Stocks for a Peter Lynch Strategy

08/31/2017 2:54 am EST


John Reese

Founder and CEO, And Validea Capital Management

When Peter Lynch took over as manager of Fidelity's Magellan Fund in 1977, fund holdings totaled $20 million. When he retired in 1990, the fund had grown to $14 billion, a 700-fold increase, notes John Reese, editor of Validea.

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During Lynch's tenure from 1977 to 1990, the fund generated returns averaging 29.2% per year compared to the S&P 500's 15.8%, making Lynch something of a legend. When he retired in 1990, the fund had grown to $14 billion, a 700-fold increase.

In Peter Tanous's 1997 book Investment Gurus: A Road Map to Wealth from the World's Best Money Managers, he outlines an interview with Lynch in which the investing legend shares insights regarding his investing strategy and the factors he deems most important.

In the interview, Lynch commented, "It's about keeping an open mind and doing a lot of work. The more industries you look at, the more companies you look at, the more opportunity you have of finding something that's mispriced."

Lynch is celebrated in the investing world for his no-nonsense, common-sense approach-one that just about anyone can understand and implement.

His fund management track record represents one of the most impressive track records of all time, and his best-selling 1989 book One Up on Wall Street provides a road map of straightforward, easily-digestible investment advice geared toward the average investor.

In the interview with Tanous, Lynch shared his view that investors should roll up their sleeves and carefully analyze companies they are considering for investment. He said:

"I think that if you take my great stocks, and you ask a hundred people to visit them and spend a reasonable amount of time at it, 99 of them, assuming they had no prejudices and biases, would have bought those same stocks."

This is consistent with what we know of Lynch's approach. He believed that if you had some knowledge about a stock-for example, you bought and liked the company's products, its marketing, brand, etc.-you could have a leg up as an investor before professional investors might get to it.

That's not to say, however (and Lynch himself has clarified this) that if you like a product, you should run out and buy the company's stock.

Rather, this should be considered a good starting point, a reason to take interest in a company and put it on your research list. This is yet another example of his common-sense investment strategy.

Lynch broke stocks into different categories and applied a variety of fundamental quantitative tests depending on where a company fit. These categories were as follows:

Fast-growers: Companies that increased earnings at a rate of 20 percent or more per year while maintaining relatively low levels of debt;

Stalwarts: Large, prominent companies with annual sales in the multibillion dollar range that experienced 10 to 19 percent annual earnings growth;

Slow-growers: Large and aging companies that paid dividends and had single-digit earnings growth.

The one metric he applied to every category, however, was the P/E/G ratio, which Lynch created himself. This ratio compares a company's price-earnings ratio to the growth in its earnings-per-share.

He felt that the P/E ratio alone wasn't as helpful a gauge if not considered against the company's growth. High price-earnings ratios by themselves weren't necessarily bad as long as a company was growing at an appropriate pace.

The P/E/G ratio was one of the key metrics Lynch used to identify growth stocks that were selling at a good price-if it was under 1.0, Lynch was interested. If it was under 0.50, he was very interested.

Here's a look at some of the most recent stocks added to our Peter Lynch portfolio:

Assured Guaranty (AGO)
Delta Airlines (DAL)
Motorcar Parts of America (MPAA)
Sciclone Pharmaceuticals (SCLN)
Sun Life Financial (SLF)

Since its inception in 2003, Validea's P/E Growth Investor portfolio, inspired by the investment strategy of Peter Lynch, has returned 181.8%, outperforming the market by 34.2%. Even though our Lynch-based portfolio underperformed the S&P 500 in 2016 and year-to-date, it still generated returns of 6.7% and 6.5%, respectively.

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