greatest fund manager of all time was a tough task. Benjamin Graham, John Neff, John Templeton, there are a number of investors that put up the type of long-term track records that make it difficult to pick just one that was the greatest, but, if you had to pick one, I think a lot of people would agree with Peter Lynch.  

During his 13-year tenure as the head of Fidelity Investments’ Magellan Fund, Lynch produced a 29% average annual return, which is 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 his tenure, Magellan beat 99.5% of all other funds, and if those numbers aren’t impressive enough, try this one.  

If you’d invested $10,000 in the Magellan the day Lynch took the helm, you would’ve had $280,000 on the day he retired 13 years later.  

Steven Halpern:  Lynch was particularly well known for having developed the PE to growth ratio as a way to value stocks. Could you explain that?

John Reese: Yes. The PE to growth ratio—or the PEG ratio—divides the stocks priced at earnings ratio by its historical growth rate, and Lynch was known, or actually, pioneered in using this particular ratio. The theory behind it is relatively simple.  

The faster a company was growing, the more you should be willing to pay for its stock, so to Lynch, PEGs below 1.0 with signs of growth, stocks selling on the cheap, PEGs below 0.5, really indicated that a growth stock was a bargain.

And to show how the PEG can be more useful that the PE ratio, Lynch sited Wal-mart, America’s largest retailer. In his book One Up on Wall Street, he noted that Wal-mart’s PE was really below 20 during its three-decade rise.  

Its growth rate, however, was consistently in the 25% to 30% range, so generating huge profits with shareholders despite the PE ratio not being particularly low, so that also proved one of Lynch’s other tenants; that a good company can grow for decades before earnings level off.

Steven Halpern: And in that case—with Wal-mart—the PEG ratio, as you explained, would have been below 1, which would’ve suggested that Wal-mart might not have been overvalued during their long growth phase.

John Reese:  Exactly.  

Steven Halpern:  Interestingly, Lynch’s strategy allowed him to buy both fast growing and slow growing stocks, and if you go through those separately, could you explain how he approached those two types of investments?

John Reese: Yes, so, Lynch actually had three different categories that he regrouped stocks in, based up on their earning growth rate. The fast growers were his favorite and those were companies that were growing earnings at a rate of 20% to 50% per year compounded and—just as an aside—I would add that Lynch didn’t want to see growth rates above 50% because he didn’t believe that they were sustainable in the long-term.  

The second categories that he examined was what he called Stalwarts. So Stalwarts are large, steady firms that have multi-billion dollar sales and moderate growth rates which are between 10% and 20%.

Those are the firms you usually know well, like Wal-mart and IBM are current examples. And then slow growers are firms with higher sales that are growing at its annual EPS at a rate below 10% and often times they are dividend payers.

Steven Halpern:  So, he would be able to pick stocks from any of the categories in terms of selecting long-term investments?

John Reese:  Yes he would.

Steven Halpern:  In your overview of the Lynch strategy, you point out that he also included two bonus categories; one based on free cash flow and another based on net cash. Could you briefly tell us how these metrics play into the analysis?

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John Reese:  Lynch also liked to find companies with free cash flow to price ratio and the net cash to price ratio; so, he loved it when a stock had a high free cash flow to the price ratio greater than 35% or the net cash to the price ratio over 30%.

So, positive cash flow is; higher, the better, and can separate a wonderfully reliable investment from a shaky one, and where there is a high value for the net cash.

The price ratio dramatically cuts down on the risk of the security because it shows you the company that has lots of cash—minus the debt, of course, on the books—to weather the tough periods that could occur in the future.

Steven Halpern:  Now, when you analyze a strategy such as Peter Lynch’s, there is a lot involved in this, but for your newsletter subscribers, you do all the hard work by applying all of these screens and then coming up with some recommended stock ideas, so, perhaps you would be kind enough to walk us through a few examples of stocks that currently meet the Lynch-based criteria.

John Reese:  Sure, and I’ll just mention the Lynch model portfolio that I run on Validea has returned 11.2% annually since 2003, compared to 6.4% for the S&P 500 and year-to-date, in 2015, it’s up 5.5% versus just 0.4% for the S&P 500, so Lynch’s fundamentals do work very well for selecting stocks.

So, as of today, three stocks that are liked by the Lynch portfolio are Lannett (LCI), the pharmaceutical firm and that’s actually a Lynch-fast grower. It’s actually growing at the rate of about 47%, almost near Lynch’s top that he will permit.  

A second stock is IDT Corp. (IDT), an example of a slow grower, they’re in the telecommunications services area, and they are growing about 9.9%, so again, it falls just under the 10% threshold.

And then, finally, one example, Sanderson Farms (SAFM)—for the chickens—and this is an example of a Stalwart. They are growing about 19%, or so, compounded per year, so all three of these are liked by the Lynch’s portfolio right now.

Steven Halpern:  Finally, the last time we spoke you had just launched an ETF that was based on your investment guru strategy called the Market Legend’s ETF.  For our listeners who may have missed that, could you briefly update us on the fund and share your thoughts now that you have the experience with launching and managing an ETF?

John Reese:  Sure. For nearly 12 years, I have been running the Guru-based models, and in 2014, we made the decision to bring this investing system to the investor community via a new ETF call the Validea Market Legends ETF which trades under the ticker (VALX).  

The Market Legends ETF is an actively managed ETF that invests in the stocks selected using a proprietary investment system, which is based on my interpretation of the published investment strategies of the Wall Street legends.  

So far, the performance has been solid, and the assets continue to grow, as investors, both individual and professional, learn about the ETF and the investing system behind it.

The ETF structure is an excellent way to bring the strategies of the great investors like the Lynch-model that we just talked about to the market in an investable, liquid, transparent, and reasonably priced investment product, and not just that, but also turns out to be tax-efficient, so people can learn more about the ETF at our fund site.

Steven Halpern:  Well, congratulations on the launch of the fund and thank you for sharing your thoughts with us today.

John Reese:  Steven, thank you very much for having me.

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