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Related Books The following books are available at MSN Shopping: Fire Your Stock Analyst by Harry Domash One Up on Wall Street and "Beating the Street" by Peter Lynch | ||||||||||||
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Recent articles by Harry Domash: • Earn 18% returns the easy way, 6/20/2004 • Watch out for companies that buy their growth, 4/25/2004 • A simple way to spot buys, 4/11/2004 More... |
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| How to invest like Peter Lynch | |||||||||||||||||||||||||||||||||||||||||||||||||||||
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The white-haired guru, now retired, made his mark by pursuing fast-growing companies that trade out of the limelight. This screen lets you emulate his legendary strategy. By Harry Domash When talk turns to market gurus, Peter Lynchs name usually pops up, and for good reason. His Fidelity Magellan fund (FMAGX) returned 29% on average, annually, during Lynchs 13 years at the helm. Lynchs stock-picking success didnt rely on secret formulas or magic indicators. He didnt buy stocks simply because they fit his mathematical criteria. Instead, he considered passing stocks as grist for further research. Once he identified a candidate, Lynch diligently learned as much as possible about its business, industry and future prospects. Lynch avoided hot, fast-growth industries, preferring instead to find an overlooked stock in a humdrum sector. Much like Warren Buffett, Lynch avoided industries that he didnt understand. Lynch revealed his stock-picking strategies in his book, One Up on Wall Street, published in 1989, shortly before he retired. That book became an instant best seller and is still in print. In 1993, Lynch followed up with a second book, Beating the Street. If youre going to read just one to glean his best ideas, choose One Up on Wall Street, because its stuffed with the specific rules that Lynch employed to qualify prospective stock candidates. "Beating the Street" is more anecdotal, discussing stocks that Lynch bought or should have bought. The only exception is the chapter on stocks in the savings and loan sector, one that Lynch didnt cover in his first book. There he gives specific guidelines for analyzing S&Ls, which these days, have morphed into regional banks. Lynch loves aggressive companies, big baggers In his books, Lynch divides stocks into six different categories including turnaround plays, cyclical stocks and asset plays. But he makes it clear that his favorite is a category he calls the fast growers. These are small, aggressive enterprises that grow (earnings) 20% to 25% a year.
Lynchs definition of fast growth is at the low end of the 20% to 40% numbers that you hear from most growth-stock mavens these days. Nevertheless, Lynch says that "if you choose wisely, this is the land of 10- to 40-baggers and even the 200-baggers. If you havent heard the expression before, a 10-bagger is a stock that increases 10 times in value. Out of the limelight and no red flags Heres a link to a screen I used to find stocks that Peter Lynch might like, based on my interpretation of his fast-grower strategy. It looks for consistently profitable, out-of-the-limelight, low-debt, reasonably priced stocks meeting his earnings growth requirements. The screen also checks for an inventory red flag that Lynch relied on to avoid risky bets. Since Lynch felt that earnings growth was a primary driver of stock prices, Ill start there. Fast . . . but not too fast. Although Lynch favors companies with a track record of fast earnings growth, he thinks that you can have too much of a good thing. Lynch's view: stocks growing earnings faster than 30% annually are risky bets. For starters, those high growth rates aren't sustainable, and worse, such companies attract hordes of competitors wanting to get in on the action. Companies showing historical average annual earnings growth in the 20% to 25% range are the best bets, and anything above 30% is verboten, under the Lynch strategy. I set my minimum allowable five-year average annual earnings growth at 20% and the maximum at 30%. I used 30% instead of 25% to increase the number of stocks turned up by the screen. Reduce the maximum to 25% if you want to stick to Lynchs ideal earnings growth range. More stock screens by Harry Domash
When I ran the screen, the 20% minimum was a tough hurdle for many stocks. For instance, I more than doubled the number of passing stocks when I reduced the minimum requirement to 10% five-year average annual growth. So try reducing the minimum to 15% if you dont get enough hits. Screening Parameter: Annual EPS Growth Rate >= 20 Screening Parameter: Annual EPS Growth Rate <= 30 Watch out for debt. Lynch prefers low-debt companies. In terms of debt/equity ratios, he cites 0.33 (25% debt vs. 75% equity) as normal for a corporation, and as far as he is concerned, the lower the better. In terms of an upper limit, he believes a debt/equity ratio of 4 reflects a weak balance sheet, but he doesn't say where he sets his upper limit. Since Lynch remains a little vague on this point, I arbitrarily