In an article for this week’s Nasdaq, Validea CEO John Reese highlights the investment philosophy of guru Peter Lynch that centers on the importance of investing in what you know. “Hardly a pithy inside tip” writes Reese, “but very characteristic of the Lynch approach.”
Lynch generated one of the most impressive track records of all time during his tenure as manager of Fidelity’s Magellan Fund from 1977 to 1990. Reese outlines the concepts that form the foundation of his common-sense investment strategy, including how Lynch categorizes companies. He also describes one of the most important metrics in Lynch’s methodology, the P/E/G ratio, the ratio of a company’s price-earnings to its growth in earnings-per-share. Lynch felt that the P/E ratio alone wasn’t as helpful a gauge if not considered against the company’s growth. He believed that high price-earnings ratios by themselves weren’t necessarily bad as long as a company was growing at an appropriate pace.
Validea’s portfolio based on the Lynch investment strategy had an annualized return of 12.1% compared to 6.5% for the S&P 500 from mid-2003 through the end of 2016, and outperformed in nine out of the 14 years. Reese points out, however, that 2014 and 2015 were difficult years for the portfolio. “It’s important to understand the types of environments where the portfolio may struggle,” writes Reese, “and given the model’s all-cap make-up there will be periods, like in 2015, when the leadership in the market narrows, thus making it difficult for the portfolio to produce good returns.”