Learn from Peter Lynch but Don’t Think You Can Replicate Him

By Justin J. Carbonneau

In December, Barron’s had two good pieces on the legendary Fidelity fund manager, Peter Lynch. Packed with Lynch-isms about successful long-term investing, active stock picking and opportunities into today’s market, the articles got the attention of lots of investors, and rightfully so since Lynch was one of the most successful mutual fund managers ever, retired at the top of his game, and left a long lasting mark on a generation of investors with his “buy what you know” investing mantra.

I thought the articles offered a good opportunity to discuss two contrasting views. First, we’ll look at the Lynch’s “Growth-At-a-Reasonable-Price” stock selection model using a quantitative approach as we’ve captured it based on his book, One Up on Wall Street. We’ll also look at the other side of things and consider why replicating Lynch is nearly impossible.  

First, Follow the Rules

Lynch offered up the following piece of advice in the interview (Peter Lynch Draws on 50 Years of Stock-Picking to Find Growth Opportunities in Today’s Market):

If you’re going to invest, you have to follow certain rules …  Don’t invest in a company before you look at the financials. If you made it through fifth grade, you can handle the math.

The models on Validea are essentially fundamental, rules-based investing strategies built using the approaches of legendary investors and other approaches that have proven themselves over the long-term. These models offer investors a way to assess companies through a series of valuation and financial metrics. So we couldn’t agree more with the spirit of Lynch’s advice.

One of the unique parts of the Peter Lynch model as we’ve implemented it is that it analyzes companies differently based on their growth rate. Lynch categorized companies in three groups – Fast Growers, Slow Growers and Stalwarts. So depending on the historical earnings growth rate, companies were analyzed differently through various fundamental factors.  

PEG Ratio: A Shortcut to GARP stocks

Not only does the earnings growth rate help us apply a different set of fundamental criteria in the assessment of each company, but it’s also used as a key input in helping us determine if the stock is a “Growth-At-a-Reasonable-Price” type of security. By taking the stock’s Price-to-Earnings ratio (P/E) and dividing it by its growth rate, we are able gain an understanding of the value the market is putting on the underlying earnings growth. This is known as the PEG ratio, which Lynch helped popularize.

Here’s a quick example: if stock has a P/E of 20 and the company is growing earnings at 10%, the PEG is 2.0. Whereas a stock with a P/E of 20 and an earnings growth rate of 20% has a PEG of 1.0. A lower PEG is considered more favorable because the stock is trading at a more attractive valuation relative to its growth rate. This is a quick formula that is digestible for even the most novice investors. 

In the Barron’s piece, Master Stockpicker Peter Lynch: If You Only Invest in an Index, You’ll Never Beat It, Leslie Norton, the author of the piece, wrote the following about Lynch’s approach:

Lynch demystified investing. He emphasized searching for companies that could deliver earnings growth of 20% to 50%. He espoused the PEG ratio, a company’s price/earnings ratio divided by its long-term growth rate; a PEG of less than one means a stock is worth a closer look. He cautioned investors to watch inventory growth rates and debt-to-equity ratios, and to make sure that a company has enough cash to weather bad times.

Combining Things Together into One

That’s a good summary, but let’s break it down a little further. In the table below you will see the categories (i.e. Fast Grower) in the headings and the thresholds for each investment criteria being looked at. These are for non-financial companies (financials have a different set of criteria). This is Validea’s best interpretation of the model outlined in One Up on Wall Street.

Fast Grower

Stalwart

Slow Grower

Earnings Growth Rate (avg. 3, 4 & 5 year)

20% to 50%

10 to 19%

Less than 10%

PEG ratio

1.0 or less

n/a

n/a

Yield Adjusted PEG*

n/a

1.0 or less

1.0 or less

Change in Inventory-to-Sales

Year-over-year change in inventory-to-sales can’t be more than 5%.
Lower is better.

Total Debt-to-Equity

Total D/E can’t be higher than 80%.
Lower is better.

Free Cash Flow Per Year-to-Current Shar Price

35% or higher

Net Cash Per Share-to-Current Share Price

30% or higher

*to determine the Yield Adjusted PEG, add the dividend yield to the growth rate. For example, if a company has a 10% growth rate and 4% dividend, the growth rate for the Yield Adjusted PEG is 10%+ 4% = 14%.

Proof You Can’t Replicate Lynch

After the interview in Barron’s was published, popular bloggers, podcast hosts and teammates at Ritholtz Wealth Management, Ben Carlson and Michael Batnick, had an interesting discussion about Lynch on their Animal Spirits podcast. At one point in the conversation, Carlson voiced doubt that investors can emulate Lynch formulaically.

This may seem a bit strange coming from a firm that has built a business around capturing approaches espoused by Lynch and many others quantitatively, but I think Carlson makes a fair point. Let me explain why.  

In a paper and analysis done by AQR titled Superstar Investors, the authors looked at the performance characteristics of a handful of great investors – Warren Buffett, George Soros, Bill Gross and Peter Lynch. For Buffett, Soros and Gross, most of their returns can be explained due to the exposure to certain investment styles or factors (i.e. size, value, quality, momentum) for the periods analyzed. However, in Lynch’s case a large portion of his returns achieved while managing Fidelity Magellan couldn’t be explained by factor exposure.

The authors write …

Part of Magellan’s outperformance seems to be from taking more risk than the market, and harvesting small cap and momentum premiums. We also find some exposure to the value premium, but smaller in magnitude. … Finally, we note that Lynch’s impressive performance appears to have been in spite of negative exposure to the low-risk premium (unlike for Buffett, who harvested it) …However, despite the plethora of factors examined here, the headline from this analysis might be that Magellan still posted more than 8% “alpha” on average each year for 13 years.

But We Can Still Learn From Lynch & Others

The AQR study shows that you can’t deconstruct the returns Lynch achieved and tie them out to specific investment factors, and so therefore a model built using fundamental criteria, just like the one we run, won’t be able to replicate Lynch either. Like Carlson said in the podcast, Lynch was encyclopedic when it came to the companies he owned and the work involved with understanding those companies and industries was massive.

But I do think there are many things you can learn from Lynch and highly successful investors. There’s the big picture investing advice – take a long-term view when investing, being optimistic about the markets and our economy, not fretting over corrections and market volatility, having some simple rules and looking at the fundamentals as best you can. These are probably the things that matter most for the majority of investors. For others who still want to be involved in buying and selling individual stocks, Lynch also provided a fundamental framework and set of rules that can be applied in identifying those GARP-like stocks that appear to have the growth, valuation and other characteristics that may make them sound investments. Even if replicating Lynch’s performance is not achievable, there are still many lessons for investors in his timeless investing wisdom and strategy.



Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management. Social | Podcast | Interviews | Articles about Justin all in one place