set my maximum allowable debt/equity ratio at 1.0, which is well below his 4.0 weak balance sheet criterion. Try increasing the limit to 2.0 if you dont get enough hits. Screening Parameter: Debt to Equity Ratio <= 1 Reasonably priced: whats low and whats high? Lynch prefers low P/E stocks, but he bases his definition of high and low P/E on each stocks historical average annual earnings growth. For instance, he says that if a stock has a P/E of 15, youd expect the company to be growing at about 15% per year. Further, if the P/E ratio is less than the growth rate, you may have found yourself a bargain. Conversely, a stock with a P/E ratio twice the growth rate is an unattractive prospect and headed for a comedown, according to Lynch. Comparing the P/E to earnings growth sounds very much like the familiar PEG ratio, which also compares the P/E ratio to growth. But there are major differences. The PEG ratio that you see on most financial sites typically compares the forward P/E, which is the P/E based on this fiscal years forecast earnings, to analysts consensus long-term earnings growth forecasts. By contrast, Lynch has little use for earnings forecasts. Instead, he relies on historical results. Since forecasts tend to be optimistic, Lynchs P/E to growth comparison is a tougher standard than the PEG based on forecasts. Besides saying that P/E to growth ratios of 2 and above are too high, Lynch doesn't specify a maximum acceptable ratio. For my screen, I set the limit at 1.75. However, Lynch would probably advise going for lower ratio stocks if you can find them. MSN Money's screener doesnt have a predefined parameter for the historical P/E to growth ratio, but its easily constructed. Screening Parameter: Current P/E Ratio <= 1.75 * Annual EPS Growth Consistency is everything Boring is good. The Lynch approach places a premium on consistency. Instead of glamour stocks with volatile histories, he prefers boring companies that churn out consistent and growing profits year-after-year. Lynch measures profitability using pretax profit margins, which are profits before deducting income taxes. Theres no screening parameter that specifically gauges profit consistency. However, if a company is consistently profitable, its most recent and long-term pretax profit margins should be reasonably in sync. To measure that, I required that the five-year average pretax margin must be at least 50% of the latest margin. Screening Parameter: Pretax Margin: 5-year avg. >= 0.5 * Pre-Tax Margin Avoid glamour: Seek out the overlooked. Lynch tries to avoid the glamour stocks everyone else is buying in favor of stocks the rest of the market is ignoring. His view is that the best bargains can be found among these neglected stocks. Among other factors, Lynch uses institutional ownership to gauge market interest. As he puts it, If you find a stock with little or no institutional ownership, youve found a potential winner. Whats little or no ownership? Lynch doesn't say. Percentage institutional ownership is the percentage of outstanding shares that are owned by mutual funds, pension plans and other institutional investors. Most well-known stocks have at least 40% institutional ownership. I arbitrarily selected 35% as my maximum. Try moving that limit up or down if your screen turns up too few or too many stocks. Screening Parameter: Institutional Ownership <= 35 Watch out for an inventory red flag. Lynch says that when he researches a stock, he always checks to see if inventories are piling up. He says that, with a manufacturer or a retailer, an inventory buildup is usually a bad sign. When inventories grow faster than sales, its a red flag. The MSN Money Deluxe Screen's inventory turnover parameter compares changes in inventory levels to sales. Inventory turnover drops when inventories rise faster than sales, the condition Lynch described as a red flag. Heres how I used the inventory turnover parameter to rule out stocks with decreasing turnover over the past year. Screening Parameter: Inventory Turnover Decreased Not Since A few surprises from the Lynch screen The screen turned up 26 stocks when I ran it near the time of this column's publication. Seven of those were banks or other financial institutions such as moneylenders or investment trusts. Peter Lynchs rules as described here do not apply to financial stocks, so I eliminated them, leaving me with 19 candidates. The remaining hit parade covered a variety of industries and included many stocks that just dont come to mind in the growth stock context. For instance, who would expect to find Warren Buffetts mini-conglomerate Berkshire Hathaway
I have no idea how Peter Lynch would react to this list of stocks that I think he would like. But one thing's for certain: he wouldnt buy any of them without doing extensive due diligence and becoming thoroughly familiar with each. And neither should you. Harry Domash does not own or control any of the stocks turned up by the Peter Lynch screen. And he is pondering why. | |||||||||||||||||||||||||||||||||||||||||||||||||||||
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MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.